Our second fund at Greycroft is just over a year old, and we have already invested in two local marketing companies.  One is called Matchbin, which provides digital marketing services for newspapers, and the other is called Netsertive, which provides digital marketing services for retailers.  Over the past year I have had a chance to look at many local marketing businesses and I have a few thoughts about how to make money in this sector.  I was hesitant to put this in print because the conclusions may be wrong (or even worse, they could be obvious), so please consider this a work in progress.

First, there are only two sources of revenue for local marketing companies: advertising (ex. Yellow Pages or Reach Local) and eCommerce (ex. Groupon or Seamless Web).  From the merchant’s perspective these are the same thing – the merchant can either buy advertising to get a full price customer or the merchant can give a cut to an eCommerce company like Groupon and Groupon gets customers on their behalf.

Second, there are only two factors that determine how big a local marketing start-up can get.  The first is Customer Lifetime Value (CLV) and the second is Cost per Gross Addition (CPGA).  I will explain what this means.

Customer Lifetime Value is the amount of money a company makes from a single merchant.  For instance:

1.) Groupon gets a local merchant to agree to 1,000 coupons at a price of $50 each.  If Groupon successfully sells all 1,000 coupons, that sale generates $50,000, which is split 50-50 with the merchant.  If the merchant never does another Groupon that merchant’s CLV is $25,000 ($50,000/2).

2.) Reach Local signs up a merchant to a $1,500/month agency services contract.  Half the money is spent on media (Reach Local buys Google keywords for the merchant) and Reach Local keeps the other half.  The average merchant stays on the service for 6 months before cancelling, so one merchant generates $4,500 in CLV ($1,500/2 x 6).

The main takeaway is that Groupon makes a lot more money in one day than Reach Local makes in six months.

The second factor is the Cost per Gross Addition (CPGA).  This is the money that Groupon and Reach Local spend to recruit new merchants.  In the Groupon/eCommerce model there is also a second form of CPGA, which is the cost of recruiting consumers.  In the example above Groupon needed to find 1,000 people to buy a $50 coupon, but Reach Local didn’t.

Cutting to the chase, the merchant CPGA is similar in both businesses. I could get very technical and show how this works (you take sales expense, divide it by sales productivity, and add in overhead), but the outcome is in a tight range from a few hundred bucks per merchant to a thousand bucks per merchant.  Managing this closely is important for Reach Local because they don’t have much margin, but this expense is insignificant for Groupon.

Thus far eCommerce is way ahead in comparison, but you will see the hard part is recruiting consumers.  If Groupon’s cost of acquiring customers goes from $5/user, to $10/user, to $25/user… all of a sudden the lucrative sample deal above swings from a profit to a loss.  As the Groupon IPO prospectus has shown it is not easy to keep these costs low over time.  This is the real challenge of doing performance-based marketing on a local basis.

I have studied this for a while and it seems to me that the eCommerce model makes more money than the advertising model.  In fact, I think we are going to see more advertising-based businesses flip into eCommerce businesses as the industry figures this out (AT&T just announced that they were launching a Groupon competitor).  I also think will see more consumer brands come into local eCommerce.  The main differentiation on the eCommerce side is the ability to segment consumers, acquire them at a low cost, and drive purchase behavior.   This is what good brand managers do for a living.  The whole local commerce movement is just an old school branding problem applied to a new school business model.