The Dangerous Seduction of the Lifetime Value (LTV) Formula

Posted on September 4, 2012. Filed under: advertising, Internet, Uncategorized, Venture Capital, Web/Tech | Tags: , , , , , , , |

Many consumer Internet business executives are loyalists of the Lifetime Value model, often referred to as the LTV model or formula. Lifetime value is the net present value of the profit stream of a customer. This concept, which appears on the surface to be quite benign, is typically used to compare the costs of acquiring a customer (often referred to as SAC, which stands for Subscriber Acquisition Costs) with the discounted positive cash flows that will come from that customer over time. As long as the sum of the discounted future cash flows are significantly higher than the SAC, then people will argue it is warranted to “push the accelerator,” which typically means burning capital by aggressively spending on marketing.

This is a simplified version of the formula:

Image

The key statistics are as follows:

  • ARPU (average revenue per user)
  • Avg. Cust. Lifetime, n (This is the inverse of the churn, n=1/[annual churn])
  • WACC (weighted average cost of capital)
  • Costs (annual costs to support the user in a given period)
  • SAC (subscriber acquisition costs, sometimes refereed to as CAC = customer acquisition costs)

The LTV formula, when used correctly, can be a good tactical tool for monitoring and comparing like-minded variable market programs, especially across channels. But like any model, its proper use is entirely dependent on the assumptions used in that model. Also, people who have a hidden agenda or who confuse a model with reality can misuse it. For many companies that subscribe to its wisdom, the formula slowly takes on more importance than it should. Seduced by the model, its practitioners often lose sight of the more important elements of corporate strategy, and become narrowly fixated on the dogmatic execution of the formula. In these cases, the formula can be confused, misused, and abused, much to the detriment of the business, and in many cases the customer as well.

Here are ten reasons to avoid worshiping at the LTV altar:

  1. It’s a Tool, Not a Strategy.  Heavy LTV companies forget that the LTV model does not create sustainable competitive advantage. You shouldn’t’ confuse output with input. The LTV formula is a measurement tool to be used by marketing to test the effectiveness of their marketing spend – nothing more and nothing less. If one asserts that buying customers below what they charge them is a corporate strategy, this is in essence an arbitrage game, and arbitrage games rarely last. Too many of the variables (specifically ARPU and SAC) are outside of your control, and nothing would prevent another player from executing the exact same strategy. It’s not rocket science; it’s a formula that any business school graduate can calculate. Do not fool yourself into believing it creates a proprietary advantage.
  2. The LTV Model Is Used To Rationalize Marketing Spending.  Marketing executives like big budgets, as big budgets make it easier to grow the top line.  The LTV formula “relaxes” the need for near term profitability and “justifies” the ability to play it forward – to spend today for benefits that are postponed into the future. It is no coincidence that companies that put a heavy emphasis on LTV are also the ones that have massive losses as they scale, frequently even through an IPO. Consider that most companies limit any “affiliate fee” they would be willing to spend to 5-10% of sales. Yet when they are marketing, they use different math. They use LTV math, and all the sudden it’s acceptable to spend 30-50% of revenue on customer acquisition. Find the most boisterous executive recommending excessive spending, and you will usually find a loyal servant of the LTV religion.
  3. The Model is Confused and Misused. Frequently the same group that is arguing for more spending is the same one that “owns” the LTV calculation. (This is a mistake – finance should monitor LTV).  As a result, it is not uncommon for one to see shortcuts taken that allow for greater freedom. As an example, marketers often divide spend by total customers to calculate SAC rather than just those customers that were “purchased.” If you have organic customers, they shouldn’t be included in the spend calculus. They would have arrived regardless of spend. Also, many people discount “revenues” rather than marginal cash contribution. It is critical to bundle all future variable costs of supporting the customer in order to fairly estimate the future contribution. As an example of the sloppiness that exists around the formula, consider this blog post (http://blog.kissmetrics.com/how-to-calculate-lifetime-value/) from KISS metrics, a company whose aim is to “help you make smarter business decisions.” Not only do they include a version of the model that specifically ignores future costs, but also they recommend taking an average of three different results, two of which are clearly flawed. This voodoo-math has no place as part of a multi-million dollar marketing exercise.
  4. Business Isn’t Physics – The Formula Is Not Absolute. LTV zealots often hold an overly confident view of the predictive nature of the formula. It’s not “hard science” like say predicting gravity. It’s at best a “good guess” about how the future will unfold. Businesses are complex adaptive systems that cannot be modeled with certainty. The future LTV results are simply predictions based on many assumptions that may or may not hold. Yet the LTV practitioner often moves forward with a brazen naiveté, evocative of the first time stock buyer who just found out about the price/earnings ratio, or the newcomer to Vegas who has just been taught the basics of twenty-one. LTV models win arguments because executives perceive them to be grounded in science. Just because its math, doesn’t mean its good math.
  5. The LTV Variables “Tug” at One Another. This may be the single most important issue and it lies at the heart of why the LTV model eventually breaks down and fails to scale ad infinitum. Tren Griffin, a close friend that has worked for both Craig McCaw and Bill Gates refers to the five variables of the LTV formula as the five horsemen. What he envisions is that a rope connects them all, and they are all facing different directions. When one horse pulls one way, it makes it more difficult for the other horse to go his direction. Tren’s view is that the variables of the LTV formula are interdependent not independent, and are an overly simplified abstraction of reality. If you try to raise ARPU (price) you will naturally increase churn. If you try to grow faster by spending more on marketing, your SAC will rise (assuming a finite amount of opportunities to buy customers, which is true). Churn may rise also, as a more aggressive program will likely capture customers of a lower quality. As another example, if you beef up customer service to improve churn, you directly impact future costs, and therefore deteriorate the potential cash flow contribution. Ironically, many company presentations show all metrics improving as you head into the future. This is unlikely to play out in reality.
  6. Growing Becomes a Grind. Let’s say you have a company that estimates it will do $100mm in revenue this year, $200mm the next, and $400mm the year after that. In order to accomplish those goals it is going to invest heavily in marketing – say 50% of revenues. So the budget for the next three years is $50mm, $100mm, and $200mm. How realistic is it to assume that your SAC will drop as you 4X your spend? Supply and demand analysis suggests the exact opposite outcome. As you try to buy more and more of a limited good, the price will inherently increase. The number one place on the planet for marketing spend is Google Adwords, and make no mistake about it, this is an increasingly finite resource. Click-outs are not growing at a meaningful pace, and key word purchases are highly contested. Assuming you will “get better” at buying while trying to buy more is a daunting assumption. The game will likely get tougher not easier.
  7. Purchased Customers Underperform Organic on Almost Every Metric. Organic users typically have a higher NPV, a higher conversion rate, a lower churn, and more satisfied than customers acquired through marketing spend. LTV heavy companies are in denial about this point. In fact, many of them will argue until they are blue in the face that the customer dynamics are the same while this is rarely the case. A customer that “chooses” your firm’s services will be much more staisfied than one that is persuaded to buy your product through spend. Find any high-marketing spend consumer subscription company, and I will show you a company with numerous complaints at the Better Business Bureau. These are companies that make it almost impossible to terminate your subscription. When you are scheming on how to trap the customer from finding the exit you are not building a long-term brand.
  8. The Money Could Go to the Customer.Think about this. If you are a company that spends millions and millions of dollars on marketing, wouldn’t you be better off handing that money to the customer versus handing it to a third-party who has nothing to do with the future life-time value of the customer? Providing a better value-proposition to the customer is much more likely to endure goodwill than spending on marketing. A heavy marketing spend necessitates a higher margin (to cover the spend), and therefore a higher end user price to the customer! So the customer is negatively impacted by the presence or “need” of the marketing program. Plus, a margin umbrella now exists for competition that chooses to undercut your margin model with a more efficient customer acquisition strategy (such as giving the customer the money).“More and more money will go into making a great customer experience, and less will go into shouting about the service. Word of mouth is becoming more powerful. If you offer a great service, people find out.” – Jeff Bezos
  9. LTV Obsession Creates Blinders. Many companies that obsess over LTV, become overwhelmed by LTV. In essence, the formula becomes a blinder that restricts creativity and open-mindedness. Some of the most efficient forms of marketing are viral, social, and effective PR (public relations). Most companies that obsess about LTV are less skilled at these more leveraged techniques. Ironically, it’s the scrappy and capital starved startup with absolutely no marketing budget that typically finds a clever way to scale growth organically.  I love this historic slide from Skype comparing their SAC with that of Vonage, an iconic disciple of LTV analysis.

Image

10. Tomorrow Never Arrives.  The Utopian destination imagined by the LTV formula is a mirage. It almost never works out as planned in the long run. Either growth begins to slow, or you run out of capital to continue to fund losses, or Wall Street cries uncle and asks to see profitability. When this happens the frailty of the model begins to appear. SAC is a little higher than expected. You met your growth target, but the projected loss was bigger than expected. Wall Street is hounding you for churn numbers, but you are reluctant to give them out. The lack of transparency then leads to cynicism, and everyone assumes the worse. It turns out that the excessive marketing spend was also propping up repeat purchase, and pulling back to achieve profitability is increasing churn. Moreover, a negative PR cycle has ensued as a result of your stock decline, and the press’ new doubts about your model. This also impacts results, and customer perception of your brand. The bottom line is that “one day we can stop spending and be remarkably profitable” rarely comes to fruition.

It is not impossible to create permanent equity value with the LTV approach, but it’s a dangerous game of timing – you don’t want to be the peak investor. Let’s say a new business starts with an early market capitalization of A (see graph below). Through aggressive marketing techniques, and aggressive fund raising, the company is able to achieve amazing revenue growth (and corresponding losses), but nonetheless creates a rather sizable organization. At this point, the company is value at point B. Eventually, however, gravity ensues and the constraints outlined herein raise their head, resulting in a collapse to point C.  For early founders and investors at point A, they may do OK (as long as C>A), but it will be accomplished on the backs of later stage investors that helped fund the unsustainable push to point B. This is the story of many a telecom and cable provider expansion history, as well as a few recent Internet companies.

Image

This should not be misconstrued as a eulogy for the LTV formula. It has a very important place in business as a way to contrast and compare alternative marketing programs and channels. It is a tactical marketing tool that requires candor and thoroughness in its implementation. The fundamental reason that it is so amazingly dangerous and seductive is its simplicity and certainty. Generic marketing is conceptual. LTV marketing is specific. Building a plan to grow to a million users organically is an order of magnitude more difficult than doing it with the aid of the LTV formula. There is comfort in its determinism, and it is simply easier to do.

Some people wield the LTV model as if they were Yoda with a light saber; “Look at this amazing weapon I know how to use!” Unfortunately, it is not that amazing, it’s not that unique to understand, and it is not a weapon, it’s a tool. Companies need a sustainable competitive advantage that is independent of their variable marketing campaigns. You can’t win a fight with a measuring tape.

Read Full Post | Make a Comment ( 8 so far )

Google’s Acquires ITA: Will Deeper Vertical Integration Lead to Higher Revenues?

Posted on July 8, 2010. Filed under: advertising, Internet, Uncategorized, Web/Tech | Tags: , , , , , |

“It’s funny how fallin feels like flyin,
for a little while…”

– Jeff Bridges, Crazy Heart Soundtrack

On July 1st, Google announced its intention to acquire ITA Software. ITA owns a primarily B2B airfare search and pricing system called QPX. Several of the leading online travel sites, like Orbitz, Kayak, and Bing Travel, use information from QPX to power their airfare search. Many in the industry view this move as a seminal event in Google’s history, as the company makes a decisive step from being a general search engine, into more structured vertical search. Certainly, Google already offers vertical search in Images, Videos, Maps, News, and several other categories. Despite that, ITA feels different. Perhaps the difference is that this is a step into a vertical where many independent incumbents, like Priceline and Expedia, who are material customers of Google, have large established businesses.

There are two reasons mentioned for why Google feels compelled to dive deeper into verticals. The most straightforward explanation is competitive pressure. Following its own acquisition of Farecast, Microsoft has subsequently launched Bing Travel, a much richer travel search product than offered on Google today. The second argument given for the move is that by moving deeper into verticals, and closer to the actual transaction that Google can actual make more money per visit. This argument suggests that CPA (cost-per-action) is a fundamental improvement over Google’s current business model, CPC (cost-per-click). The competition argument seems obvious and accurate. However, it is not at all clear that going deeper in verticals will raise Google’s revenues. In fact, there are several scenarios where they could actually go down.

Let’s first address the easy part – competition. Bing buys Farecast and Google needs to respond. This make sense, but it is not the whole story. If you are searching for a book or an author you go to Amazon, or at the very least you do a search like “Man in Full Amazon” so that you go directly to the page you want on Amazon. The same is true for hotels with TripAdvisor and for restaurants with OpenTable. These sites offer deeper and richer experiences for a vertical searcher precisely because they incorporate deep meta-data, faceted search, transaction connectivity, and typically a form of community or UGC (user generated content). These things simply do not exist in the simple but limited Google user interface that Om Malik affectionately refers to as “10 blue links.”  So Google has competition in verticals not just from Microsoft, but also from best of breed vertical sites offering users a richer, deeper experience.

Some have suggested that Google’s move into a deeper vertical experience is more about greed (more money) than fear (competitive) response. The argument voiced by Barclay’s analyst Douglas Anuth and others, is that by moving closer to the transaction, Google can ask for CPA fees, which naturally carry higher margin. Clearly, a single CPA fee will be much higher than a single CPC fee, but you will also have much fewer of them. The variable that links the two is conversion. One can certainly argue that Google can drive higher conversion if they can help drive the customer closer to the actual result they need. This will require a materially better product. Even then, however, there are two key reasons Google may not see higher revenue with deeper vertical integration.

Reason #1: Irrational CPC Pricing on Google Today, “Uber-Optimization”

Some might argue that Google’s current bid-based CPC model results in “optimal” pricing. The argument would be that the market-clearing price settles out at the precisely rational price for each and every keyword pair. A market-place model naturally results in efficient pricing. While this makes logical sense, we all know that there are companies participating in the CPC purchasing game who simply are less sophisticated than others. Moreover, many of these buyers win bids and have huge CPC budgets. The point is that there are plenty of startups, arbitragists, and even large companies “experimenting” with CPC purchasing in an attempt to gain an edge. The winner in this bidding game isn’t the most rational, but simply the one with the highest price. Certainly, over the long run if a company irrationally pays too much for CPC ads, they will eventually go out of business. But the key word here is eventually. For a long period of time, they are paying an “uber-optimized” price for their keywords.

If there are enough of these players in the market, then Google’s CPC prices aren’t economically rational. Rather, they live slightly above that level driven by irrationality and experimentation in the market. If you have a hard time with this theory try typing a search term like “laser treatments” in Google and look through the list of CPC purchasers on the right side of the screen. Would you put money in these companies?  Do you have confidence they will be around in ten years?  Have you ever heard of them? It gets even better. Many believe that Google uses a low quality rating score on these “middle-men” to force them to pay a higher fee for a single CPC, thus getting an even higher price than previously discussed. That’s right, for certain CPC buyers, Google has a mechanism for extracting an even higher price, even if the buyer is already the high bidder!

As Google moves past its “10 blue links” model and connects directly to airlines, hoteliers, etc, it will be removing the irrational and arguably temporary middle-man from the system. This fleeting but determined participant, very likely has a negative long term ROIC, and Google, riding the brilliance of the CPC model, stands as the beneficiary. With this player out of the system, and with the connections directly to the service provider, the model will naturally trend to a more efficient pricing.  You will have fewer larger players, who are all more rational, and all more experienced. As such, you would have to expect more rational, and therefore lower, pricing. Building a better product could actually result in less lead-generation revenue.

Reason #2:  Moving from a Marketing Channel to a Transaction Channel

If you have ever sold anything on the Internet, ask yourself the following question. What is the maximum amount you would want to pay for a transaction fee?  5%?  10%? There is data in looking at typical affiliate fee percentages, which can range from say 4-15%. Amazon charges 6-15%. Ebay charges about 11% (with Paypal).  Comparison shopping engines make even less. When an etailer assumes they are “always going to pay” for something on every single transaction, they are very sensitive to the % of revenues, as this payment will always reduce their margin. One could assume the general average for all affiliate fees or similar distribution type arrangements is around 10%.

Now, ask someone in your marketing department how much they are willing to pay to “acquire a customer.” While I don’t pretend to support this logic, the Lifetime Value of the Customer (LTV) model depicted herein mesmerizes many marketing managers. Using this simplistic but highly regarded model, many marketers justify “acquiring a customer” not as a percentage of revenue, but as a percentage of life-time value. The key to reaching this Zen state of marketing awareness is to believe that Google is sending you this customer only this one time, but for here ever after this customer is going to come directly to your own site, bypassing Google. This logic supports a much larger denominator, known as LTV. With LTV, ad buyers are easily willing to spend 25-50% of a first purchase in order to “acquire a customer.”

We could talk forever about the LTV formula, and we could argue back and forth about its efficacy, but that would miss the point. Consider the following assertion. People that are buying CPC ads are frequently marketers, and marketers are much more likely to think in terms of LTV. When you enter into a CPA deal it feels very transactional. When you do deep integration it feels very transactional. And, if Google is building a deep vertical site in travel that will pass leads to companies like American Airlines it will feel very transactional. It will be harder and harder to assume that you are “acquiring a customer,” and it will feel more and more like you are paying a distribution fee to a channel. As such, it may turn out that moving deeper into a vertical will puncture the illusion that marketers are “acquiring a customer” from Google, and get them in touch with the fact that they have a permanent CPA “transaction fee” they need to “pay” to Google. The end result is a lower overall rake for Google with the per transaction model.

Could this be wrong? Absolutely. Perhaps conversion rates will triple due to the incredible design, implementation, and ease of use of the Google’s new product, more than offsetting the two points we just mentioned. Or perhaps, Google will have such a powerful place in the travel ecosystem that travel companies will simply be “price-takers.” If this is the case then Google will once again find the exact right way to optimize their business model. It is equally likely, however, that Google’s current business model is highly, highly optimized and tweaking it may have as much risk as upside.

Read Full Post | Make a Comment ( 18 so far )

    About

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

    RSS

    Subscribe Via RSS

    • Subscribe with Bloglines
    • Add your feed to Newsburst from CNET News.com
    • Subscribe in Google Reader
    • Add to My Yahoo!
    • Subscribe in NewsGator Online
    • The latest comments to all posts in RSS

    Meta

Liked it here?
Why not try sites on the blogroll...