Become a better investor
Lesson in Course: Medes Newsletter (advanced, 7min )
Why do companies offer products for free? Should I be worried about investing in these companies?
“I am never offended by freebies. But this arrangement seemed almost obscenely generous.”
Derek Thompson of The Atlantic writes about the Millennial urban lifestyle.
The “Millennial urban lifestyle”, while it sounds like it could be an early morning MTV show, is Derek referring to the venture capital subsidized consumer lifestyle that’s been afforded to anyone with a smartphone in big cities of America. Whether it is hailing a ride with Uber or Lyft, ordering dinner through Door Dash or Seamless, and riding a Lime or Bird scooter to work, these are all improvements to the lives of consumers that have happened within the last ten years. What has been incredible is the willingness of consumers in major metropolitan areas to embrace the new way of doing things and not look back. Imagine how long it would take for a modern-day Rip Van Winkle, who’s just awoken in 2019, to stand on the corner in the rain waiting for a cab before he decides to just download the Uber app.
The “freebie” mentioned by Derek is $30 in credits redeemable at a variety of retailers and represents a cash or cash equivalent incentive that companies pay to sign-up new users and encourage the use of the product. He continues to discuss his concerns around how tech startups have gone to great lengths to heavily provide incentives or subsidize consumer lifestyles at the expense of profitability. With the recent debacle of WeWork’s scrapped IPO, startups are forced to reconsider profit margins and dial back the freebies or goods offered.
While there’s no question that these incentives reduce short-term profitability, I disagree with Derek and I don’t think these incentives are going away anytime soon. Instead, if done correctly, these incentives may greatly help future profitability. To understand this further, it’s important to understand why companies choose to incentivize users and how they track the economics behind it.
In a previous post, we took a look at Net Dollar Retention or how well SaaS companies can effectively grow their recurring revenue from existing users. For companies that have large expansion revenue, the future growth in revenue from existing users becomes more valuable over time. To the point that the future growth eclipses the amount of money made today on a new customer. Following that logic, many companies employ a “land and expand” tactic which involves the aggressive acquisition of customers or users (the landing) so that the future upsells (the expanding) can happen as soon as possible. How does a company sign up a bunch of users? Offer them freebies of course!
Incentives or freebies can come in many forms. They can be direct monetary credits for the user signing up, or they can be referral bonuses. For example, Robinhood awards you random stock for inviting your friends. The action of you inviting a friend is the acquisition of an additional customer or user for Robinhood and in turn, you are compensated for it.
These incentives offered are covered within the company’s marketing budget and sometimes represent the lion’s share of the Customer Acquisition Cost or CAC for the company. The rest of CAC includes other advertising costs and sales costs to acquire a new customer.
In Derek’s example, Seated, a restaurant booking app, awarded him $30 in credits for using the platform to book his happy hour. It’s likely that Seated has arrangements with retailers for a certain amount of credits in exchange for new customers so that Seated doesn’t have to pay the full amount of $30 for these credits. To keep things simple, let’s assume there were no additional marketing or sales spend and that Seated received no discounts for the credits. We can say that the CAC is $30.
The payback period is how long, generally in months, it takes for a customer to pay back the acquisition cost. There isn’t a public pricing page for Seated at the time of this writing, but let’s assume the business can make $5 for each user per month from restaurants. This means it would take an active user 6 months before the $30 would be paid back. If the user churns or stops using the app before 6 months, Seated would have lost money on the customer.
The shorter the payback period, the more desirable the user is for the business and not all users have the same payback period. Users who generate more revenue for the business, frequent user of Seated, or customers who pay for a higher price point, Netflix premium vs basic, will pay back the acquisition cost sooner. Knowing the payback period for each customer helps the business manage the amount of risk it is taking to rapidly acquire new users.
So how does Seated know $30 is an appropriate amount to convince new users to download and use their service? Why isn’t it $20 or $40?
The decision is ultimately based on the Life Time Value or LTV of a customer. The LTV is a calculation in dollars of how much revenue a customer will generate on average for a business in the entirety of the business relationship. LTV is expressed as a product of the average revenue per user (ARPU) and the average business life span of the customer.
LTV = ARPU × Average business life span of customer
Average business life span of customer = 1 / churn rate
LTV =ARPU / churn rate
A refresher on what churn rate is in our previous post.
Note: Both SaaS companies, as well as non-SaaS companies, track this metric; for example, here’s an infographic on Starbuck’s LTV.
Since we don’t have Seated’s churn data, let’s assume that after 1 year, Seated retains 75% of all users signed up, or 25% of users have churned. The average life span of a customer would be 1 / 0.25, or 4 years. The ARPU per year would be $5 × 12 or $60, a year. LTV would thus be $60 × 4, or $240.
At a bare minimum, the LTV of the customer should outweigh the cost of acquiring the customer, or else we’d be in a perpetually losing business. In the simplified case mentioned above, a $240 LTV compared to a $30 CAC represents a decent growing business. A general rule of thumb for SaaS companies is that the ratio of LTV:CAC should be no less than 3:1. A ratio of 4:1 or 5:1 represents a great business. In our scenario, $240:$30 comes out to 8:1. So, in this case, we could argue that Seated would be able to give even more freebies. In reality, the CAC is most likely much higher than $30 due to additional advertising costs. We also used fictitious numbers here for the churn rate and ARPU. We might be able to back into current LTV by assuming $10 worth of advertising would bring CAC to a total of $40. At 3:1 to 4:1 ratios, Seated might have LTV within a range of $120 to $160.
It is important to note that the customer economics covered here in this post does not address the immediate profitability of a company. Even with great customer acquisition at an LTV:CAC ratio of 8:1, a company can still be deep in the red financially if the product is very expensive to develop, or if the pay-back period is long. However, understanding and tracking these metrics in addition to NDR can help both investors like you and internal executives at the company understand the earning potential and profitability of the company in the future. A company with a strong acquisition model and expansion opportunities can quickly overcome the initial costs and become very profitable a few years into the future.
What is interesting to me is that by going through the exercise today, it is clear that there is no such thing as free lunch. All of the subsidies, provided by venture capital, enjoyed by current consumers, are intended to be paid back many times over by the consumer in the future. The bet Seated is making is that their product is good enough that current users will continue to use it and generate cash for the company. There is, in fact, nothing generous about these offers at all.