In today's lesson, we're going to focus on one of the most critical challenges faced by the entrepreneur, particularly in early days, which is the acquisition of customers. In order to do this, we're going to focus on two areas. First of all some simple customer acquisition economics. These are really critical to understand. Of course I'd encourage you to take the principles and apply them to your own business, but I'm going to give you the overview and the framework, and then secondly we'll look at some examples and some concepts around companies that have actually been quite successful at acquiring customers through taking on board different principles, some different concepts. So, among customer acquisition economics, we want to think about customer value over time. We want to think about the idea of what customer life time value is as a mathematical concept and relate it to that, the return on investment. And then thirdly, this idea around customer equity. When we go into those examples, I'm going to give you some theory in terms of principles for what do we keep in mind, top of mind, when we acquire customers and then I'm going to give two examples. One practical example and one example from some of my own research that I did here at the Wharton School. So just before we get into the real content of acquisition, I think it's really important to keep in mind, as we see here on the slide, that acquisition is one component of an overall funnel or an overall process that's about acquiring, engaging, and retaining customers, and of course extracting value from the customers while giving them value in return. And so even though today's lecture is really just about acquisition, it's very, very important not to lose sight of the fact that it's part of a wider ethos around interacting with customers, and you'll see that in fact in some of the content. So here's perhaps my favorite chart as it relates to customer acquisition because it really shows the whole story of what goes on with customers. Typically when we first acquire customers the return is negative. We have to encourage customers to learn about us. We have to encourage customers to go through the process of search and evaluate us. Sometimes we have to give customers freebies. We might have to give them hardware in order to sign them onboard for our product. We may have to give them discounts. So initially, there's usually a hurt in terms of our margin, in terms of our overall value to getting a customer on board. Over time hopefully the economics change such that what we're getting from that customer is positive and also it becomes layered up. So in the beginning maybe I'm just getting the margin from you using the product or service. As time continues and you become a little bit more attached to whatever I'm offering, I may start to upsell you. As the customer base gets bigger and I get scale at the same time, I might start to reduce my operating costs, and therefore improve the customer margin. Again, as you get more happy with what it is that I'm doing, you might start to refer other people and bring those into the network. And then finally, if you really love me and I've got you hooked on the product or service, I may be able to explicitly or at least implicitly charge you a price premium. So I'd really encourage you as entrepreneurs out there, think about what your typical customer is in that process in terms of you just acquiring them through to everything else you can layer up. The time scale I have in the chart is years. Of course it doesn't have to be. It depends on the natural cycle of period decity for your specific business. And now, in this diagram here, what's important is the idea of separating out the effort and the cost of acquiring from the reaping or the harvesting of value over time. So what we see here is we see the typical flow that customers go through in terms of learning about us and the dividing line is showing activities that we might actually have to pay for or encourage. And then on the right-hand side is the revenue and the profitability hopefully that we're reaping in return. So what I'd like you to think about when you think about acquisition. What are all the activities that you have to engage customers in, in terms of making them aware of the need for the product or service. Hopefully someone else has already done that for you so you don't incur the cost. Encouraging them to think about the alternatives, specifically your one, encouraging them to get information about those alternatives, and to evaluate them in a way that leads them to choose you and not somebody else. So all of those discrete activities involve cost and they're all critical to the acquisition process. But if done correctly, they will then be then counterbalanced by the right hand side. Which is the value and the margin that you reap and you get from repeated purchase and engagement. So let's go into that now in terms of the concept of customer lifetime value and how that relates to acquisition. I'm then going to show you a formula, well two formulas in the next slide that I encourage you to work through at a very basic level with your own business, your own product or service. So when we think about customer lifetime value as a concept. We initially have, of course, the acquisition cost. And then in addition we have some repeated things that happen as per that previous slide. We have a retention rate, so the chance that you keep going with our business whenever you have a option to defect and go with someone else. But you actively choose to stay with us when they had the option to leave. The revenue that gets spent by the customer every period, the cost that we have to incur to maintain that relationship, and then finally the wave from financial perspective how we discount that money. So those are the things that we need to mathematically develop a very, very simple formula. The reason I'm showing you this, is it's a good way as an entrepreneur to impose some discipline around what it's really costing you to get those customers through the gate and what you might expect to get in return. So, let's now go into those formulas. So, I'm going to go through the components of the formulas on the slide, and I'd really encourage you with your team, to take your core product. And to actually go through your own productal service and apply some of the logic here. So, in what follows in the formula, there's just going to be three or four simple components to determining value and relating that back to acquisition. So first of all, there will be a margin which is the price that you're getting from the product minus whatever costs you've got of servicing the customer on an ongoing basis. That's not the acquisition cost, the acquisition cost on the model you'll see on the next page is M0 or M margin time period zero right in the beginning. The idea of retention this is some number between zero and one. That's the probability that the customer comes back when they're thinking about potentially leaving us. So they renew a contract with us or they decide to stay with us or to purchase from us in the future when they could of purchased from somewhere else. So, the way that we typically estimate retention, many of you out there might already be doing that is. You take a cohort of customers, maybe a group of 100 customers that you acquired, at the beginning of the year or the month or whatever length of time makes sense for your business. So let's assume for argument's sake it's a year. So I acquired 100 new customers at the beginning of the year. At the end of the year, 80 of those customers still remained with the business. So one simple way of the retention rate is 0.8, or 80%. The next component of the customer lifetime value formula that we're going to relate back to acquisition is the discount rate, or sometimes in other formulas, it's i. The interest rate, this reflects the time value of money. Money that I'm getting from customers in the future is not as valuable as money that I'm getting today. And is not as expensive as money that I'm paying out right now to acquire them. t is going to be an index or a subscript for time periods, for how many time periods might we expect to keep the customer. So one example that was discussed in some of our other lectures and sessions together is Dollar Shave Club. So you can look that up on the website. But if Dollar Shave Club were to acquire me as a customer, what's the change that I'll be a customer for one month, two months, three months, and so on. The number of months they can expect to keep me is going to increase the financial value in terms of by customer lifetime value. And then finally I'm going to introduce a concept on the next couple of slides. Called customer return on investment. This concept was first introduced by my friend and colleague, Ali Offeck, who is a professor up at the Harvard Business School, and it's very powerful an adds another additional wrinkle or nuance. So we'll go through that in a moment as well. And so now let me explain the two formulas that you see on the slide in front of you. Again, there's all kinds of complexity that we can add, but it's always good to start and debate with the basics. So as entrepreneurs we're trying to figure out what value we might get from a customer in the future. The two formulas I'm showing you are exclusive of the acquisition cost. So think of the acquisition cost as negative. So the example I'm going to give you I'm just going to construct it. It's for a company we've discussed in some of our other lessons and sessions together, Dollar Shave Club. We can all relate, I think, to the process of shaving. So let's imagine that the customer acquisition cost is a dollar. So it costs Dollar Shave Club to get my attention to encourage me to use them, the money they're spending on search, all of the things they're doing they're figured out on average it's costing them about a dollar to reach me. And how much money might they expect to get from me in the future? Well let's imagine that the margin they get, that's m from selling me a $6 razor is about $5 because of some shipping costs. So m is $5. Let's imagine that by looking at past data they figured out that about 90% of customers continue from one month to the next, so r is .09. And let's imagine for simplicity they decided that the discount value, or the time value of money is 10%, so d is 10%. So now, let's calculate the customer lifetime value for me, a customer that's going to be around for three months or three periods, so big T is equal to three. So, the margin in the first period, t equals 0 at the beginning, is $5.00. We multiply $5.00 by 0.9 raised to the 0, that's just 1, divided by 1 plus 0.1 to the 0, that's just 1 as well. So, time period, t equals 0 we get $5. And then, in t equals 1, we now take the $5, we multiply it by 0.9, raised to the power of 1, divide it by 1 plus 0.1 again raised to the power of 1 and so on. So, what's interesting about this formula is we've made two implicit assumptions that are simplifying. First thing is, we've assumed that the margin is constant every period, which of course may not be true, because we may be able to up-sale the customers into other products or services. And then secondly, we've assumed also that the retention rate, as constant over time as well but of course the retention rate could be going up as I'm becoming more captive or it could be going down as I think about switching away to other competitors like Gillette or Harry's or one of those other companies. But again, what I'd encourage you to do is to sit down and play around with these two formulas with your team to see if you can't get a sense of how much value you might extract over time from your customers. The bottom formula just makes it a little bit more simple by saying that the customer is essentially living in perpetuity. If that's the case then we can simplify the equation just to be the margin multiplied by the retention rate divided by one plus again the interest or discount rate minus the retention rate. So try and play around with those numbers a little bit for your own business. The next piece I'd like to introduce now is the idea of return on investment. And so now if you take the customer lifetime value that you've calculated by either of those two methods. And you subtract the acquisition cost and then divide that whole number by the initial acquisition cost itself. You've got sum estimate of the return on investment that you're getting from each customer. So, now what I'd like you to think about is if you have different kinds of customers with different labels of CLV and also different labels of acquisition cost. You might be able to then plot the customer lifetime value against the return on investment, and you might find that customers that have very, very high lifetime values are not necessarily the ones that give you the highest return on investment. Now again, the whole goal of going through this exercise as we think about acquisition is not to be absolutely precise on these numbers because we just using a model after all. But to think about the important components that then also tie back into the diagram that I showed you in the beginning that the value of the customer can be increased over time, hopefully to recoup the acquisition cost. So as you're doing it, two other things I want to mention number one in the formula for customer value, the most important component typically is retention. The more you can increase the retention rate of the customer the larger that number is going to be. And then secondly, goes without saying but often firms violate this principle, particularly entrepreneurs in the early days. Never pay more for a customer than you can expect to get back in return. That's the relationship between CLV that you see right there and the acquisition costs that we're paying to get customers into the fold to begin with. So now as entrepreneurs, if we take the concepts around customer acquisition and we marry those with the customer lifetime value ideas and return ideas that we just talked about. We then sometimes want to sit back and take a very holistic view of what I term customer equity. And customer equity really has four pieces to it. We've really just focused up on the upper left, which is the direct value that we get from a customer, the acquisition cost, and then the lifetime value. But we might also think about, as entrepreneurs, is there an information value from dealing with customers? The customer data that we have may allow us to be better at servicing customers in the future or it may be monetizable even in its own right. As we continue on around the circle, we also think about communication value. So maybe there's something going on with customer equity, certain kinds of customers. I'm going to give an example in a moment. That generate value for us by telling other people to join our business and also become customers. And then finally, of course, in customer equity there's the notion of relationship value. As you start to build trust and you build the brand that you have as an entrepreneur. Then you can start to have a relationship, not just transactions with customers and they may be willing to buy other products and services. So if you're somebody like a Dollar Shave Club or a Harrys.com selling razors, as the trust is built the customer may then be willing to buy other products related to shaving or other kinds of products that the customers is using in the home. And so, now let's move on to the absolutely critical concept of what I call acquisition targeting. And here's five principles that I want you to have top in mind as you go through and you run the numbers, and you look at what's really happening as an entrepreneur to the customers that you're acquiring. So first of all, you want to be as selective as possible when you acquire customers, and you should only acquire customers in the beginning, unless there's some crazy exception where the customer lifetime value is positive. So be selective, make sure that you're getting the right customers through the gate in the beginning, the ones that have the highest propensity to not only enjoy the product. But also give you feedback about what they like and they don't like and also to refer others. Second thing you've got to be prepared for on the slide to see your acquisition efforts get more and more difficult. So the customers that you acquire in month three and four or year five and year six typically be harder to acquire and harder to obtain than the initial ones. The initial customer should be the enthusiast, so you should be prepared for your efforts to get more strenuous and the costs to go up accordingly. Third you should be aware that the more leverage you get from retention, the more you should be paying upfront to acquire customers. So, if you believe there are really critical things that you can do to increase that retention rate lever, which is the most important component of the formula that I just showed you If that's really true, you might be willing to spend more in the beginning. If you don't think there's much that you can do to bump up retention, then you should be wary of overspending on acquisition to begin with. And bullet point four on the slide is be aware that investors, particularly savvy investors, like to see you recover the cost of acquisition in the smallest number of transactions possible so if you're telling your investors it's going to take a long time to pay back initial acquisitional. Many, many transactions. That can often be a red flag to the investor. And, lastly as entrepreneurs, let's be reminded that one of the most critical principles of marketing always holds true. Customers are heterogeneous. Some customers have large retention profit potential. Some guys will be shaving with Harry's Dollar Shave Club for 20 years. Others have much lower retention profit potential. So understand what that spread is and also understand that acquisition recovery time might differ for different kinds of customers. Some customers, the payback is coming quickly others more slowly. So those are two dimensions that you can essentially use to plot your customers. How long will it take to get the money back? And then relate that on the Y axis to the retention profit potential. And now, we're going to close out our discussion of customer acquisition. Which is a fascinating topic and critical for all of us as entrepreneurs with, first of all, an example, and then secondly a piece of research that I think gives us some additional insight. So on the slide there you're going to see the icon for Jet.com. I'd encourage you to go to the website and check it out. Jet is a relatively new company that's a challenger in the United States to Amazon, has a very interesting business model around price transparency and so on so. As part of the homework I encourage you to take a look, maybe read a few articles about the company. So, there were two critical principles that apply to customer acquisition by jet.com and also other companies. The first is the principle of selection and the second is the principle of treatments, so let me explain those. The principle of selection is that customers that are selected by other customers, or that come in because of referral, on average tend to have higher customer life time values and lower customer acquisition costs. So if I refer my friend Kat to Jet.com, she's likely to be a better customer than somebody who was just acquired at random because the reason I referred her is I know that this product or service is going to be a good match for her. So this tells us that encouraging customers to acquire other customers on our behalf is an absolutely vital level in the customer acquisition process. Secondly in the customer acquisition process, is the idea of a treatment of fate. So one of my colleagues, Crystal Vandenbolt, here at the Wharton school, did a very, very nice piece of research looking at a European bank, and their customer acquisition process. And you found the customers who became customers because of referral, also had a higher customer lifetime value and were also more likely to refer other customers. If that's the way I learn about a business, I'm just more likely that it was the treatment, I'm more likely to then to do it myself. So one really important engine for the entrepreneur and acquisition dynamics is, get existing customers to refer other customers, they'll have higher CLV's. And those customers who were referred, will then be more likely to do referral themselves. This now brings me on to a piece of research that I conducted myself with some colleagues on an e-commerce business, that's going to tie some of these ideas together, and make one additional final point. And so what I'm showing you here on the slide, is some data from a very prominent c-commerce company, that was worth several hundred million dollars, and showing you how the method by which they acquire customers varied according to location. So, this is just another important factor to think about when you acquire customers. So, there are four methods here. Method number one is to acquire customers through offline word of mouth. I just happened to tell my neighbor about this new business that I came across, traditional word of mouth. We also have on the right hand side of this screen online word of mouth. So I learn about a new business through a blog or an online community. Or maybe through an email I received from a friend. And then at the bottom we have traditional forms of acquisition through magazine advertising. And also through people doing online search. Now what's interesting for this particular company is that the number of customers that they acquired through three of those methods was exactly the same but the methods worked differently in different kinds of geography. So in this particular instance, the number of customers acquired through offline word of mouth, magazine advertising, and online search, so people just typing in their needs into Google was approximately the same. However, what you notice is those methods of acquisition were differential in terms of their effectiveness in different locations. So what we found in our research is the offline word of mouth works particularly well where customers can observe each other and where customers are more physically dense. The tighter population are more likely to see each other and interact and communicate. If you look at something like acquiring customers though online search, through Google search and so on, that tends to be roughly proportional to the population. So if I have one area of the country with 10,000 people, another area with 2,000 people, then the area with 10,000 people will acquire about five times as more people through Search. And then finally, in this case, a traditional form of acquisition through magazine advertising. That was equally as effective as the other two, but it was particularly effective in geographies where people were more likely to live in larger homes and not as physically dense and physically close to each other. So this is going to be true for a lot of different business. Think about how the method of acquisition that you're using. Traditional method, or word of mouth method, or a technology enabled method like search and so on might differ according to the circumstance or location of the customer. And so now as a last word just an exercise that I'd like you to do to really reinforce the key ideas behind this lesson. I'd like you to think about the three main channels through which you're acquiring customers. Or the three main methods that you use, and then for each of those methods go back and draw the diagram that we had at the beginning of the lesson where we showed on the x axis. The time scale, and the y-axis the profitability of a customer as a function of the base level of transactions as a function of ancillary services that we can add as a function of reduction in cost as we get better and better at servicing customers, and also referral and also creating a price premium. So see if you can't relate the acquisition method to how that diagram evolves over time. And by doing that, try and identify the channel that seems to be the most profitable channel for you to acquire customers right now, subject to all of those caveats and constraints that we talked about.