The rule of 3 - Know this equation and scale infinitely

“First time founders are obsessed with product. Second time founders are obsessed with distribution” - Justin Khan

Justin Khan, the founder of Twitch, which was acquired by Amazon for $970M in 2014, had a saying that became popularized within the startup ecosystem.

"First time founders are obsessed with product. Second time founders are obsessed with distribution."

While it's not foolproof - Justins’ second company Atrium raised $75M before shutting down - the reasoning of Khan’s statement rings true.

Building a great product is hard, but getting that product into the hands of customers in a uniquely profitable manner is often overlooked. 

Luckily, there are frameworks you can use to help you understand early in a startup’s lifecycle if the product or idea has a real chance of success.

I’m referring to unit economics. If a startup's unit economics are strong, they have a much higher chance of success.

Let’s dig in!

Unit Economics Described:

To put it simply, unit economics is a measure of a startup's costs and revenues on a per-unit basis.

Meaning it costs a company $X to acquire a customer and that customer will spend $Y each month, for Z months.

Some founders know this and will highlight it clearly within their fundraising deck, but there are many other (aspiring AND existing) founders who have no clue what it means. 

This method makes it easier for investors to forecast important data such as gross margins and break-even points. You’ll be able to create sturdy predictions about how a startup might grow and what the best paths to distribution could be.

Let’s Start Crunching Numbers

There are two main concepts that can help you calculate positive unit economics: Customer Acquisition Cost (CAC) and Lifetime Value (LTV). 

These variables are used in tandem to determine the potential for overall business profitability at scale, but first, let’s look at each one independently.

Concept 1: Customer Acquisition Cost (CAC) 

CAC measures the amount of money needed to acquire a single customer. While the calculation itself is simple, it requires you to closely track a customer’s journey. 

Here’s the formula → Total costs of sales and marketing / Number of customers acquired = CAC

I like to use the coffee shop example because who doesn’t like coffee? 

Let’s say in any given year, a coffee shop owner spends $50,000 to acquire 1,000 customers. 

$50,000 / 1,000 = $50 per customer 

That means they spend $50 to acquire each customer. 

Simple enough, right?

A startup should know their CAC for each acquisition method (e.g SEO, Content, Paid Media Acquisition, Outbound, Partnerships).

Okay, moving on to the second method. 

Concept 2: Lifetime Value (LTV)

LTV looks at the total revenue you can expect to gain from each customer over a period of time. 

This  number is critical -  a startup's success is dependent on whether or not a customer is spending more than the amount spent to acquire them. 

In other words, LTV needs to be higher than CAC in order for a business model to be profitable. More on that later, though.

Okay, this is a little more involved. 

Calculating customer LTV requires knowing how long each customer will likely stay and how much revenue they will generate. 

There are many ways to calculate LTV, but here’s a simple one:

LTV formula → Average Value of Sale × Number of Transactions × Retention Time Period = LTV

It can be challenging to determine these data points as they often fluctuate. If a startup has only been operating for a few months, you can use a 1-month timeframe as a sample to acquire a decent average. If the business is pre-launch, you can ask the founder for data-backed assumptions (e.g Competitor CAC & LTV).

Let’s go back to the coffee shop example. 

Let’s say an average customer sale is $5. That’s your first value. Then, the customer purchases about 3 times per month. That’s your second value. Finally, your retention period is 10 months.

$5 x 3 x 10 = $150 LTV

Combining CAC and LTV

Now that you know how to calculate CAC and LTV, let’s bring them together. 

I’d like to tell you about something called the Rule of 3.

“The lifetime value (LTV) to customer acquisition cost (CAC) ratio should be at least three...If your LTV/CAC ratio is lower than three, investors will question the scalability of growth and spend needed to grow larger.” [Crunchbase]

This is saying that your CAC:LTV ratio should be 1:3 or higher. 

According to our coffee shop calculations above, here’s the ratio: 50:150 or 1:3

This is an excellent example right here, but to achieve this ratio in reality takes careful balancing and consideration. 

Startups shouldn’t spend too little on customer acquisition because they might miss out on high-quality, repeat customers, but the company shouldn’t spend too much because it may risk going out of business.

At the end of the day, the goal is to spend just the right amount on CAC to drive new customers to your business while increasing LTV from that customer. 

Some startups will calculate CAC and then use that data to inform their pricing. 

If you’ve invested in a business where the company’s CAC is currently higher than its  LTV, there’s no need to freak out. These numbers are constantly fluctuating based on a wide variety of factors such as competition, economic conditions, time of year, and so much more. 

But over time the CAC to LTV ratio should always be positive.