Viral growth is a complex topic. In this article, we will introduce some financial formulas which will help you to value word of mouth in business.
You should start with the most simple model: a customer recommending yearly a fixed number of new customers. Then, we can value Customer Acquisition Costs (CAC) savings related to the recommendation process. Finally, we can start to look at variable recommendation rate models.
STEP 1: Customer Lifetime Value with constant recommendation rate
Firstly, you need to start with a Customer Lifetime Value (CLV) formula:
Here, the CLV is defined “net of Customer Acquisition Costs (CAC)”. To create value, the net present value of your future margins (ARPU= Average Revenue Per User less C2S=Cost To Serve a customer) should be higher than the cost to acquire a customer. For additional definitions, please find a great presentation from Dan McCarthy.
With a constant recommendation rate, sometimes called K factor:
After isolation of the viral CLV on the right:
And you can define the first term on the left part of the equation as the Viral Multiplier:
As you can notice, this formula don’t accept a recommendation rate higher than the Churn plus the Weighted Average Cost of Capital (WACC). This is solved by using variable recommendation rates in Go-To-Market models with a saturation (The most famous is the Bass Model).
STEP 2: valuing Customer Acquisition Costs savings
One of the goal of virality is to save on the acquisition of new customers. Some would tell you that no CAC should be deducted on recommended customers. The truth is more often a partial saving compared to a direct acquisition cost (you still have onboarding costs).
And the formula becomes:
For example, if the conversion rate is the double for referred customers, we could input CAC savings equal to 50% of the CAC.
STEP 3: variable recommendation rate CLV or General Formula
The value of the 1st year recommendations is:
The customers acquired the 2nd year recommendations are valued:
The value of the 3rd year recommendations is:
So, a viral customer acquired the 1st year is:
And the General Formula valuing a viral customer is:
To simulate variable recommendation rates, we modified a Bass model with a churn rate and average parameters of innovation and imitation.
The number of new imitators divided by the previous stock of customers (innovators and imitators) represents the recommendation rate at a specific horizon.
As the pool of prospects decreases, because potential prospects become customers, the recommendation rate is diminishing.
So, every additional cohort of customers will have a decreasing CLV. Please find under a graph of our modified Bass Model:
Finally, we controlled that the net present value of the viral CLV (Customer Based Valuation or CBV with virality) are similar to the DCF valuation of our modified Bass model:
Our General Formula is correct. However, you should consider with cautiousness the high multiple of the first cohort of customers. It could come from the fact that we simulated an average exit of $50 million (not so average).
Nota bene: You are free to share this article! Thanks in advance. Damien