Robbie Baxter [00:00:00] For context, this interview was recorded in June of 2020 amidst the COVID-19 pandemic.

Narrator [00:00:11] We all want a business like Netflix or Amazon Prime. Businesses where once a customer engages with them, it becomes automatic, and part of their lifestyle from then on. But how do you build that Forever Transaction? Robbie Kellman Baxter has been studying subscription and membership models for nearly 20 years. And in this podcast, she uncovers the secrets and strategies of the Membership Economy. Join us for Subscription Stories: True Tales from the Trenches.

Robbie Baxter [00:00:39] Welcome to the show. It’s your host, Robbie Kellman Baxter, sharing subscription stories with you. And today’s guest is Daniel McCarthy. Dan is an assistant professor of marketing at Emory University’s Goizueta School of Business. Among other things, he’s an expert on valuing companies by focusing on the lifetime value of their customers. A novel approach at the intersection of marketing and finance. His approach, which has won him many accolades, is known as customer based corporate valuation, or CBCV. His approach values companies from the bottoms up by predicting what those companies’ customers will do in the future.

Dan McCarthy [00:01:23] Think very thoughtfully about unit economics and don’t ignore the growing body of evidence for why it matters for their ultimate valuation. You really can’t escape it, so you might as well be upfront about it and use it as a tool to be the heat seeking missile that you use to measure and manage the value of your company over time.

Robbie Baxter [00:01:44] Dan’s research has been accepted and published in top tier academic journals, as well as nearly every major financial publication from HBR to the Financial Times to CFO magazine. In 2015, he co-founded a predictive analytics company, Zodiac, which was later acquired by Nike. Dan subsequently co-founded Theta Equity Partners to commercialize his work on CBCV, customer based corporate valuation. We’re going to be talking about why customer lifetime value is such an important and misunderstood metric, how to rethink the way companies are valued by the public markets and what all of this means for subscription businesses. Since we’re recording in June of 2020, we’re going to discuss corporate valuations in times of great market volatility as well.

Robbie Baxter [00:02:46] Welcome to the show, Dan.

Dan McCarthy [00:02:48] It’s great to be here with you, Robbie.

Robbie Baxter [00:02:50] Let’s dive right in. Can you explain customer based corporate valuation for the lay person.

Dan McCarthy [00:02:57] Customer base, corporate valuation at its most basic level is an enlightened way of forecasting a company’s future revenues, but driving that revenue forecasts off of what the customers will do. So hopefully it’s pretty intuitive that pretty much every major valuation method starts with some sort of a revenue forecast. And the main thing that we would say is every dollar of revenue has to come from a customer who’s making a purchase. So if I can just take these best in class marketing science models for how customers are acquired over time, how long they stay with the firm, the orders they place and the amount that they spend, that’s gonna give me unique insight into what that future revenue stream is going to look like. That might have been hard if I didn’t have all that customer level visibility. And so we’re just going to kind of exploit that accounting identity for all that it’s worth and bring all that marketing into our financial model.

Robbie Baxter [00:03:54] Can you talk a little bit about what what was missing before? What is the value of this that, you know, what you call that marketing information that was missing from past methods of valuing businesses?

Robbie Baxter [00:04:08] Yeah. So oftentimes you call it 30 years ago, we just didn’t have that view of the customer and what the customer is doing over time. And so our valuation method, you know, we could we would know that customers are going to be placing those orders. But if we can’t actually see what anyone is doing, we can’t actually incorporate that into our model. And so if we can’t do that, we’re going to rely on everything else that we do have access to. We know the number of stores that we have. We know basically if I’m extending loans, I know the number of loans that I’m passing out to consumers. Basically, I’m going to take whatever I can get it to put it into my model. But if I don’t have that customer level data, I really can’t do this approach. I’d say the big thing that’s changed over the past 20 years is we suddenly have this really nice view of what the customers are doing, whether it’s data coming in through digital that we can now track and tag what customers are doing online much better than we ever could in physical stores. But even within physical stores, we’re doing a much better job of being able to trace back those purchases to specific customer I.D.. And so it just opens up a whole new world of possibilities for methods like this.

Robbie Baxter [00:05:23] Yeah. Because what I remember I mean, my my job between years of business school, for a brief nanosecond, I worked in investment banking, doing value. It was not the place for me. I spent many, many days crying in the bathroom. But that’s another story. But, you know, one of one of the things that we did is we valued businesses. And a lot of times, as you said, we were valuing it based on, you know, well, if last year this store, the average revenue for this store was X, and we’re opening three new stores, then our revenue is going to be 4X, right, because we have four stores or whatever it is. And so assuming that every store would have similar revenue, even though, let’s say, the customer behavior might be different, the type of customer coming in might be different. Maybe the early customers that come into a store are different than the ones who come in over time or return and become more profitable. And so I think when you when you talk about the data that we have now, part of it is about the accessibility of the data. And I think part of it is about a changing mindset among businesses to think more and understand more about how the customer, each individual customer’s behavior impacts that rolled up quarterly revenue number or rolled up annual revenue number.

Dan McCarthy [00:06:48] And I think that’s exactly right. And it’s actually a really good analogy, because if you start playing it out right now, you can see how it just is different now that you might have a company like Wal-Mart or, you know, Williams and Sonoma. Williams and Sonoma, they do a lot of business in stores, but they get over 50 percent of their revenues online now. And so, yeah, how do we think about that? And typically they think about that in the same way that we think about how an existing store is going to do in future years. You know that. Well, you know the store. Did you get 10 million in sales last year? Seems like the economy’s going to be pretty good. So maybe it’s going to grow four percent this year. Basically some sort of benchmark for same store sales growth. But it’s like, OK, so how how are those sales coming about and where are we getting that four percent number from? And typically it’s again, it’s some sort of very top down way of thinking about the world, this is to say, you can keep thinking in a top down way, but we still know that all the sales would come from customers. And so, you know, let’s incorporate that into that that model for what the revenue is going to be next year.

Robbie Baxter [00:08:01] It’s so interesting, the power of the marketing data in the world of finance. You know, back to, you know, when I was in investment banking and I’d come out of it, I did marketing strategy for I was a Booz Allen consultant focused on marketing intensive companies. And I saw the power in understanding the customer. But it wasn’t something that was valued in the same way that it is today. This kind of whole idea of customer centricity and yet understanding, you know, what a financial person might call unit economics can provide so much more insight about the health of a business model. And I want to ask you about Blue Apron, because I know that’s a company that you’ve looked at in great detail. And what you saw that I think some of the public markets missed is such a good example, I think, of the power of CBCV. So could you share a little bit about the Blue Apron story?

Dan McCarthy [00:09:02] Yes, this was back, I think it was early June 2017, and I had just finished defending my dissertation. Obviously my dissertation topic was customer base corporate valuation. And it was it’s kind of like you have this hammer and you start looking for nails. And someone had asked the question, you know, over Twitter, actually, you know. So what do you think about Blue Apron? And, you know, I didn’t have kids at that time. Again, I just finished the dissertation as like, why the heck not? I’m just going to dive in and see what’s in there. And what was interesting was there was no measures of customer churn in the filing, but it did provide some really interesting data about how customers monetize over time. And basically, there was kind of almost like, you know, we should be able to run a model on this. You know, we should be able to take this methodology and just port over to Blue Apron’s data. And so when I did, there were kind of two main conclusions that kind of popped out of that. The first was that their customer retention was not so good. They had something like 70 percent of their customers churning after six months. And it’s hard to build a durable business when you basically you kind of have to reinvent yourself every year or every 15 months, technically. So that was kind of conclusion number one. Conclusion number two was in the run up to the IPO, they started to spend a lot more money on marketing. And and obviously that was spurring on revenue growth and customer growth, but not to the same extent that it was before. So basically, you know, I had concluded that their customer acquisition cost was rising very rapidly and it had gone from your call it sixty dollars per customer to more like one hundred or one hundred and ten dollars per customer. And if you just think about unit level profitability and how you know how that changes when you’ve kind of almost double the amount that’s spent to acquire customers, that can really change the game. And I think what they were trying to do was they were trying to hit certain key trophy metrics. It just so happened at the quarter right before the IPO was the very first time they had a million active customers. And this is something really nice, about a million. So I think as they were doing that, they were potentially actually destroying value at the end, which is obviously that’s really not good, even though it is creating revenue growth.

Robbie Baxter [00:11:33] I love the story, of course. And not just because, you know, Blue Apron, of course, is a subscription business. Your customer base corporate valuation is not limited to subscriptions, but the relationship with subscription businesses I find so useful. And of course, Blue Apron is a subscription business. It’s a a meal kit, which with very high variable costs because, you know, you’re not sending out streaming content or access to software. You’re sending out boxes filled with food that have shipping costs. And you know what I found so interesting about your analysis about Blue Apron and the way I looked at it was they were as you said, they were spending more and more on acquisitions. So basically they were giving people free meals to experience their offering and people were taking that. So they had very high acquisition costs because they were actually giving away food and shipping it to people. And, you know, the more you give away, the longer the more months you need to be guaranteed that somebody is going to stay. Let’s call that, you know, if they needed to stay, let’s say, seven months, but they’re not getting profitable. You know, they’re leaving after six months but it takes seven months to get to profitability. You can see that they’re effectively losing money on every new customer. This is not, as you said, a durable model. It’s not a profitable model. It’s not about scaling up. It just doesn’t make sense if you really have to spend that much to acquire somebody. But if you’re looking at it in aggregate, what you see is we put money in for acquisition and we got customers out the other side. And the revenue number that big revenue number didn’t tell the story of how people were churning out and what, you know, whether or not each individual customer’s profitable. So I feel like there’s a lesson there for the operator. And there’s a lesson there for the investor. For the investor it’s you know, as you point out, trophy metrics aren’t always the best. They’re not the most reliable. If you tell somebody what what the metric is that you care about, they’ll do everything they can to hit that metric, even if, as you say, it destroys the rest of the of the business model. And I think for the company, it’s really important, especially in a subscription business, to start by making sure that your unit economics work, that you know, that if you bring in a new customer, they’re going to stay long enough to justify the cost of acquisition. Before you, you know, what I think of as turn on your marketing loudspeaker and try to bring a lot more customers in.

Dan McCarthy [00:14:18] I think that’s exactly right. Yeah, I think that of for investors. If you knew nothing else about a company except that their revenues for growing 100 percent a year, well, you know, growing 100 percent a year is better than growing 20 percent a year. But all else is not equal. And we need to take into account, you know, all revenue is not equal. And, yeah, you mentioned the example of a software as a service firm, particularly at businesses like that. When they acquire customers the following year, oftentimes they make more revenue from that cohort than the previous year. And that’s very, very, very far from the truth with, you know, B2C businesses in general, but specifically meal kit companies and the software as a service firms typically are generating, you know, gross margins of 80 percent, 85 percent and not, you know, 25 percent, which that makes a world of difference.

Robbie Baxter [00:15:18] Yeah. Which, you know, is another really important point, I think, for for subscription entrepreneurs who are listening to this discussion, you know, doing a subscription box just of any kind is much harder than a subscription to digital goods, you know, digital services or digital content, because you have such high variable costs because you have to ship the product and you have to buy the product. It’s each new widget. You still have to pay for it. And, you know, I spoke last year, I think you’ve also spoken, at one of the big subscription box conferences. And I feel like a lot of them underestimate those costs and how difficult it is to generate profit and also how difficult it is to retain a customer for long enough for you to really enjoy the benefits of subscription, which, as you pointed out in the world of software, is that long tail, that long relationship from that initial marketing spend. Right. That you catch them once and you keep them forever.

Dan McCarthy [00:16:31] Yes. I think you’re absolutely right that there are big implications for businesses over and above the fact that obviously businesses want to be mindful of how investors are going to think about them, because ultimately, to the extent that these businesses need capital, they need to raise money. They’re gonna need to speak to those investors. So good to, you know, know how the investors are thinking about them and what the report card might look like. Even holding that aside, I think just as an operator, you can think of things like retention and customer acquisition cost as of your kind of measures of product market fit. And if you know that you’re not able to retain most of your customers after some reasonably short period of time, there’s something about the business model that may require improving. So I think about similarly to kind of how you’re describing it as well. When we when we think about acquisition costs and how it makes sense to kind of structure the business, really what a lot of this work will, you know, kind of imply is it really matters how much value you’re able to get from customers after they’ve been acquired. And if you’re able to get three hundred dollars of marginal profit for every acquired customer. You’re doing really well. Yeah, that’s a very, very good level to be operating from. Because that means that obviously in the early days when you’re getting a lot of your customers organically or through word of mouth, your CAC is going to be zero. But, you know, as you grow, sorry, customer acquisition cost. Yeah. As you grow in scale, you’re not going to be able to get all your customers coming into organic channels. So word of mouth anymore. And you’re going to be rotating into, you know, pay channels. You going to pay for things like Facebook ads and Google ads, probably. And those channels get pricey. And that does mean your business is bad. It just is the costs of doing business at scale, oftentimes.

Robbie Baxter [00:18:37] The cost of acquisition goes up. Most of you know, you want to think that you’ll get more efficient at acquisition. But if you’re relying on pay channels, your cost of acquisition will go up. It only goes down if you’re getting word of mouth kind of growth as as opposed to, you know, paid channels.

Dan McCarthy [00:18:57] Yeah, I’d say the other area where oftentimes your CAC may generally move down are marketplace businesses, where there’s some sort of network effect that can be exploited. And just the fact that you have a lot more people on the platform, a lot more people in the market will make it so much more appealing to potential prospects.

Robbie Baxter [00:19:17] Can you give an example of one of those kinds of businesses that saw their CAC go down as a result of growth on the platform and a network effect?

[00:19:26] So we had done work on a company called Far Fetch. And for them, their CAC had gone down over time modestly, which again just kind of bucks the trend. Another company actually that we’ve done work on was with Lyft, the ride sharing service. Now, certainly, you know, with Lyft, the unit economic picture, it looked OK, but not great. And certainly they were IPO ing at a really high valuation. So we ended up kind of being a bit negative on their valuation. But. But it wasn’t because their CAC was moving up. Their CAC was very marketplace like that. It came from kind a higher level and they moved to a lower level.

Robbie Baxter [00:20:07] So just to summarize, with Lyft as they started and people didn’t know about them and there weren’t enough drivers out on the road to give people confidence that they should use it, getting each new rider was very expensive. But over time, as there were more Lyft cars available and more of your friends knew what it was, it became easier for people to find out about it and have faith in it and sign up. So the cost went down.

Dan McCarthy [00:20:40] That’s exactly right. With the marketplace typically in its infancy, oftentimes it’s going to try and lubricate the market on both sides. It’s going to provide incentives to both the buyers and sellers and the riders and the people doing the rides. And that’s going to cause the CAC to be higher. But, you know, once you become a verb, you know, I’m going to Uber now, then obviously that that’s going to create the word of mouth that you need to not have to spend nearly as much money, which will make the economics a lot better.

Robbie Baxter [00:21:17] So the messag is for people listening is that you should really think logically about you can probably anticipate which way your cost of acquisition is going to go over time, depending on whether you’re counting on word of mouth or a network effect because you have some kind of a platform or whether you’re going to continue to acquire new customers through more traditional kinds of advertising, paid outreach. And that will help both you as an operator anticipate your costs. But also if you’re an investor and you’re trying to understand, you know what some, you know, perspective investment, what some entrepreneur is telling you about the you know they kind of spit shine their business. These are good questions to ask to try to understand. What do you expect your CAC to be? How confident are you in terms of the lifetime value of each new customer who signs up? How are you tracking that? Those are the kinds of questions that might get you better data to make a more informed assessment of the value of the business.

Dan McCarthy [00:22:27] That’s right. If you’re again going back to the subscription box example, if you if you’re going to pitch me that your business is great and you’re basically turning your customers are worth one hundred dollars after they’ve been acquired. And you’re not spending anything on paid marketing. Yes, your CAC is zero. You will be profitable. But I know for sure, as soon as you start trying to scale that, you know, you’re probably going to move from zero to 70, 80. And that’s going to really erode the incremental profitability of your customers. So, yes, the CLV (Customer Lifetime Value), obviously all of this, it’s all basically customer lifetime value. But it’s also kind of this decomposition of customer lifetime value into what I call the customer acquisition costs, which is what you spend to get to people in the door. And the amount of value that you get after that, after they require you what I call the post acquisition value. And so being able to kind of see where those numbers have been, how they’ve been evolving, how the marketing budget’s been evolving. And then just knowing kind of given the nature of the business and where it’s looking to go, how those should move in the future, I think that can give you a very good kind of prior view of how that business is going to do.

Robbie Baxter [00:23:54] It’s more complex or more nuanced, I think, than a lot of people understand. I wanted to ask you about, you know, this is June of 2020. You know, some of us are on third or fourth month off of, you know, restricted movement, sheltering in place. What have you seen in terms of the impact of that on your model and how well your model can incorporate these kinds of disruptions of revenue and dramatic changes in customer behavior?

Dan McCarthy [00:24:28] Yeah, I think the way that you framed it was right that basically it’s kind of this dramatic disruption that obviously if we were sitting here in January of 2020, you know, our model will not predict that, you know, we take historical data. We use it to predict the future. I think as we have worked our way through it, it’s a framework like this that can really allow us to understand how these companies are doing and be able to answer questions like is the drop in revenues at a particular company because the company is no longer acquiring new customers but the existing customers are doing OK? Or is it more broad based than that? And being able to have those diagnostic conclusions about where the weakness is coming from can have definite implications for how that business is going to kind of muddle its way back. You know, as we kind of move our way slowly but surely back toward some sort of a new normal, I would say the impact that COVID has had on consumer behavior has been so randomly different for different types of companies where there’s been some narrative about it’s just kind of a great acceleration of what was already in place. And, you know, obviously the trend towards digital had been in place before. Now it’s just continue to accelerate, but seems a little too pat to me. You know, I think that there’s still significant variation where it wasn’t even really due to any fault of a particular company that they might have gotten completely hosed by COVID. You know, even to the point of, well, you know, we sold shirts. So we did a bit better. You know, we sold underwear and thus we’re not there on the Zoom camera, you know, shoes aren’t doing well. When you have some very hyper synchronized omni channel strategy, well, all those stores are second wind, whereas the company that really wasn’t trying and just sold e-commerce only they’re sitting pretty.

Robbie Baxter [00:26:26] It was a good dose of luck I think in this one there, you know, things that you can’t predict it. I mean, what it does to theme parks and hospitality vs., you know, like you said, e-commerce and how, you know, King Arthur Flower is having a field day because everybody’s staying home making bread. You know, just crazy.

Dan McCarthy [00:26:47] Home improvement’s been, you know, much more resilient because people are now at home and they say oh, darn, I need a better chair for my home office. And was that because they knew it was coming all along? I mean, this is just kind of a random fluke that because people are at home, you know, the mix of products that they need as has significantly changed. So, see, I think that, yes, certainly there’s going to be an element where we’re just going to need to kind of properly control for what’s going to be more temporary. And I think what’s going to be more likely to persist into the future. So I think that the CBCV framework could be a very helpful way of being able to see that play out. But I think that there is going to be an element that will need another another handful of minds to really tell what’s going to be more transitory and what’s going to be a bit more, you know, more permanent.

Robbie Baxter [00:27:44] Okay, we’re just wrapping up and I have some fun questions for you. What advice do you have for entrepreneurs as someone who has started multiple companies?

Dan McCarthy [00:27:57] Oh, that’s a great question. I think knowing what you’re good at and knowing where where your competence ends is extremely important. I know for myself I thrive when I’m the geek in the back room. I really don’t thrive when I’m kind of the day to day leader who’s calling all the shots. And that’s just that’s not an environment that I do well in. And I don’t think I make those decisions particularly well. So, yes. So it’s not that you wouldn’t want to start a business, obviously I have started two. But it can really help inform the composition of the team and the composition of the skill sets of those team members.

Robbie Baxter [00:28:36] That’s wise. And then in terms of your advice for academics who are thinking about, you know, kind of straddling between their research and the commercial side.

Dan McCarthy [00:28:51] That’s a hard one. Typically, in general, I’d recommend that academics don’t do it. Actually, there’s a lot of things that are good about it. That you get access to great data, oftentimes you hear these really interesting problems. And so it can help spur on what might be the next great academic paper that you write. But oftentimes they can encourage kind of quick and dirty ways of solving problems. So, it’s like yeah, yeah this is like the 70 percent solution that gets done right now versus the 100 percent solution that takes, you know, a full year to do oftentimes to get a paper published in the top tier academic journal. It’s more the latter type of paper that’s going to end up succeeding. And so and so having to kind of think about the problem solving decision in these very different ways, I think that can lead to bad muscle memory.

Robbie Baxter [00:29:50] It’s like two different, you have two different goals. Okay, so the last little bit. I have a speed round for you. So just answer with the first thing that comes to your mind. What was the first subscription you ever had?

Dan McCarthy [00:30:03] That’s actually a really good question. I don’t know if I, it might be something like digital news subscription. I’m thinking.

Robbie Baxter [00:30:12] OK, your favorite subscription today?

Dan McCarthy [00:30:15] The geek answer. Crunchy roll.

Robbie Baxter [00:30:17] Yeah I know that one. The very well-run subscription. Your superpower?

Dan McCarthy [00:30:25] My superpower. Being a random geek and being unabashedly proud of it.

Robbie Baxter [00:30:32] What do your colleagues hate and love about working with you?

Dan McCarthy [00:30:36] What do my colleagues hate about working with me? I am kind of idiosyncratic, so I’m a bit of a perfectionist so that can swing both ways when, you know, you’re working with other human beings. And then in terms of what what they love about working with me, certainly I’m kind of a zero or one hundred fifty percent sort of a guy. And so when I’m really into something, I really try and carry my weight and you kind of take take it all the way to the finish line. So, yeah, hopefully that benefits everyone is involved.

Robbie Baxter [00:31:12] Yeah. That makes for a good colleague. And then what is the one thing that you the subscription entrepreneurs and practitioners who are listening to this conversation, what is the one thing you’d like them to take away?

Dan McCarthy [00:31:25] The one thing that I would like them to take away is to think very thoughtfully about unit economics. And don’t ignore the growing body of evidence for why it matters for their ultimate evaluation. You really can’t escape it. So you might as well be up front about it and use it as a tool to be the heat seeking missile that you use to measure and manage the value of your company over time.

Robbie Baxter [00:31:53] Unit economics are the under loved and so important data for most entrepreneurs. Great point. So thank you very much, Dan McCarthy, for spending time with me and sharing your wisdom on Subscription Stories.

Dan McCarthy [00:32:12] Thank you for having me. And hopefully we’ll get a chance to pair up again sometime soon. You mentioned that the CFO piece, obviously, that was one that that we’d done together and I’d a lot of fun doing that. So we’re looking forward to hopefully the next one sometime.

Robbie Baxter [00:32:25] Yeah, yeah. Me too. I look forward to collaborating again soon.

Robbie Baxter [00:32:33] Thanks for listening, everyone. This has been Subscription Stories. Today, I was talking with Dan McCarthy of Emory University’s Goizueta Business School to hear more success stories of entrepreneurs creating their Forever Transaction in this new and exciting Membership Economy, subscribe to my podcast wherever you download your podcasts. Also, if you’d like what you’re hearing, please give us a rating and review. They mean so much. Thanks for listening and for your support.

Robbie Baxter [00:33:07] To learn more about Dan, go to Daniel Minh, that’s M-I-N-H, McCarthy dot com. (DanielMinhMcCarthy.com) I’m Robbie Kellman Baxter.