Personal Learnings← Lenny's Newsletter  Library

Lenny's Newsletter · Product & Work

How to describe your business as an equation

TIER 5   2024-01-16

👋 Hey, Lenny here! Welcome to this month’s ✨ free edition✨ of Lenny’s Newsletter. Each week I tackle reader questions about building product, driving growth, and accelerating your career.

If you’re not a subscriber, here’s what you missed this month:

  1. What to do if your product isn’t taking off
  2. First-principles thinking
  3. Inspiration for the year ahead

Subscribe to get access to these posts, and every post.

Every business can be distilled into a simple equation.

And until you can express your business as one, you don’t fully understand it.

Figuring out this equation forces you to think about the inputs that drive your business, the outputs you want to prioritize, and how these variables interact. It also gives you a map for understanding which metrics you need to track, what factors drive the growth of your business, and, most importantly, where you have the most leverage to drive an outsize amount of impact (and thus where to assign your precious people and resources).

To help you flesh out your own business equation, Dan Hockenmaier and I put together example equations for the most common tech business models:

  1. B2B SaaS

  2. Bottom-up B2B SaaS with seat-based pricing

  3. Bottom-up B2B SaaS with usage-based pricing
  4. Top-down B2B SaaS

  5. B2C/consumer

  6. B2C subscription (trial or freemium)

  7. B2C free (ads)

  8. Marketplaces

  9. B2C marketplaces

  10. B2B marketplaces
  11. DTC/e-commerce

First, a few disclaimers:

  1. This won’t be easy. These equations and concepts can be some of the most divisive within your company, particularly between your product, GTM, finance, and sales teams. But once the equations are defined, your teams are aligned, and the equations operationalized, you’ll experience a huge force multiplier—because everyone will be focusing their energy on the same (high-leverage) levers.
  2. This won’t be perfect. While we lay out the different “recipes,” every business is unique. Thus, the equations will require some adapting to match your business. Please send us feedback (or leave a comment below) on anything you think we’re missing, or anything unique about your business that caused you to modify the equation you use. We’d love to hear it.
  3. We focused on ARR and revenue. All of these equations output revenue or ARR. If your business has high gross margins (e.g. >80%-90%), like some SaaS businesses, you may be able to stop there. But for any business with meaningful cost of sales, such as DTC and most marketplaces, you’ll want to instead output a metric like contribution margin. For these cases, see the section at the end of the post on adding margin to your equation.
  4. Business equations don’t cover every important metric. One key metric for every business is customer acquisition payback period. This is related to but not directly captured in the equations below. See the section at the end on how to calculate your payback period.

How to make the most of this post

  1. Create your own business’s math formula, with inspiration from a formula below
  2. Have a discussion with your team about how your business grows through the lens of this formula
  3. Identify the highest-leverage lever(s) within your formula, and put more resources behind it
  4. Identify one new lever you haven’t invested in, and experiment with it
  5. Turn the formula into a full-fledged growth model (something we’ll explore in a future post)

A huge thank-you to Abi Noda (DX), Alex Bilmes (Endgame), Alexa Grabell (Pocus), Barry McCardel (Hex), Boris Jabes (Census), Christina Cacioppo (Vanta), Colin Dunn (Visual Electric), Dom Wong (Pogo), Emily Kramer (MKT1), Jeremy Cai (Italic), May Habib and James Lee (Writer), Merci Victoria Grace (Panobi), Nels Gilbreth, Peter Kazanjy (Atrium), Reed McGinley-Stempel (Stytch), Rujul Zaparde (Zip), Whitney Steele (Descript), William Hicks (Magic Mind), and Zach Grannis for sharing feedback and advice on this post 🙏

Also, don’t miss Dan Hockenmaier’s newsletter, which is a must-read for anyone working on growth and marketplaces.

B2B SaaS equations

A B2B SaaS business sells cloud-hosted software on a subscription basis (that’s what makes it software as a service—SaaS) to other businesses (that’s what makes it B2B). Examples include Snowflake, Slack, and Jira.

B2B SaaS businesses typically monetize in one of two ways—per seat (e.g. Slack) or by usage (e.g. Datadog)—and grow in one of two ways—through a bottom-up motion (i.e. individual employees within a company discover the product on their own, as with Figma and Notion) or a top-down motion (i.e. salespeople sell the product into company leaders, as with Salesforce and Box). And though not exactly the same thing, a bottom-up growth motion is, in practice, essentially the same as a “product-led growth” (PLG) motion.

Below, we’ll look at the three most common B2B SaaS business models, sharing both a simplified version of each business equation (as an image) and the full equation in the text under it.

1. Bottom-up B2B SaaS with seat-based pricing

Examples: Figma, Slack, Zoom, Adobe Creative Cloud, Asana, Jira.

Image from How to describe your business as an equation

ARR = New ARR + Expansion ARR + Reactivation ARR – Churned ARR – Contraction ARR

2. Bottom-up B2B SaaS with usage-based pricing

Examples: AWS, Datadog, Twilio

Image from How to describe your business as an equation

ARR = New ARR + Expansion ARR + Reactivation ARR – Churned ARR – Contraction ARR

3. Top-down (sales-led) B2B SaaS

Examples: Snowflake, Box, Salesforce, Workday, Looker

This category includes both seat-based and usage-based pricing and normally ends up as a predetermined negotiated annual contract.

Image from How to describe your business as an equation

ARR = New ARR + Expansion ARR + Reactivation ARR – Churned ARR – Contraction ARR

B2C/consumer equations

Consumer businesses make a software product for individual consumers. Examples include Netflix, TikTok, and Google.

Consumer products typically monetize in one of two ways—subscriptions (e.g. Duolingo, Spotify, Tinder) and ads (e.g. Instagram, Snap, YouTube). Below, we’ll look at these two models.

4. B2C with subscription-based pricing (trial or freemium)

Examples: Duolingo, Spotify, Tinder, Calm, Strava, MyFitnessPal

Image from How to describe your business as an equation

ARR = MRR x 12 = (New subs + Retained subs + Reactivated subs) * Average monthly revenue per sub * 12

5. B2C with ads (i.e. free for the user)

Examples: Instagram, Google, TikTok, Meta, Snap, Twitter

Image from How to describe your business as an equation

Revenue = Active users * Impressions per user * CPM/CPC/CPA

Marketplace equations

A marketplace business facilitates transactions between buyers and sellers. Examples include Airbnb, DoorDash, Uber, eBay, and Faire.

These businesses don’t own the supply (e.g. the homes, the cars, the restaurants) but instead make it easy for customers to find and purchase from these sellers.

Marketplaces monetize primarily through a transaction fee and occasionally through a subscription fee.

There are two types of marketplaces—B2C marketplaces, which cater to individual consumer customers (e.g. Airbnb, Uber), and B2B marketplaces, which cater to business customers (e.g. Faire, Pachama).

6. B2C marketplaces

Examples: Airbnb, Uber, DoorDash, Etsy, eBay

Image from How to describe your business as an equation

Revenue = Transactions * AOV * Take rate

7. B2B marketplaces

Examples: Faire, Amazon Business, Pachama, Novi

Image from How to describe your business as an equation

Revenue = Transactions * AOV * Take rate

8. DTC/e-commerce equation

Finally, we have direct-to-consumer (DTC) and e-commerce businesses, which sell a physical product to individuals. This includes companies like Warby Parker, Casper, Glossier, and Dollar Shave Club.

Image from How to describe your business as an equation

Revenue = Transactions * AOV

Adding margin to your business equation

For any business with sufficiently high cost of sales, you can’t stop at revenue. What you’re really optimizing for is contribution margin, or what is left over after you take out all variable costs of a transaction.

This is a key metric because it describes how much you have left over to reinvest in the business. It’s also how more margin-intensive businesses will typically ultimately be valued, as opposed to high-margin businesses, like SaaS, which are often valued on multiples of ARR.

To apply margin to the equations above, all you have to do is calculate your average contribution margin rate (CM%) and multiply it by revenue. So for a DTC business, the formula would be:

Contribution margin = Transactions * AOV * CM%

There are two big components of cost to consider. Deducting only the first would give you a gross margin, and including the second gets you to contribution margin.

Direct variable costs: These are costs that are directly driven by a transaction and are easy to attribute. For DTC models, this would include things like cost of goods sold, incentives, and shipping. For marketplace models, it would include things like payment processing fees, incentives, and defaults.

Indirect variable costs: These are costs that are not directly driven by transactions but tend to increase as transactions increase, and include things like marketing and customer support.

Calculating payback period

For every business model here, one of the most important metrics that is not directly covered in these equations is customer acquisition payback period, i.e. the amount of time it takes for you to recoup the costs of customer acquisition. This is a better measure than LTV/CAC because it tells you how quickly you can invest in driving more growth.

At the highest level, you can calculate payback period as CAC divided by annual contribution margin per customer. For example, if you have a CAC of $100 and an average annual contribution margin per customer of $120, your payback period would be 0.83 years, or 10 months.

For certain business models, especially marketplaces, this equation gets more complicated. See “problem #2” in this essay for an explanation of how to calculate payback periods for marketplaces. Also, here are handy benchmarks for good and great payback periods.

📚 Further study

  1. The ultimate guide to product-led sales, with Elena Verna
  2. The SaaS Metrics That Matter, by David Sacks
  3. The Burn Multiple, by David Sacks
  4. Drive Growth by Picking the Right Lane—A Customer Acquisition Playbook for Consumer Startups, by Dan Hockenmaier and Lenny Rachitsky
  5. How to kickstart and scale a consumer business
  6. How to kickstart and scale a marketplace business
  7. How to kickstart and scale a B2B business

Have a fulfilling and productive week 🙏

👀 Hiring? Or looking for a new job?

I’m piloting a white-glove recruiting service for product roles, working with a few select companies at a time. If you’re hiring for senior product roles, apply below.

Apply to join

If you’re exploring new opportunities yourself, use the same button above to sign up. We’ll send over personalized opportunities from hand-selected companies if we think there’s a fit. Nobody gets your info until you allow them to, and you can leave anytime.

If you’re finding this newsletter valuable, share it with a friend, and consider subscribing if you haven’t already. There are group discounts, gift options, and referral bonuses available.

Sincerely,

Lenny 👋