Creating Referrals

Many companies have had success with referrals. The idea is to get your existing customers to recommend that people that they are related to, work with, or know also become customers. In other words, your customers become advocates. They tell their friends what a wonderful company or product you have, and they get these friends to try your product. Once someone has become a customer as a result of a referral, something wonderful happens. These referrals who become new customers display, as a group, higher retention levels and higher spending levels than the average customer who is recruited by other means. You can prove this for yourself.

First, you have to set up a formal referral program. Tell your customers about it, and make it easy for them to generate referrals by contacting a customer service rep or by going on the Web. Once you have a new name, address, and email name, it is your job to get that person to become a customer. However, you put the person’s ID number into the referring customer’s database record, and you put the referrer’s ID into the referred customer’s record. They are now tied together. You can now measure their retention and spending rates and their lifetime value.

Let’s say that you have done this, and you discover that your typical customer has a 3-year LTV of $70, whereas your average referral has a 3-year LTV of $100. What can you do with that information? You can use it to create a special referral incentive program. America Online has done this. At various times, it has rewarded customers with $25 or $50 for recommending someone who also becomes a customer. This is a wonderful example of successful database marketing. There are two parts to the AOL story. In the first place, AOL has to spend a lot of money to acquire customers. It places ads on TV, sends out CDs in the mail, puts CDs in tens of thousands of stores in POS displays, and recruits customers through partnership arrangements. This must be expensive. I would imagine that it costs AOL at least $100 to acquire a new customer. Once acquired, however, these customers pay AOL $23 per month forever. What is the marginal cost of servicing a new customer? Not very much. Once you have the system and software in place, it is not that expensive to add a new customer—perhaps $5 per customer per month. At that rate, AOL is doing very well if it is spending $100 to acquire customers who produce $18 in net revenue per month.

Of course, some of these new customers do not stay. They cancel after a few months. This is true of all customers and all types of companies. That is where the referrals come in. Referrals are much less likely to cancel than people who are recruited by other means. Why? Because they know someone who is on AOL—the person who referred them. They may have joined to send that person email. They will some day have to face the question, “Well, how do you like AOL?” They don’t want to have to say, “Well, I tried it, but I couldn’t get it to work” or “I didn’t like it” or “It was a waste of my money.” They are not going to want to say these things to their friends. So they are more likely to remain as customers than people who have no such connections. For this reason, AOL can afford to give away a little money to acquire such people, and so can you.

Do your homework and find out how much you are spending to acquire customers. Keep track of who is referring whom. Find out how much more valuable referrals are than regular customers. Then set up a program to share that profit and to reward your customers for referring other people who become customers. Table 13-5 shows how regular customers might look on a LTV chart.

Table 13-5 : Regular-Customer LTV

	Year 1	Year 2	Year 3
Customers	100,000	60,000	39,000
Retention rate	60%	65%	70%
Spending rate	$275	$285	$295
Revenue	$27,500,000	$17,100,000	$11,505,000
Cost rate	60%	55%	54%
Costs	$16,500,000	$ 9,405,000	$6,212,700
Acquisition/retention cost ($120/$20)	$12,000,000	$ 1,200,000	$ 780,000
Total costs	$28,500,000	$10,605,000	$6,992,700
Profit	($1,000,000)	$6,495,000	$4,512,300
Discount rate	1.00	1.07	1.15
NPV of profit	($1,000,000)	$6,058,769	$3,926,525
Cumulative NPV of profit	($1,000,000)	$5,058,769	$8,985,294
Lifetime value	($10)	$50.59	$89.85

Your regular customers cost you $120 to acquire and $20 to maintain once they are acquired. Your retention rate begins at 60 percent. These customers are worth $90 in the third year. Now let’s look at referred customers (see Table 13-6). Let’s say you can generate 10,000 referrals. As you can see, these referred customers have a much higher retention rate. As a result, even after we reward our regular customers with $50 per referred customer, these customers have a third-year LTV of $206 instead of $90. They are really profitable customers. You will discover the same thing. Figure it out, and design a referral program.

Table 13-6 : Referred-Customer LTV

	Year 1	Year 2	Year 3
Customers	10,000	8,000	6,560
Retention rate	80%	82%	85%
Spending rate	$275	$285	$295
Revenue	$2,750,000	$2,280,000	$1,935,200
Cost rate	60%	55%	54%
Costs	$1,650,000	$1,254,000	$1,045,008
Referral fee/retention fee ($50/$20)	$ 500,000	$ 160,000	$ 131,200
Total costs	$2,150,000	$1,414,000	$1,176,208
Profit	$600,000	$866,000	$758,992
Discount rate	1.00	1.07	1.15
NPV of profit	$600,000	$807,836	$660,462
Cumulative of NPV profit	$600,000	$1,407,836	$2,068,298
Lifetime value	$60	$140.78	$206.83