Why LivingSocial can Sell $20 of Amazon Gift Cards for $10 (Or the Economics of Setting Fire to Money as a User Acquisition Strategy)

Twitter was alive with conversations today about the latest LivingSocial Promotion – where users can purchase a $20 Amazon gift card for just $10.  And as Jason Calcanis just pointed out, this deal is well on its way to selling over one million gift cards.

As would be the case with any deal where a company is literally giving away free money, many people were pointing to this as a sign of a technology bubble.  My favorite tweet came from Hunch’s Chris Dixon, who reminds us of the awesome business models of the 90’s:

However, before you start selling all your stock to go hide in the mountains, this is probably one of the most brilliant ways for LivingSocial to try to become relevant in the daily deal space again.

But before we get into that – some background on the economics of daily deal websites and the value of distribution.

Economics of Daily Deals

At the core of every business is a very simple equation:

Lifetime Value of a Customer – Cost of Customer Acquisition = Gross Profit**

Which means, that your entire job in creating a successful business is ensuring that:

Lifetime Customer Value > Cost of Acquisition

and being able to replicate that formula at massive scale.

In pivoting from The Point, Groupon built an entire business that focused solely on the above funnel – the process of acquiring customers as cheaply as possible while optimizing the total amount the customer would spend on the site over their lifetime.

The end result was a cash machine – in which NEA (and then Accel and Battery) could simply pour a ton of money at the top of the funnel and mathematically predict the return – where every dollar spent on customer acquisition would result in hundreds of dollars of gross profit.

Customer Acquisition is Expensive

As with everything economics, as you expand – the value of each marginal dollar invested will begin to decline – and customer acquisition becomes more expensive.

Specifically with daily deals, this effect has been magnified with the rush to launch new competitors in the space.  You can’t go to a meetup without meeting 5 or 6 companies who are “looking to the monetize through the use of daily deals” and we even have companies who have built entire businesses designed to aggregate offers from the different sites.

My favorite anecdote from YC-Graduate Amanda Peyton:

The primary issue is that each channel of marketing gets more crowded and more noisy – and as such – it becomes much more expensive to acquire customers.

Anecdotally, I’d put the cost of acquiring a new customer for LivingSocial today at $7 to $12 – potentially even higher in competitive markets like San Francisco & New York.  This amount is massively higher than when Groupon initially launched and will continue to grow as more players bid up the costs of AdWords, FB Ads, etc

The Value of Distribution (or Why I Heart Lolcats)

As Total Customer Acquisition Costs represent a weighted average of organic customer and paid customer acquisition cost – the best way to drive customer acquisition cost down – is to focus on increasing the number of organic customers signing up – also known as the “Viral Coefficient” of the business.

This is the true value behind platforms like Gilt Group, Zynga, CheezBurger Network and other consumer sites that have learned to leverage their market leader status to drive organic adoption.  Not only does the name brand drive new user acquisition, these platforms can easily cross-sell their new products to existing customers for free!  Once Facebook shut down access to a user’s wall, Zynga leveraged this to the hilt – locking users into their platform and advertising new games to existing users.

How Valuable are Your Customers

The other half of the equation relates to how much customers will spend on your platform during their lifetime as a customer.  Initially, this number is usually higher in a product like Groupon – because they truly find value with the product and are more engaged with the core offering.

Overtime, as more and more users join the platform – LTV tends to trend downwards – usually as businesses are trying to decrease their cost of customer acquisition at the expense of acquiring lower quality users.

The secret – which I would argue has led to Foundry Group’s most recent investment theme – is that organic customers tend to monetize better than the customers found via longtail paid acquisition.  This is the magic behind Groupon (as well as Gilt, Zynga, and Cheezburger Network) – being market leader creates buzz – buzz drives quality organic user adoption – which drives profit.

So what are the economics here

Let’s assume that Amazon has nothing to do with this promotion and LivingSocial just bought the gift cards outright.

At this scale, the deal economics are:

  • Amazon would provide a 15% discount meaning the direct cost of each card to LivingSocial is: $17.50
  • After each user pays for their order, LivingSocial is left with a gap of: $7.50
  • Let’s assume that 1/2 of buyers are new or dormant users: $15 cost

But the magic in this deal is the viral buzz that has spread across the web today – with the opportunity to double their money with the click of a button – users flocked in droves to the site to sign-up.  Impressed with their ability to magically double their money – they told their friends, they told their Twitter Followers, they told their Facebook friends, some even blogged about it :)

In the end – it means that LivingSocial ended up paying only $15 to acquire these new customers – since most, if not all will purchase this item today after being told about via word of mouth, email, twitter, or Facebook – a price that is just slightly above their normal cost of customer acquisition today. ****

This type of viral magic is what the leading company in each space experience everyday – without having to set fire to money to do it.  And while it may or may not hold true here – these organic customers are far more valuable over their lifetime as a customer.

Will it work?

No idea.  It’s still early and only LivingSocial will really know the total effect of their promotion.

But more broadly, this promotion really demonstrates the power and value of being the market leader in a consumer market.

Or more appropriately, the true value of a lolcat.

* True is an investor in daily deal site Bloomspot.  None of this post was based on information from Bloomspot, but if you’re looking for a great way to get deals on Lamborghini Rides or awesome weekend getaways – you should definately sign-up!

** Note this is Gross Profit: Businesses have other expenses for daily operations which are unrelated to the number of customers on the platform.  As gross profit increases, so does total profit as other costs remain basically stationary.

*** I have no inside information on why Foundry invested in Cheezburger Networks, Zynga, or other deals.  I do however, happen to love the potential economics of major platforms with distribution.

**** Where the model potentially breaks down is in the mix between new and returning customers purchasing the deal.  Though the math becomes far less clean, I’d argue the value of increased brand visibility & reengaging dormant customers is worth the spread – especially if this reminds users to start buying on LivingSocial again.

Related Articles:

  • dtearl

    I'm also curious to see how the "social" component of living social, which allows users to get a free deal in return for serving as the source of three other purchases, impacts the economics of this move.

    Essentially, how well did users mobilize to maximize the economy of their purchase, and how well did regular users leverage this new attention into free gift cards? This inevitably translates to (possibly substantially) greater upfront costs for LivingSocial.

  • adaugelli

    It's a good question, which I don't think LivingSocial will ever share (unless Steve Case opens up on Quora.)

    I think the sharing details are also interesting – currently – 40,000+ have shared on Facebook while 4,000+ have shared on Twitter. Directly, I think its a function of people sharing with their closer friends but indirectly a commentary on the true scale of Facebook relative to Twitter.

    • http://twitter.com/yaoyaowang @yaoyaowang

      I love this article but I'd have to disagree with Amazon's 15% discount. I know you're just doing a random number for the sake of it, but this is good business for Amazon, too.

      • http://www.lifeinbeta.org Adam

        Bulk orders of Amazon Gift cards to resellers receive a 15% discount – of the numbers used in this article – it is the most concrete.

        Doesn't mean its a bad business for Amazon at all – they'll win not only by the uptick in purchases – but also via breakage and excess spending.

  • http://twitter.com/palbi @palbi

    I don't necessarily agree when you say that these new customers will be more valuable in the long run. This looks much more like "incentivization" as opposed to organic growth to me
    An Amazon gift card is not a typical LS deal and there's no reason to expect these guys to be more likely to get back to the site to buy, say, a spa treatment. Quite the opposite actually

    • adaugelli

      I agree with you 100%

      What was interesting to me is how LivingSocial was able to mimic the exposure that Groupon, Zynga, etc experience everyday with respect to social sharing & name recognition in driving organic adoption.

      Will the customers be as valuable? Probably not. But it shows the difficulty in competing with a leader in a consumer market.

  • http://twitter.com/biggiesu @biggiesu

    There are another two things that are brilliant about this campaign that hasn't been mentioned much:
    1) Breakage. On average, customers leave 15% of the value of a card unspent. That means you can knock another 15% off the value of the card, or another $3 per customer, so your customer acquisition cost really goes down to $12.
    2) Overage. I don't have any numbers, but certainly for those that do spend the entire value of the card probably spend over the $20. Amazon may factor this in and give an additional credit to livingsocial, or discounting the value of the card.

    Either way, the use of a gift card is brilliant because it is optically an amazing deal to the user, yet is financially a better bargain than, say, when paypal flat out offered $10 in cash for referrals.

    • adaugelli

      I agree with you but only if Amazon was directly involved in the promotion.

      From the wording of the terms of the promotion (and knowing that other sites directly buy Amazon Gift Cards for similar purposes) – I don't know if Amazon was directly involved in the deal.

      The math above is based on LivingSocial simply buying gift cards to give away – if Amazon provided them at a greater discount (either directly or as part of a deal) – the economics work out even better for LivingSocial.

  • http://twitter.com/DreMoran @DreMoran

    It should be noted that while Zynga does have a large viral coefficient, their early rise to the top was accomplished by paying for new users via advertising.

    • http://www.lifeinbeta.org Adam

      Totally.

      Early Zynga grew in a similar fashion to early Groupon – paying to acquire customers through paid channels.

      What's interesting is that the same thing that happened in local deals, also happened in social games as people rushed to launch competitors – where acquiring paid users got more and more expensive. That ultimately helped Zynga, as they were able to leverage their position in the market and their large userbase to continue to grow organically.

  • http://twitter.com/boltron @boltron

    One factor that has a huge impact on the total cost for Living Social, and makes them look even smarter, is that a percentage of respondents never redeem Amazon gift cards, as with all gift cards. Now redeeming isn't the same as "using," which in this case means people that never click through to their amazon account. Once recipients click through to their account, they have forever. But somewhere between 5% and 10% just never click through to Amazon. And as a large scale corporate consumer of amazon gift cards, you get that money right back. On a million cards, that's a sizable chunk of cash back to Social Living. Well played.

  • http://twitter.com/jpundyk @jpundyk

    thoughtful piece, but i'm not sure how buying customers is "organic" customer growth. yes, they heard about the deal organically, but they're there to claim their $, not to develop a relationship with living social. my guess is a large percentage of customers won't stick. it's the same issue that groupon vendors complain about…people use the loss leader but don't convert to real customers.

  • Pingback: An Analysis of My LivingSocial Blog Post (or the Value of Relationships and Why the NYTimes is in Trouble) | Life in Beta()

  • micubogdan

    Hi Adam.What do you think, did LivingSocial pay some tweets?
    And which of the 40 000 shares vs 4000 tweets where the most valuable? (Facebook vs Twitter in this aspect)

  • Pingback: AustinStartup» Have I Got a Pizza for You! An Unscientific Survey of Austin Mobile Deals()