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June 22, 2005

Nerd CEO - When Free is the Right Strategy (Cont)

OK.  Giving stuff away can be either a world-beating strategy or an excuse for having no strategy at all.  How do you tell the difference? How do you know if you’re kidding yourself, your VCs and your friends and family?

As I blogged Monday, three good reasons for giving things away are 1) to build a large network; 2) to establish a standard; or 3) to establish a prospect base.  Also, of course, it can be perfectly good business to give content away and sell ads (unless you’re a blogger) but that’s another story for another day.

Let’s start with #3 because that’s easy to figure out.  If you’re running a contest or giving away window-washing software or providing free videos of a questionable nature in order to get a list of prospect to whom you plan to sell something, all you need to do is figure out whether each prospect is expected to be worth more to you than the cost of acquiring that prospect.  Sure, there are lots of guesses in making that calculation; but, once you’ve made the guesses, the math is easy.  For those non-nerds who never liked word problems, the formulae are below and here’s a link to a simple spreadsheet which implements them.

            Cp = Cf/n+Cv+S*Cc/R

Where:

Cp is the cost per prospect

Cf is the fixed cost of the promotion

n is the total number of prospects you’re expecting to harvest

Cv is the variable cost per prospect – includes the cost per unit to you of what you’re giving away

Cc is the cost per click-through of any search engine you’re using

S is the percentage of your total prospects (n) that you expect to get from search engine click-throughs

R is the percentage of click-throughs you think will accept your offer and become prospects.

The attached spreadsheet contains an example showing that, if you have a promotion with a fixed cost of $10,000, a variable cost per prospect of $.10 (perhaps what you pay the developer of the window-washing software for each download), a cost per click-through of $.45, obtain 50% of your total prospects from click-throughs, and have a click through conversion rate of 20%, then the average cost per prospect will be $1.33.

            $1.33 = $10,000/100,000+$.10+.50*$.45/.20

Obviously, if you can buy a list of prospects who have at least the same expected value elsewhere for less than $1.33 each, you may want to do that first.  Also, obviously, search-engine costs are a big part of prospecting.  The cost of what you give away may be immaterial compared to search-engine costs.

            Vp = S di*Pi*Mi

Where:

Vp is the value of a prospect

S is a funny symbol that means you gotta add a lot of things up that come after it

di is the discount rate applied to sale i depending how far in the future it is

Pi is the probability that a prospect will buy the offer in sale i

Mi is the margin in dollars you make on each purchase in sale i

i is a number from one to something for each offer you intend to make to the prospects

So, for example, if you plan to make four offers discounted respectively 98%, 97%, 95%, and 92% (because of the time value of money) and you project the excellent take rates of 10%, 15%, 12%, and 5% with margins of  $1.00, $1.50, $5.00, and $.95, each prospect will have an expected value of $.93.

            $.93 = .98*.10*$1.00+.97*.15*$1.50+.95*.12*$5.00+.92*.05*.95

In this case, the promotion wasn’t worth doing because the expected value of each prospect is less than the expected cost of acquiring the prospect!  However, a careful observer will notice that most of the cost came from using a search engine to gather half the prospects.  The $.10/copy cost to you of the free software you gave each prospect who enrolled was not the problem.  Presumably, the promotion would have been profitable if use of the search engine were eliminated as long as we believe that we would really have gotten half of the prospects without its help.

Also, more offers to the same prospects might make gathering them worthwhile.

This is called guessing with Excel.  You certainly shouldn’t spend any money the spreadsheet says you will earn until you earn it.  However, the exercise of making the assumptions is worth doing even though they will never resemble the real world.  You will be surprised how many times someone will give you a plan for prospect gathering which can’t possibly make money even under the rosiest set of assumptions. Sometimes but rarely you’ll find a promotion which makes sense even under gloomy assumptions: do it fast before your competitors do!

I’ve blogged previously about the importance of asking for money and of creating perceived value through a high price.

The first post about free as a strategy is here.

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» When Free is the Right Strategy by Tom Evslin from Hispanic Business Info
By Tom Evslin "When Free is the Right Strategy" Tom Evslin Former ITXC CEO provides formula to whether "Free" is the right approach to building a prospect base. OK. Giving stuff away can be either a world-beating strategy or an... [Read More]

» When Free is the Right Strategy by Tom Evslin from Hispanic Business Info
By Tom Evslin "When Free is the Right Strategy" Tom Evslin Former ITXC CEO provides formula to whether "Free" is the right approach to building a prospect base. OK. Giving stuff away can be either a world-beating strategy or an... [Read More]

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