What's a free customer worth?

That's what an article (sub required for full version) in this month's HBR asks. As usual for business school professors, the authors don't give as satisfying an answer as one might want (and take a long time to make some pretty obvious points), but there are some interesting nuggets in the piece.

It starts like this:

Customers who pay little or nothing and are subsidized by another set of customers are essential to a vast array of businesses, including shopping malls, real estate brokerages, information technology providers, auction houses, print and online media, and employment and dating services. According to one estimate, this business model accounts for a majority of the revenues of 60 of the world’s 100 largest companies.

With the explosion in the number of free services offered on the internet, the prevalence of so-called two-sided markets is likely to grow. The rationale for this approach, of course, is that by charging one set of customers little or nothing, the business will attract the critical mass of them required to draw in large numbers of another set of customers, and the income generated by the latter will handsomely exceed the cost of acquiring and serving the former. The high-stakes challenge is figuring out the true value of each “free” customer. Although executives know that free customers matter, they tend to underestimate their significance for two reasons: First, managers naturally focus more on customers who generate the bulk of revenues, and second, they lack a rigorous method for calculating the lifetime value of free customers.

The authors base most of their analysis on one case study, a research project that they did for an undisclosed online auctions company that they call "auctions.com". Sellers paid, but buyers could use the service for free. The question was what these free buyers were worth.

The answer is this: more at the company's start than after it was a few years old. The early adopters, enticed by the free service, were more important in bringing in other buyers and sellers than later adopters. This is basic network effects, but they at least quantify it with this chart:

   

You can see an earlier paper from these authors that gives the models behind this here.

Comments

[Santiago Velasco]

I just got home from a Google sponsored event. I received as a gift the Longtail book I will thank Google properly for such a gift. I have a few additional comments; When I asked you about the business model for your next book and you answered that you were even looking forward for the Chinese to copy it, I wanted to share a personal anecdote but it was not the appropriate moment, I had no chance or intention to mingle, but I can share it here in your blog.
My father once told me that he had seen in other countries pirate book markets, where you could get pirated books. He then went on to tell how he regretted the fact that we did not have that type of criminals here.

Along with this anecdote I would also like to share that I had a quick glance at the copy of your book that I received, and let me tell you I am grateful I would not even dare to frown, then I need to add that the translation was done in Spain and it feels a bit alienating while reading.
I would like to offer my services as a Spanish translator (Mexican local) for the copy of your next book, the price I ask for my services is a copy of your next book.
I know that I probably did not help my service sales pitch with my anecdote, yet there is a theory floating around that says that there is money at the in the long-tail, and that being the case of a localized translation.

I hear another theory is emerging that could help me make business sense.

If my services are not required I could do what a french kid did for Harry Potter.

http://www.boingboing.net/2007/08/10/french-kid-who-trans.html

And after translating it, I would then go look for the non existent copied books market.

I have used this comment field to contact the author if this is an editorial blog, please forward my comments to the author, if not then I am glad to have shared my anecdote.

Someone in the longtail

[Mark LaRosa]

This is a fantastic overview of the declining value of a free customer as your business grows.

Where this also has implications, and something I've spent a lot of time thinking about, is in how you compensate a sales team for growing the free customer base. If your free product can not be sold only through marketing and you need a direct sales team, you need to essentially pay commissions on the "yet-to-be-earned" revenue. Compensation should be based on the projected lifetime value of a customer, and also the effort to grab that customer. As the acquisition gets easier (more and more customers on the system), and the increased value of each new customer goes down, the amount of compensation in theory will also go down. However, not all customers are created equal in value and you also do not want to continually de-motivate a sales team by paying less and less for each additional customer brought onto the system.

I've worked on some very interesting compensation models to motivate sales people selling free products which balance the value of the customer and also the motivation of the team. I won't say I've found the perfect balance, but my team has had success - reaching the critical mass point described in the article.