As this is my nineteenth post about customer lifetime value (LTV), I obviously think it is very important, but I wanted to take some time to provide examples of how it can impact almost any business. Even if the examples do not cover your initiative, they will hopefully help you see how understanding, marketing and designing for LTV is crucial to any company’s success. Examples range from tech companies to business types that have been around longer than the United States. The breadth of companies that LTV is critical for shows its central importance.

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Mail order catalogs

Catalog companies, from the days of Sears and Montgomery Ward, to the current heavyweights like Restoration Hardware and Crate & Barrel, have always needed a deep understanding of LTV to succeed.

With the cost of printing and mailing catalogs, these merchants need an LTV higher than the shipping/printing costs. Thus, they have to first understand different customer segments (by location/postal code, sex, age, etc.) and only send catalogs to those people who will have a higher LTV. If they sent their catalog to everyone, the average LTV would decline and make their efforts unprofitable. In addition to understanding the LTVs of each segment they have to optimize along the three key LTV variables, retention, monetization and virality. If a person reads through the catalog once, makes an order and never picks up the catalog again, it is hard for their value to be higher than the costs of shipping them the catalog. If they, however, keep the catalog and place ten orders in a six months period, the LTV is likely to exceed to costs of sending them a catalog. Monetization is also critical. If they love the catalog, keep it on the coffee table, but never make a purchase, the merchant loses. Even if they make very small purchases the merchant proposal loses. Successful direct marketing companies succeed by getting larger shares of wallet from their customers. Finally, virality is important even for a non-digital good. If the person shows the catalog to ten family members or friends (who have an equal potential to buy), then the costs of sending a catalog are effectively one tenth as you are reaching 10X people.

Casinos

Casinos (the land-based ones you find in Las Vegas or Monte Carlo) are masters of using LTV to generate strong profits. Casinos were one of the first industries to embrace analytics, back in the early 1990s Harrah’s was the top case study for SAS (the privately held statistics software company). What casinos realized is that by understanding and estimating each player’s lifetime value, they could focus their efforts on those who would generate the highest profits. Rather than just using intuition to find good customers, they would look at gambling patterns (frequency, size of bets, favorite games, et. al.), credit scores, location, etc., to calculate the expected LTV of everyone entering the casino. This capability is enhanced by their rewards programs, which allows them to track almost everything.

Once they have an expected LTV for a customer, they then use that information to focus their marketing efforts. They will offer these players special perks to visit their casino (ranging from free hotel rooms to use of their private jets) and discounts on their gambling, all intended to increase their LTV (either through better retention or more monetization). They also use this data for their player acquisition efforts, since they have a profile of their most valuable players they can then reach out to others who look like those profitable players.

Social games

I have spoken ad nauseam on the importance of LTV to social and mobile game companies (think Candy Crush) but would be remiss in not including them in this post. For a social or mobile game company, LTV is critical because we rely on performance marketing, such as cost per install (CPI) and cost per click (CPC) advertising. Given that LTV provides the total value of a customer, as long as you can acquire new customers for less than their LTV, you should continue to use your current methods of customer acquisition (in a future blog post I will discuss how customers from different sources have different LTVs). Once the cost of an acquisition exceeds the value of the new customer, it is unprofitable to acquire that customer. The difference between the LTV and CPI is the long-term profit—or loss—from the new customer (including revenue they bring in by acquiring other users for free).

LTV tells you if a new customer or player is worth more than the cost of acquiring them. Simply put, if bringing in new customers is not profitable, there is no reason to bring in customers. If there is no reason to bring in customers, you have a game without players. If you have a game without business, you do not have a game, at least not for long.

E-commerce

E-commerce is a space where LTV is critical to success. With virtually limitless options available to consumers, they both have to be able to acquire and retain customers. User acquisition is central to LTV, since the lifetime value of a customer always has to be higher than the cost of acquiring them. If you look at a company like Harry’s, the men’s shaving retailer, they could only afford to advertise their brand in your Facebook feed and everywhere else because their projected lifetime value of a new user is more than the cost of the ads. If they were not able to generate as much from customers, nobody would have heard of them and they would just be another start up with a website.

The plethora of options to online shoppers also points to why it is so important to optimize all three elements of your LTV, retention, monetization and virality. In particular, virtually no online retailer could stay in business if users they acquired just purchased once and never returned. Thus, would have constant churn and would have to have incredibly high margins to justify getting a new customer. The inverse is Amazon, who through programs like Amazon Prime keeps customers year after year and are become their primary shopping outlet. Amazon market valuation of over $150 billion reflects the high LTV they get from customers.

Restaurants

A few weeks ago, I wrote about Groupon, and how a restaurant needs a good LTV to use it as a channel. This argument can be extended to the entire restaurant business. The key to a restaurant’s survival and profitability is LTV: virality, monetization and retention. Virality is important as word of mouth is one of the largest drivers of new users. If customers talk about a restaurant, then they get more customers with no additional marketing expense. Retention is always important, virtually no business can afford to only have a user visit once or twice. And finally, monetization is crucial, you have to make enough from customers to not only cover all your expenses but earn a profit.

Franchising

The key to being an attractive franchise is the lifetime value the franchise model creates with customers. Potential franchisees are paying for a business template that acquires customers whose lifetime value is greater than the cost of acquisition.

There are thus two key elements to a franchisor’s success. The first is the ability of the franchisor to generate customers at a low cost. They will often achieve this through national advertising campaigns or because they have built a strong brand. The second part is having a product that has high LTV, either overall for the franchisor or for the individual franchise owner. If it is a food product like McDonalds, the fact that people will return multiple times in a week provides value to both the individual restaurant and the franchise in general (as customers may go to different franchises within the network). This retention helps keep LTV greater than the cost of acquisition and leads to profitability of the franchises which leads to more demand (and revenue) for the Franchisor.

SaaS (Software as a service)

Software as a service experiences virtually the same dynamic as a social game. Examples of software as a service (SaaS) include Salesforce.com, Dropbox, Workday, LogMeIn, etc. For all of these companies, they must generate more value from a new user, who may start as a free user, than the cost of acquiring that user. As with the free to play model, value from the user comes from monetization (though more often a subscription model for premium serivce than virtual goods), retention (the longer they subscribe) and virality (how many co-workers they sign up). Although user acquisition may come more from a salesforce (though not with all SaaS), you still need to generate more from these users than the cost of the salesperson. The higher the difference between LTV and cost of sales, the larger the sales force you can afford and the quicker you scale.

Automaker

One of my favorites examples of the importance of LTV is an industry that is the opposite of the tech space most of my readers are in, the automotive industry. In particular, the failure of the US auto industry is largely a result of not understanding and focusing on LTV. US automakers created a weak product but for many years enjoyed good profits by covering a weak product with an attractive façade and having great transactional marketing. Through rebates, billions of dollars in advertising and high-pressure sales people, they were could sell large numbers of cars. These cars, however, provided customers a bad experience so retention became low. Cadillac and Dodge customers, after buying a vehicle, would not buy another and switch to a Japanese or European car. Virality became almost negative, as people would tell others about their bad car experience. Thus, even though monetization was high, the other elements of LTV were so weak that it almost destroyed the US auto industry.

Key takeaway

While I normally list three key takeaways from every post, there is just one from this post. No matter what business you are starting or career you are entering, understanding and using LTV is crucial to your success.

I have written many times about customer lifetime value (LTV), but primarily from a theoretical framework. In this post, I will use Groupon to exemplify many of the key principles at work with LTV. Groupon is very well known, particularly in the United States, as a coupon or discount-deal website that normally offers 50 percent off deals with local merchants, particularly restaurants, spas and similar retailers. Started in 2008, it went public in 2011 and currently has a market cap over $4 billion.

The Groupon problem

One of the biggest issue Groupon has run into the is the perception that most retailers who run Groupon promotions find them highly damaging, and there are frequent stories of Groupon promotions that have put companies out of business. It is easy to see how this could happen, as Groupon typically gives customers a 50 percent discount and then keeps 25 percent of the remaining funds. Thus, a retailer only sees a total of 25 percent of the normal revenue they would from the consumer if the person had made the purchase without a Groupon. Since most retailers do not have a 75 percent margin, they will lose money on the Groupon. Moreover, because of Groupon’s strong distribution, they may lose a lot of money.
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If a retailer, however, understands customer lifetime value, it can make the right decision about the value of offering the Groupon and whether it is a positive to their store.

The importance of retention

The first element of LTV that is crucial to Groupon success is retention. If people normally come to your business once and never come back, the Groupon is not going to work. You will lose 75 percent of the check or bill and never see the customer again.

Conversely, if once you get a customer they come back twice a week for six months, then the Groupon is a great marketing tool. While you will lose money on the initial transaction, you will have 48 (2 times per week, 4 weeks per month for 6 months) more profitable transactions, which will more than cover the loss. As I discussed in my post about retention, retention is the key to success in any business and the Groupon examples shows the impact of weak versus great retention.

How virality plays into the equation

Virality is also a key to the success of a Groupon. If people use the Groupon deal but do not tell friends about it, then the Groupon must generate enough lifetime revenue from that user to be a new positive. While this is possible, it increases the risk that the Groupon initiative is not successful if you do not have strong retention.

If you create, however, an experience that people tell their friends about, and then their friends try your establishment and you can retain them, the value to you of offering the Groupon increases dramatically. I have written before about how to create strong word of mouth, and it is more than just offering a good product, but if you follow the STEPP model (create a product or offering with social currency, triggers, emotions, practical and public) and users bring in more users, the Groupon can have tremendous impact.

Let’s say someone buys the Groupon and comes into your store. Because of the discount the purchase is a net wash and the consumer value is no more or less than the cost of servicing him/her with the Groupon. If, however, the consumer persuades five friends to also visit, and each of those friends adds $20 of profit, then the Groupon has generated $100 in profit for you.

Why segmentation by LTV is so crucial

The other key lesson regarding LTV that is exemplified by Groupon is the necessity for understanding different segments of your user base and how Groupon users fit into these segments. Many establishments (let’s use restaurants for this example) have found out that Groupon users do not fit the same model as their other customers. While they may normally see great retention and virality, Groupon customers just go to wherever they have a coupon and do not revisit or talk about establishments. Thus, a restaurant may normally have a very high LTV for a typical user, say $100, so if the Groupon cost them $50 per user, long-term they would still make $50 from the promotion. However, if the Groupon customer exhibits different traits and only uses the Groupon and never comes back, the restaurant loses $50 per customer. In many ways, Groupons can be looked at as the equivalent of incentive installs in the app space; while there is a role for this channel you must measure the value of these installs differently than other marketing channels.

Thus, it is important to see how the Groupon demographic normally behaves for the establishment. If you expect the Groupon to generate male users with an average age of 25,  with a low income, look at the LTV of that user segment when estimating the impact of the Groupon rather than the LTV of all your customers. Also, do a test (limited number of offers) and get data on how Groupon users perform compared with other marketing channels, and divert your resources where they will have the greatest yield between marketing cost and lifetime value.

It is not about tricking your customer

One thing that you will notice I did not discuss is the common practice of trying to trick users of Groupons into spending more to lessen the cost of the Groupon. You can adjust the amount of the Groupon so the typical session cost or restaurant check is not covered, the user spends more, and you either profit from the Groupon or lose less. This technique ignores the underlying issue that you are trying to build a business with a strong long-term stream of profits. Manipulating customers short term could pay a few bills or extend your runway a month, but unless you address the lifetime value issues you will be left with nothing long-term.

The right decision making regarding Groupons

Despite the popular Techcrunch piece, “WhyGroupon is Poised to Collapse,” Groupon is not a loan shark or other immoral business. Rather it is another marketing tool that advertisers will only use successfully if they understand and can optimize their customer lifetime value. If they have a low LTV, nothing is going to help. Their Groupons will fail, but so will their advertising in newspapers or online (or the guy wearing the sign outside the restaurant). If they can create customers with a high LTV, they will see a long-term positive net return from offering Groupons.

Also notice how monetization is not the key driver here of success. It is less about how much you make or lose on the initial transaction that leads to program success, and more about how well you generate virality (and how good your virality is). Even if you improve your margin slightly, the impact of improving monetization tied to the Groupon will be much less than the impact of the other two variables (retention and virality) .

Key takeaways

  1. Groupon promotions showcase the importance of LTV. Despite negative press, Groupons can be successful if you understand and can optimize your customer lifetime value.
  2. Your Groupon promotion will only work if you can generate strong retention or great virality. If customers come back or tell their friends about your business, then the Groupon will have a positive ROI.
  3. Monetization is not a big factor for Groupon success. A change in monetization may make the program cost less but long term success of the program and your business depends on strong retention and virality.