How to succeed in advertising
In markets like telecommunications, cable, and credit cards--where customers sign up to subscription services and churn is measurable--many companies treat such outlays as "customer acquisition costs." These expenditures, which are sometimes called origination fees, are compared not to the imminent sale price, but rather the lifetime value of the customer. That lifetime value is equal to the future cash flows (not revenue) expected over the life cycle of the customer, discounted back by a reasonable rate. What we are really doing is treating the customer acquisition as an investment and the lifetime cash flows of the customer as the yield on that investment.
If you expect the customer to stay forever, you can simply treat the cash flow as perpetuity and divide this periodic influx by the discount rate to arrive at customer value. So let's say that a telephone company expects to earn $40 a month in revenue from a customer and $6 a month in cash flow. If they can keep this customer for life, the value of that customer will be equal to $72 divided by the discount rate. If we use 15 percent, this equals $480. Therefore, this telco might be interested in spending up to $480 to acquire this customer, as any amount below that level would be considered a value-creating investment.
Many Internet retailers are using this formula to justify expenditures on the Web. This may make sense, but you must be very careful with your math. In the above example, we assumed zero churn, which may not make sense for a CD store on the Web. You must also account for churn in the following way:
Let's say you expect to lose 5 percent of your customer base a year. With this model, the average life of a customer equals 1/0.05, or 20 years. Here, instead of using a perpetuity model, you discount the life costs back over 20 years. For very low churns, this has little effect (at 5 percent, the $480 above only falls to $450). However, the value of the customer decreases exponentially as churn increases. At 10 percent churn, this figure falls to $361 and at 25 percent churn all the way to $205. Internet retailers with little track record will have a hard time calculating churn, but a mistake could be quite costly.
Another problem presented to Internet retailers is that of repeat customers. At present, most affiliate programs pay for all customer leads, yet only new leads really make sense with the above model. To compensate for this, it is important to discount the approximated customer value by the percentage of new customers vis-à-vis old ones. For instance, a $300 customer is only worth $210 if 30 percent of the referrals are from repeat buyers. As the Web matures, this percentage is likely to rise, which should push down the amount people are willing to pay for customer acquisition. One last concern may be efficiency of the Web itself. Price comparisons are very easy on the Web, which could lead to increased competition and lower profitability.
I have heard stories that CD retailers are paying as much as $40 for a customer lead. If we assume that the average consumer spends $100 a year on CDs (at a given retailer), has a modest 10 percent churn, and produces a 10 percent cash flow margin, then this customer is worth about $50. Of course, this assumes that there are no repeat buyers. Throw in 25 percent repeat buyers, and this falls to $37.50--and below the magical $40. So while the current success-based advertising expenditures may not be totally out of line, they are dangerously close to the edge.
One could even proclaim these fees as acceptable. If an Internet retailer can attract enough viewers, then they themselves may be able to become bounty hunters. Consider Amazon.com: With 2.5 million users and a firm understanding of their interests, the bookseller is in a good position to produce leads for others. Looking for a book on real (not virtual) surfing? Don't be surprised if Amazon offers to send you to a site that will sell you a surfboard or book a trip to Hawaii. Now what if Amazon can generate 5 percent of sales for each trip and surfboard sold? In this case, it might be willing to treat books as a loss leader and make it up on 100 percent gross margin referrals. Think about what effect this could have on the book business.
There is no question in my mind that success-based models will eventually rule on the Web. This is not to say that impression ads will go away, but this remarkably efficient advertising will serve an increasingly larger portion of this powerful new medium. Every industry from product sales to doctors, lawyers, and other complicated service providers will eventually use ad programs such as this. What's more, these programs could have very interesting effects on the competitiveness of each industry and potentially neighboring ones.
Of course, if you extrapolate this vision, you see a world that looks more like a flea market than Hollywood. Have you ever stepped onto a public beach outside a Mexican vacation resort? How do you say no dinero in Webspeak?
J. William Gurley 1997-8. All rights reserved. The information contained herein has been obtained from sources believed to be reliable but is not
necessarily complete, and its accuracy cannot be guaranteed. Any opinions expressed herein are subject to change without notice. The author is a general partner of Hummer Winblad Venture Partners (HWVP). HWVP and its affiliated companies and/or individuals may, from time to time, have positions in the securities discussed herein. Above the Crowd is a service mark of J. William Gurley.