How to Succeed in Advertising

Posted on April 20, 1998. Filed under: Web/Tech |

“If you’re makin’ me wait, if you’re leadin’ me on, I need to know”
     -Tom Petty, I Need to Know

Over the next few years, there is likely to be a huge rise in performance-based advertising on the Internet. Historically, Internet ads have been sold on an impression-based metric known as “CPM”. CPM, which stands for cost per thousand, represents how much an advertiser will pay to get in front of a thousand individual eyeballs. Some have suggested that price per click-through is a better model, but why stop there? The proper model is performance-based advertising. In this world, an advertiser will only pay for an ad when and if the referral leads to an actual customer sale. Not impressions, not click-throughs, but honest to goodness revenues.

To be sure, this idea is not new. Businesses already accustomed to “origination fees” have already flourished on the Web. This includes everything from long distance, to credit cards, to mortgages. In each of these cases, content-based sites help customers identify a personally appropriate credit card or mortgage, and the matchmaker is then paid a certain bounty for finding a customer. GetSmart (www.getsmart.com) is a great example of a business built around this concept. Affiliate programs are another form of success-based advertising. Amazon.com has no less than 35,000 affiliate sites that receive approximately 15% of sales on book sales that are directed to Amazon.

Another form of success-based ad models are pay-for-performance banner ads. Internet advertising service DoubleClick believes in this market and has launched an interesting initiative known as DoubleClick Direct. However, the general new media community has shied away from this market, with many executives dismissing the likelihood of adoption. I think the problem is that success based programs fall way too close to direct marketing on the marketing continuum. For most media types, comparing traditional impression based advertising to direct marketing is quite a bit like comparing Paris to Las Vegas. Performance based advertising would seemingly jeopardize the essence of the experience.

Despite this snobbish reluctance, I see four reasons why success based ads will flourish on the Web. The first and primary reason is that customers want it. With success based advertising, the advertiser can assure that his/her advertising programs are economically sound. You simply add the “bounty” fee to the cost of goods sold and you can predict the margin on each sale. This is simply not the case with traditional advertising. The model shifts the burden of evaluating the quality of each ad program to the content company. If an ad doesn’t have good responsiveness, the seller loses nothing, although the content company has used up inventory. Therefore, it is up to the content company to determine exactly which ads are likely to produce results. This shift of responsibility is quite palatable to the advertisers, and let us not forget the age old adage — the customer is always right.

The second reason to believe in this emergence can be found in the evolution of the last media revolution – cable television. If you watch one of the less popular shows on cable you will began to notice an overwhelming amount of 1-800 ads. This is because these programs have excess inventory and the best way to maximize the revenue with respect to these programs is success-based ad programs. Want a Topsy Tail? Need a citrus slicer? Want to add Super-Hits of the Seventies to your music collection? Ever notice the plethora of 1-800 ads on the financial news network CNBC? And to highlight the issue of ad choice responsibility have you noticed how often CNBC plugs Evita Nelson’s MoneyLetter? That thing must be selling like hotcakes!

The third reason these programs will flourish is the rising quantity of unsold ad space on the Internet. In its most recent quarter, Internet bellwether Yahoo reported record revenues and earnings. Interestingly enough, page views actually grew faster than revenues. This results in lower and lower average revenue per page view, which is also known as the effective CPM. Internet advertising continues to grow at a healthy rate, however, an increasing number of pages remain unused with respect to advertising. Some suggest this inventory glut will lead to price erosion. I think that there is another cure in performance-based advertising. What better way to bring economic equilibrium to the ad market than to fill the marginal page view with a performance-based ad?

One unique aspect of success-based advertising is the opportunity for marketers and financiers to conduct a more thorough quantitative analysis. How much should you pay for a referenced customer? You might think this is an easy question. Simply treat the bounty-fee as an outsourced marketing expense. In this case you would be willing to pay the same percentage as your sales and marketing expense ratio. If you normally expect to spend 12% of sales on marketing then you would be willing to pay a 12% “sales-charge” to anyone that brings you a guaranteed sale. However, life on the Internet is not this simple, and many Internet retailers are willing to pay much more than this for a lead.

In markets like telecom, cable, and credit cards, where customers sign up to subscription services and churn is measurable, many companies treat such costs 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. The lifetime value of the customer is equal to the future cash flows (not revenue!) expected over the life cycle of the customer, discounted back by a reasonable discount 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 the periodic cash flow 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% this equals $480. Therefore, this telco might be interested in spending up to $480 to acquire this customer, as any amount below this 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 0% 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% of your customer base a year. With this model, the average life of a customer equals 1/0.05 or 20 years. In this case, 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% the $480 above only falls to $450). However, the value of the customer decreases exponentially as churn increases. At 10% churn this figure falls to $361 and at 25% 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. Currently most affiliate programs pay for all customer leads, yet only new leads really make sense with the above model. In order 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% of the referrals are from repeat customers. 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 increasing competitiveness and lower profitability in the future.

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% churn, and produces a 10% cash flow margin, then this customer is worth about $50. Of course this assumes that there are no repeat buyers. Throw in 25% 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.

Of course, one could even proclaim these fees as acceptable. If an Internet retailer can attract enough viewers, than they themselves may be able to become bounty hunters. Consider Amazon.com. With 2.5 million users and a firm understanding of user interests, Amazon is in a good position to produce leads for others. Looking for a book on 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% of sales for each trip and surfboard sold. In this case, they might be willing to treat books as a loss leader and make it up on 100% gross margin referrals. Think about what affect 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 increasingly serve a larger and larger portion of this powerful new medium. Every industry from product sales to complicated service providers (such as doctors and lawyers) will eventually use ad programs such as this on the Web. What’s more, these programs could have very interesting affects on the competitiveness of each industry and potentially neighboring industries. Of course, if you extrapolate this vision forward 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 Web speak?

    About

    …focusing on the evolution and economics of high technology business and strategy. By day, I am a venture capitalist at Benchmark Capital.

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