Why Churn is SO critical to success in SaaS

Summary: Illustrates graphically why churn is a huge problem a SaaS company gets larger. It also looks at a very surprising factor that can massively accelerate SaaS growth: negative churn. (This article  is applicable to any recurring revenue business, not just SaaS.)

Introduction

As a SaaS company becomes larger, the size of the subscription base becomes large enough that any kind of churn against that base becomes a large number. That loss of revenue requires more and more bookings coming from new customers just to replace the churn. As a result growth slows substantially. To illustrate this point, I built a very simple model and graphed the output below. The model starts with MRR (Monthly Recurring Revenue) at zero, and bookings from new customers at $10k in the first month, increasing by $2k every month after that (represented by the dotted blue line in the graph below).

 

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The red and yellow lines show the lost revenue due to customers cancelling their subscriptions (churn). These show the impact of churn at a 2.5% and 5% monthly level.

Looking at the graph above, we can see that Churn is really not that big of a number in the early startup months. But as the company gets towards the end of its fifth year, even at a relatively low churn rate of 2.5%, you are losing $64k a month which is extremely hard to replace with new customer bookings. And with a churn rate of 5%, that number is even worse at $90k.

The graph below shows the impact on Total MRR (monthly recurring revenue) of each scenario, which is fairly substantial.

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The Impact of Negative Churn

It is possible to run a SaaS, or any other kind of recurring revenue, business in such a way as to get what I call Negative Churn. This happens when the expansions/up-sells/cross-sells to your current customer base exceed the revenue that you are losing because of Churn.  The graph below shows what happens to your bookings if in addition to your sales to new customers, you are seeing a expansion revenue from your current customer base of 2.5% every month (green line).

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The result is quite shocking. The expansion revenue from the existing customers starts to become a huge number, and by the end of year five is contributing close to $180k every month.  Let’s take a look at Total MRR to see what effect this has (see green line in graph below):

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It’s an amazing result. The business is nearly three times bigger than one with 2.5% churn. Clearly getting to negative churn is one of the most powerful accelerators for growth. Since this can be hard to achieve, this does beg the question of what happens if you can’t get to negative churn, but were able to get to 0% churn. See the dotted line in the graph below:

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The 0% churn line is still nearly 60% more than the one shown in the yellow line (2.5% churn).

How do you achieve Negative Churn?

Getting to negative churn requires that you can do one or more of the following three things:

  • Expand revenue from your current product.  This is best done by having a pricing model that increases the pricing according to some usage metric that will grow over time. As an example, Dropbox charges you more as you use more storage. Email marketing companies charge you more as your email list grow, etc.  For more on thinking through how to get your pricing axes designed right, you may want to read this blog post: Multi-axis Pricing: a key tool for increasing SaaS revenue.
  • Up-sell customers to a more highly featured version of your product.
  • Cross-sell customers to purchase additional products or services.

Same salesforce for Expansion/Up-sell/Cross-sell?

While not a hard and fast rule, my usual recommendation is to split the sales organization into hunters that chase deals with new customers, and farmers that work on expanding the revenue from existing customers. There are two reasons for this:

  • Focus: if I am a rep that has the choice between phoning an existing customer to increase revenue, or calling a new customer, I will usually pick the existing customer as that is easiest. That means a lack of focus on new customers.
  • Different skill sets: The skill set required for expansion sales is often more about how to make the customer extremely successful with the product. This is more of a consulting, customer service, product expert skill set, than a sales skill set.

How to track the different factors that make up Bookings

Assuming that your SaaS company has a way to get expansion sales, your net bookings number will be made up of the following three components:

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It makes sense to track each of these separately in a graph that looks like the following:

 

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When to focus on negative churn?

A lot of this blog’s readers are from very early stage startups, and I don’t want to give them the sense that they immediately need to focus on creating complex pricing schemes and product variations for up-sell or cross-sell. In the first 12-24 months of your business, it is frequently too early to figure this out. At this stage  it is more important to get broad customer adoption, and that often means simple pricing that leaves something on the table for your customers.

However, even for early stage startups, I do recommend focusing hard on reducing churn. High churn is usually a clear indication that your product is not meeting customers needs or expectations. And that is not a formula for long term success.

Tactics to help reduce churn

  1. Call your customers. If you are an early stage startup with significant churn, the first place to start is to call the customers that are cancelling to find out why. I recommend that the entrepreneur (or CEO) themselves make these phone calls, as only they will have the ability to change the product vision or other service attributes based on the feedback. This function is far too important to delegate. Frequently these calls will tell you is that your product is either not solving their problems, or that they are having trouble implementing it. This can often be solved by changing the product, or the way in which you support them during the implementation phase.
  2. Measure customer engagement. The heading for this tactic should have read: measure customer happiness, but that is hard to do. So instead, I recommend measuring their engagement with your product. You can do this by instrumenting the key features in the product, and sending a log entry to a customer engagement database every time they use that feature. Based on assigning a weighted value to each of these events, you can create a customer engagement score. The score is a great indicator of which customers are getting good use out of the product, and therefore not likely to churn, and which are at risk. Now you can use your customer support folks to email/call those people with help and advice on how to get going using the product. (I have another blog post on this topic here: Measure Customer Engagement – Increase Conversions & Lower Churn.)
  3. Figure out what features make your product sticky. In the early days at HubSpot the company suffered from fairly high churn. The reason for this was that a key focus of the initial product was SEO, and once a customer had finished search-optimizing their site, they didn’t see a need to pay for keeping it optimized. HubSpot had work to identify what features they could add that would be sticky. The belief was that anything that became a core part of that individual’s regular workflow was one way to get stickiness, and the other was to become the repository for some critical data. Once you become the system of record for that data, it is much harder to switch to another service.
    Ask yourself if you know what are the key features that make your product sticky, and then use measurements of customer engagement to see which customers are not using those features. Those are the customers most at risk of churning.
  4. Allocate your best reps to the job of saving customers that call to cancel. It is often possible to save a customer that is about to churn. But it requires your best sales skills to achieve good results.
  5. Consider testing a longer term contract. The discussion so far has assumed that you have customers on a month to month contract. One way to lower churn is to ask customers to sign up for a longer commitment up front (usually 6 or 12 months.) This has the effect of lowering churn, as they are more committed to the product, and more will get through the phase of fully implementing the product and seeing benefits. The negative is that it will dampen sales. So the best way to proceed is to test to find the optimal level. It is also possible to encourage sales to sell these longer contracts without forcing it.
  6. Look for other factors that correlate with churn. For example, you might be selling to small and large customers. If so, it’s likely that you will find that your smaller customers churn more than your larger customers. This might incline you to focus more of your sales and marketing efforts on your most profitable type of customers (taking both CAC and LTV into account).  But you might also find that customers from a particular vertical/lead source/etc. have a tendency to churn more. As you investigate this, you may discover that either these are a poor fit, or that your product needs some modification to better suit their needs.

Managing Churn is harder if you are selling to Small Businesses

The reason for this is that many small businesses go out of business. They are also quicker to cut costs when things are not going well.

In addition, getting to negative churn is even harder, as many small businesses have a clear limit to what they can afford to pay for any given service.

How Churn affects Valuation

If you are presenting your SaaS company to a VC, expect them to pay very close attention to your churn numbers, even if you are early stage. They will be looking at churn as a great indicator of whether or not you have good product/market fit.

Wall Street and public stock buyers have also realized the importance of churn in SaaS companies. There is an great research report out from one of the leading investment banks talking about the factors that drive public company SaaS valuations. While the top factor impacting the multiple on revenue is growth rate, they clearly show how both retention and upsell are strong secondary factors. Their analysis shows that an incremental 2% increase in retention leads to a 20% higher multiple, and an incremental 2% increase in up-sell leads to a 28% higher multiple.

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  • Adrian Nita

    Hi David. That’s a great article! I would ask if you know what the ideal churn/retention rates are for an SaaS company? We all talk about retention, but we do not have a minimum idea about what the ideal retention rate is! Thanks a lot and keep the great work!

  • http://www.apptegic.com/ Ryan Connors

    David this is a phenomenal resources. The charts do a great job helping to visualize the impact of churn on profits. Thanks for putting this together.

  • Ryan

    can I ask what that Wall Street research report was called or which firm put it out?

  • http://www.forentrepreneurs.com David Skok

    It was Goldman Sachs.

  • http://www.stephdokin.com/ Stephen King

    GREAT article on the topic. This is why TCELab CRD Voice of Customer Survey product is SO vital for SaaS companies. Check it: http://www.tcelab.com/#!/crd (See: points 2 and 3 of David’s article “Tactics to reduce churn”: measure engagement and figure out what makes your product sticky!). Until end of June 20% off CRD #iwantmyCRD (Thanks for letting me spam your post!)

    Stephen King, CEO, TCELab.com

  • Javiero

    Dear David,

    We owe you a big appreciation from Spain as we have been learning a lot from you.

    We set up a SaaS company a year ago in Spain and now we have a plan to expand internationally . Although we focus only on growth and do not distract ourselves, ultimately we dream a day where our company will be acquired. So my question is; Shall we expand to structured market where competition is high and market is big like UK, Germany or developing countries where competition is low and market size is fair enough and market-entry is hard like Russia.

    Which one potential acquirer love more? Acquire a company where acquirer do not have presence or acquire a company which has a mid-level growth in established markets like UK?

    I know that this is “it depends question”, I really do need your personal opinion.

    Thanks very much and appreciate your time .

    Best regards from Spain

  • http://www.forentrepreneurs.com David Skok

    First of all, I personally believe that the best way to run a company is not to think about getting acquired (at least not until you are right in the end game and looking for an exit). The reason for this are as follows:

    1. You don’t control getting acquired. Only the acquiring company controls that decision.
    2. Acquiring companies generally are most interested in buying companies that are not trying to get bought
    3. Acquiring companies can tell when you are trying to get bought. They smell that, and it makes realize they can pay a low price
    4. Running your company to optimize for acquisition will lead you to do the wrong things
    5. The best people won’t want to come and work for a company that is trying to get acquired.

    Now that I have that out of the way, I can try to answer your next question, which is where (geographically) should you focus your attention first. I would first try to make really sure that I had demonstrated clear product/market fit, and also a repeatable and scalable sales process in my own market before trying to establish the company in yet another market. (See this blog post if you are not sure why: http://www.forentrepreneurs.com/setting-the-startup-accelerator-pedal/). It would be a big mistake to be experimenting on these important issues in two different markets.

  • Sebastian

    Nice post. It would be interesting to see the churns for different business models. I always found it difficult to
    define the right churn rates.

    On the other hand i would rather focus on
    actions to lower the rate and wrote a post about that on
    http://community.netigate.net/sample-questions-for-a-churn-survey-to-improve-your-churn-rate-9300.html

    Let me know what you think!

  • http://www.forentrepreneurs.com David Skok

    Check out the latest blog post that has Churn data from a survey we just did.
    http://www.forentrepreneurs.com/2013-saas-survey/

  • http://www.reenhanced.com/ nhance

    There’s a lot in here, but the math is fundamentally wrong.

    Let’s look at profit as an equation.

    Profit = Traffic * Conversion Rate * ((Lifetime Value * (1 – Churn %)) – Customer acquisition costs)

    Let’s look at what a change in conversion rate does:

    Traffic = 100

    Conversion rate = 1%

    Lifetime Value = $10

    Churn = 1%

    CAC = 0

    For these base values, profit = 100 * 0.01 * (10 * 0.99) = $9.90 / month

    If the conversion rate changes by 1% to 2%, then profit becomes $19.80 / month

    However, if churn changes by 1% to 2%, then profit becomes $9.80/month

    A 1% change in conversion rate is worth FAR more than a 1% change in churn, and it’s proved by MATH.

    However, churn is attractive to focus on because it has the benefit of human psychology on its side. It’s called Loss Aversion (http://en.wikipedia.org/wiki/Loss_aversion), which states basically that a person will work harder to prevent from losing $100 than they will to gain $100.

    Business Growth for a SaaS will always be worth more than churn. Churn is still important, but if you have to pick on one to focus on, use the math. Focus on conversion rate. No SaaS (except maybe Constant Contact) is large enough to have to worry about running out of new customers.

    I really appreciate the work you put into this, but I don’t agree. Please let me know what you think!

  • http://www.reenhanced.com/ nhance

    I’m sorry if this comes across as overly critical! I just want to point out that as a growing business, focus should be on gaining new customers.

    It’s a fact of life in any SaaS that all of your customer base will churn out eventually, but in order to have the traction a business needs to grow, the limited attention of the founders is best placed upon improving conversion rates and traffic.

  • http://www.forentrepreneurs.com David Skok

    Your point is a very good one. The only small change I would make to that is this: there is no point in focusing on gaining new customers if they all churn out quickly. You are simply filling a leaky bucket, and will not be able to build a long term sustainable business. You will also have difficulty attracting investors who will focus on whether you are providing real value to your customers. However if your churn rates are reasonable, this won’t hurt you too much in the early days, as there won’t be a big installed base. So you have time to fix that as the business grows.

  • http://www.reenhanced.com/ nhance

    I totally agree. Decisions should always be made with the big picture in mind

  • http://www.forentrepreneurs.com David Skok

    Your equation doesn’t take into account how churned $’s grow as the size of your installed base grows. If you have a very small startup, you are right, focus on conversion rates. But as you get into your later years, you will soon see that your installed base not renewing will quickly wipe out most of the gains you make on conversion rate. Example: let’s say you are able to grow your MRR by $10k every month, and that you have an installed base of $300k in MRR. If you are churning at the rate of 3% a month, you will be losing $9k a month in revenues, which is almost more than you are able to bring in with new bookings.
    The problem only gets worse as the size of your installed base grows. You can ignore churn for a while, but there is a point in time where it becomes extremely hard to bring in enough bookings to overcome the lost revenue from churn. At that point in time your business will stop growing.
    Put this another way, for any given churn rate and specific bookings rate, there is an absolute maximum size of business that you can reach.

  • http://www.reenhanced.com/ nhance

    I agree that churn is more important as the installed base grows. Any change to any of the variables in the profit equation will have an impact on profit and they usually won’t change independently of each other.

    If the team has a monthly new revenue goal that’s fixed, meaning sales must do $10k/month and is not working to increase that number, then churn becomes a much bigger concern as that will have the effect of fixing the conversion rate, assuming traffic remains relatively stable.

    But the equation still holds, even for more mature companies, as it works off percentages. However, I am very interested to tweak it if you see something that’s wrong, as this forms a good chunk of my understanding of this whole space. Can you suggest an improvement?

    Is it that maybe what you’re talking about is how the size of a 1% change in churn with a large installed userbase is much bigger (and thus higher impact) when the size of the installed userbase approaches the size of the new traffic that sees the app?

    Once the traffic count (the number of new eyes that see the business) is below the number of paying customers (hopefully this never happens), then the importance indeed does flip, even though the equation has no input for the number of existing customers. At that point, when no new traffic can be brought in, then you’ll need to focus on keeping rather than losing. Decreasing churn like you mention here indeed does lead to an increase in profits.

    However, I wonder if it just comes down to philosophy. I’m of the opinion that I always want to seek out more new customers as churn will eventually eat every one of the customers of the business. Churn can be slowed, but it will never stop.

    I’m excited for your feedback. Thank you for your response!

  • TheSmileCeo

    Some great points, specifically I think that the focus for startups and beyond, should be “how do I best spend the limited funds that I have available to me”. If your limited resources are best spent on attracting new clients, then that is what you should do. So if creating new customers can come cheaper, than retaining customers lost to churn, then the decision is easy, (although it is likely not always the case). I think the better or best exercise is to regularly check in on those costs to ensure that when the scale tips, your efforts follow the optimal ROI.
    Great article and an even better reminder for me personally given where we are in the development of our business. Thanks :)

  • http://www.forentrepreneurs.com David Skok

    Agreed. Nicely put.

  • Benjamin Bondurant

    Hi David,
    I spent the last two weeks reading as many posts on your blog as possible. I’ve downloaded two excel files and started playing around with them for my business.

    I’ve also read your SaaS metrics post(s) about 5 times each. I am not kidding. Thank you so much for these valuable insights. You are doing a lot for the startup community.

    Do you have an excel file for the graphs shown in this post? I have seen that you have similar graphs in the other excel file but I’m curious if you have an excel file for these specific graphs (i.e.: churn graphs) ?

    Thanks again for everything!

    -ben

  • Arrun

    Could you also share with me which bank this was? akapoor@sjfventures.com

    Many thanks for the thoughtful pieces. Very insightful.