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SaaS metrics: The no-BS guide to understanding churn

Posted by Steli Efti on Mon, Mar 14, 2016

Churn measures the ultimate failure in SaaS—all of the customers who tried out your product and decided it isn’t worth paying for.

Nobody’s dumb enough to ignore churn point-blank, but a lot of founders have a tendency to calculate churn in a way that makes their company look best. That way, when they get together in a room, they each can brag about how great their churn looks.

More often than not, these comparisons don’t actually mean anything—they confuse apples with oranges. They’re basically bullshit. Are we talking about net churn? Gross? Month-to-month subscription? There’s a lot of different ways to calculate churn, and they each tell a different story about your business.

Don’t approach churn by trying to put lipstick on a pig. Churn is one of the most serious, persistent problems that startups face, and the only way to deal with it is through brutal honesty. You need to narrow in on an understanding of churn that accurately portrays your company, ruthlessly sniff out your retention issues, and fix them before they become full-blown disasters.

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Here are the three key questions every SaaS founder needs to answer about how they calculate churn.

1. What are you measuring?

Most people think churn only measures one thing: customers who cancel your service. But that’s a gross oversimplification.

Think about it this way: if you sold SaaS to restaurants, would you consider a little cafe down the street cancelling to be as bad as a giant chain with 5,000 locations cancelling? Of course not. They’re not equally important customers.

Customers leaving is the direct cause of churn. But churn actually affects two different bottom-line numbers that you can track. You need to figure out which one most aligns with your goals and best reflects your retention issues.

Customer churn

Despite its shortcomings, customer churn is the simplest and most well-known way to measure churn. It’s the percentage of customers who leave your company in a given time frame—in this case, one month.

Formula: churned customers/total customers.

Here’s a hypothetical situation:

  • Let’s say you have 100 customers at the start of the month.
  • Five of them cancel by the end.
  • Your churn rate is 5/100=0.05, or 5% customer churn.

5% monthly churn isn’t sustainable in the long run, but it’s fixable for an early stage company.

Just because customer churn is simple doesn’t mean it’s not useful. It’s probably the only measurement a startup needs to address retention in its infancy.

As growth expert Andrew Chen points out, young startups need to be data-informed and not data-driven. Recognize that in your early days, you don’t have enough customer data to learn anything important from a super complex churn calculation.

Grasping customer churn allows you to get at other critical metrics for your business. For example, you can use customer churn rate to calculate average customer lifetime if you divide 1 by your churn rate.

By dividing 1/0.05, we see that a 5% churn rate equates to a customer lifetime of 20 months. You can use that to calculate your average customer lifetime value (LTV)—another number you need to get a grip on.

As your company matures, however, you’ll find that customer churn simply isn’t enough.

Revenue churn

Enter revenue churn—the percentage of monthly recurring revenue you lose from cancellations.

Formula: churned MRR/total MRR

If you charge per user or have different pricing tiers, revenue churn lets you put a dollar amount on what churn is actually costing you, and at what velocity. Revenue churn can be drastically different than customer churn, and will often tell a completely different story.

Imagine the same scenario as before:

  • You have 5% customer churn.
  • But all five customers were big enterprise companies who bought your most expensive plan. Out of a total MRR of $50,000, they accounted for $10,000.
  • That gives you a whopping 20% revenue churn rate.

Your business is failing its biggest customers and hemorrhaging money as a result.

If you only tracked customer churn, it would be easy to convince yourself that your retention issues weren’t a big deal. You’d also be dead wrong.

Look at the graph below to see what would happen to your otherwise growing business if these conditions held over the course of a year. We’ll assume you acquire 10 new customers and $5,000 in new MRR per month.

customer-churn-vs-revenue-churn

Your revenue churn makes it impossible to grow. You’re bringing in new customers, but the money they pay is being swallowed up by your off-the-charts revenue churn. Your growth is just an illusion. In reality, the company is shrinking.

Customer churn isn’t a remotely accurate metric for your company in this case. By using the calculation that looks better, instead of the more realistic one, you’d be sheltering yourself from the gravity of your churn issue—and it could kill your company.

2. Are you accounting for contract length?

SaaS subscriptions typically run month-to-month, but you should try and get as many customers as possible to sign up for an annual contract. Consider the benefits:

  • It’s much safer to get the money up front and know that the customer can’t churn within the first year.
  • You’re getting extra money for work you haven’t done yet. It’s like a no-interest loan—something no early stage company should turn down.
  • You get better customers. As Patrick Campbell of Profitwell and Price Intelligently points out in his GrowthHackers AMA, “annual plans have better active usage and retention than monthly plans because those individuals are more invested in the product.”

That’s why so many SaaS companies, Close.io included, offer a discount to customers who pay for a year up front. But for those same reasons, you can’t include annual contracts in your monthly churn formula.

Monthly subscription churn

It’s the regular churn calculation, but only for customers on month-to-month plans. Just leave annual contracts out of it.

Formula: churned month-to-month customers/total month-to-month customers.

Another hypothetical situation:

  • Imagine your company starts the month with 100 customers. 50 signed an annual contract, 50 pay month-to-month.
  • This month, you lost 7 customers. If you calculate total customer churn, you get a rate of 7%. You figure that’s not great, but decent for a young, growing company.
  • But that would be the wrong conclusion. Your monthly subscription churn rate is actually 14 %. That’s much worse. It means your monthly customers have an average lifespan of just over seven months.

Plus, if you’re leaving so many monthly customers dissatisfied, the same could probably be said for your annual customers. When their contracts run out and many of them inevitably don’t renew, your churn will suddenly compound and pile up—then you’ll really be in trouble. Using the less accurate formula makes it easy to ignore the signals of how bad your retention really is, until it’s too late to fix.

You can see that on the graph below. Let’s assume that your 14% monthly subscription churn holds true for your annual contracts as well, but that otherwise you’re growing at a healthy rate of ten new customers per month.

monthly-churn-vs-total-customer-churn

That year of growth was just an illusion. You were actually shrinking the whole time, but it wasn’t clear until your annual contracts started jumping ship in January ’17. By then, it was too late to do anything about it.

Segmenting churn by contract length would have shown you that churn was much higher than it appeared. You could have diagnosed and solved the retention problem before it ballooned out of control.

3. Are you factoring in expansion?

Being honest with yourself about churn doesn’t always have to be brutal.

So far, we’ve only looked at gross revenue churn—the overall percentage of existing MRR you lose in a month. But your SaaS company needs to do more than just retain customers. The goal is to add enough value that you generate expansion revenue, either from customers upgrading to a higher-tier plan or buying more seats.

Expansion revenue counteracts the effects of churn. Instead of losing money from customers getting disappointed and cancelling, customers love your product so much that they pay you more. Factoring them into your churn calculation is crucial for putting a finger on your trajectory of growth.

Net churn

Net churn calculates churned revenue minus revenue you get by upselling and expanding current accounts. Note that you can only calculate this by revenue since it’s all about existing customers paying you more—it has nothing to do with adding new customers.

Formula: (churned MRR-expansion MRR gained)/total MRR

It doesn’t take a quant to look at that equation and see that if expansion outweighs churn, you get a negative number. That’s known as negative churn, and it's the holy grail of SaaS.

Imagine this:

  • Let’s say your company starts the month with $100,000 in MRR.
  • By the end of the month, you lose $5,000 from cancellations but gain $10,000 in new revenue by upselling clients.
  • So, while your gross revenue churn is 5%, your net churn is actually -5%.

It might not seem like that big a difference, but as Tom Tunguz shows in this blog post, the effects are huge: a healthy, growing SaaS company with -5% churn has 73% higher revenue than one with 5% churn.

positive-churn-vs-negative-churn

(image source: Tom Tunguz’s blog)

Not only does net churn more accurately portray your revenue churn, but it’s important to your company’s overall strategy.

As you grow, the only way to tap into negative churn is to build out more powerful, higher-priced versions of your product. Why deny yourself the chance to better serve your bigger clients and get paid more?

Take Slack, for instance. They’ve blown up the last two years and hit the viral growth most startups only dream of. But even so, they’ve built out higher pricing tiers and are set to release an enterprise plan with new features for bigger customers.

Scaling upmarket is the logical way for your startup to keep growing after its initial traction. Plus, as Lincoln Murphy writes here, getting an already-happy customer to pay a bit more for a superior version of your service is much easier than selling to someone brand new.

Net churn paints you the full picture of retention—not just where you fail, but where you succeed as well.

Deal with unavoidable churn

Even founders who have a grip on churn and how it happens often fail to take the final and most important step as to why churn happens. If the numbers look good, they don’t bother to dig deeper. Some churn, or so the thinking goes, is always unavoidable.

Let’s say you lose a customer because they go out of business. Your instinct might be to throw your hands in the air and say it couldn’t be helped. After all, you’re only selling them a product—you can’t stop them from failing.

Some churn is unavoidable. But leaning on that as an excuse to do nothing is dangerous. As Gainsight CEO Nick Mehta points out, it's unproductive because you start writing off more and more of your churn as “unavoidable” instead of looking for solutions.

You need to ask yourself:

  • How many customers churn for reasons that could have been headed off with stronger customer success?
  • How many customers churn for reasons that are completely out of our control?

Measure the impact of so-called unavoidable churn on your business. If it happens all the time and destroys your retention, then guess what? You can call it unavoidable all you want, but in order to survive you have to adapt your business strategy accordingly.

Let’s look at how you can address instances of unavoidable churn:

  • A customer goes out of business. Businesses fail. It happens. But if you keep attracting failing customers, then you need to make targeting healthy businesses a priority in lead qualification. Consider moving upmarket—big enterprises are much less likely to go out of business than SMBs.
  • A customer wants something you’re not prepared to give. You can’t give everyone what they want, right? If a customer insist on something untenable, like a crazy new feature or a 24-hour on-call customer service, you can’t appease them. But if this is happening over and over, you need to evaluate your customer success team and see if they’re helping clients unlock more value from your product.
  • A customer never even gives the product a chance. Here’s a frustrating scenario: Someone buys your product, doesn’t use it for three months, then cancels. Sure, you can’t make them use it. But if this is a trend, it’s probably because of a breakdown in the onboarding process. You need to hammer our a better education strategy for new customers.

Is every single instance of churn really avoidable? No. Sometimes there are circumstances beyond your control.

But there’s a difference between acknowledging that reality and leaning on it as an excuse. Whenever you’re tempted to say a cancellation was unavoidable, prove it by challenging yourself to look for a solution anyway.

Be honest with yourself

For entrepreneurs, taking a step back and examining what you’ve built with a critical lens can be difficult. When you toil away and pour your blood, swear, and tears into an idea, you’re determined to see it succeed. Just as no one wants to hear their baby’s ugly, no founder enjoys poking at the exposed underbelly of their company.

In order to succeed as a startup, however, you have to do what hurts. And in SaaS, churn is the most crucial problem you need to solve—not only to stay afloat, but to actually grow.

It’s not just about how you measure churn. After all, finding the right formula won’t convince more of your customers to stay. But what it does do is give you a deeper, fuller understanding of your business. It shows you the patterns and behaviors behind why different customer cohorts churn—which is the first step towards actually fixing it.

 

Recommended reading:

Why you need to call your churning customers (and how to do it right)
Your churning customers can your greatest teachers. Here's how you can learn from them how to build a bigger, better SaaS business.

Selling to the wrong customers will kill your startup
Advice for startup salespeople on why selling to the wrong people can be disastrous and how to find the perfect audience.

5 myths about SaaS sales you probably believe
Here's a much-needed SaaS sales myth buster for everyone building a startup. Have you fallen for any of these myths?

Topics: SaaS Churn

    
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