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.

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About adam

I work for True Ventures, an early-stage venture capital fund with offices in Northern Virginia, San Francisco and Palo Alto. We partner with promising entrepreneurs at the earliest stages in the technology market providing hands-on management support to guide our portfolio companies through the challenges of early growth. View all posts by adam →