Fred Wilson over at AVC has stirred up something of a hoo haa about the value of marketing to a technology startup. I think Fred has point about the poor contributions marketing has made to technology startups. My experience in business and school is that marketing tends to attract bs artists who talk a fast game, but aren’t interested in doing any hard analytical work. For a big company, this is often not a problem. But for a little one it can be quite dangerous. With this post I’m going to describe using Customer Lifetime Value (CLV) as a useful tool for measuring marketing effort. Many startup technology firms have ignored this useful tool at their own peril.
CLV answers the question: How much money is this customer worth to me? This is an essential question, because without this measurement, it is impossible to determine how much can be profitably spent acquiring a customer. For example, suppose your funny new super bowl add costs $10 million dollars and brings in 1 million new customers. You’ve just paid $10 per customer. If your CLV is greater than $10, you’ve made a profitable marketing investment. If you CLV is less than $10, you have problem. Many dot com businesses made this exact mistake: they paid more money to acquire customers (think Super Bowl ads) than they made in profit from those customers. If you don’t know this key metric, you can’t tell if you are making good or bad marketing decisions.
The basic idea behind CLV is to discount the profits from a customer to the present value. In this regard is quite similar to the Net Present Value (NPV), but there are key differences. Input components to the formula are:
- Retention Rate – This is the percentage of customers who repeat from one period to the next.
- Discount Rate – This is the percentage used to calculate the value. Often times it is the companies cost of capital.
- Retention Cost – The amount of money spent during each period to keep the customer purchasing. For example, sales and support costs would fall into this category.
- Period – Also called the horizon. This is the number of periods the calculation will cover. While it is possible to do this on monthly basis, the most common method is to years. For a technology startup, 3 years is about as far out into the future as I think you can go.
- Customer Contribution – How much profit the firm makes off of a customer (usually the average) in that year.
CLV = Customer Contribution * The Total of (Retention Rate /( 1 + Discount Rate – Retention Rate))
In a previous post I calculated that the Huffington Post was making between 30 and 70 cents per unique visitor. Without knowing the retention rate we can’t calculate the CLV, but we can understand that is unlikely to be much more than $1. A low CLV doesn’t leave much room for expensive marketing techniques and tools that are better suited selling high margin items like sneakers.