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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  • Chris

    David, great article.  We are introducing a biology research consumable and realize that getting to reoccurring revenue and ‘a lifetime customer’ is critical to our success.  This post is just relevant to our product as a SaaS product.  And you have made me think more critically about what we need to track and manage.  Thank you, Chris

  • http://twitter.com/MightyWiseMedia Eric T. Wagner

    Hi David.

    Wow.  Good stuff here.  Can’t believe a measly 2.5% churn can have such a huge impact as you grow.  

    I’m bookmarking this article as we launch our membership programs.  Gotta watch out for the “churn” monster.  :-)

    Thanks for sharing your wisdom.  Appreciate it…  :-)  Eric

  • http://www.saasmarketingstrategy.com/ Peter Cohen

    David, 

    Thanks as always for your valuable insights.
     
    You could have mentioned, as well, the disastrous impact of churn on customer acquisition costs.  When a customer departs, a company may not have yet generated enough revenue from that customer to cover the sales and marketing expenses needed to acquire them.  Plus the company needs to go out and spend more on sales and marketing to replace the existing customer. 

    In addition to the tactics you’ve suggested to reduce churn and promote “negative churn,” companies should also consider enhancements to their on-boarding process.  The experience of new customers over their first few hours and days can have a significant impact on their satisfaction, the value they derive from the solution, and their propensity to remain a customer.

    Peter Cohen
    SaaS Marketing Strategy Advisors

  • http://twitter.com/4WalkMe WalkMe

    I’m glad I found his article now since we have just launched our interactive guidance SaaS product. There are definitely things that I am taking away from this article. Thanks for this valuable input! 

  • Bharath Gowda

    Great article. Can you please point us to the Research Report on public company SaaS Valuations

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

    I have emailed that info to you. It is unfortunately not published on the web.

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

    Thanks for the feedback. Best of luck with the new business.

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

    Peter, thanks for adding this. As usual, you are very much on point.

  • Aaron Fulkerson

    Excellent David, thanks. 

    MindTouch offers a SaaS based help system that is popular among SaaS vendors for exactly what you’re writing about here: churn. Our customers (ExactTarget, SuccessFactors, Intuit, …) use our product to make “happy customers”, ie- product experts. When users are experts they churn less, buy more and cost less to support. 

    Please send me the report too. Thanks. 

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

    Thanks Aaron. Unfortunately I can’t send the report, as the bank in question did not give me permission for that. However I will send you an email letting you know which bank produced it, and you can approach them directly.

  • http://www.josephfung.ca Joseph Fung

    Great article. The charts you have emphasize revenue churn, though, and perhaps mask the issue of customer churn? Particularly with enterprise SaaS apps, where deployment and growth happens within an employee base at a customer, those that churn are likely at the beginning of a deployment and thus won’t contribute much to revenue churn.

    Since customer churn has a direct impact on customer lifetime value, it’s as important to monitor that in tandem with revenue churn.

    An interesting exploration might also be the impact of customer churn on growth, when compared to the viral/referral coefficient of each customer. I suspect a strong and effective referral mechanism might have a similar impact on growth as it might behave like negative customer churn.

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

    Joseph, you make two excellent points. Thanks for bringing these up. The first: the need to separately track the number of customers that are churning (customer churn) from revenue churn is very important and something that I should have mentioned in the article. I agree that SaaS companies should track both in tandem.

  • http://www.cosential.com Dan Cornish

    Hi David, great article! One of the things which is hard to measure is how churn affects your reputation. If we loose a customer because they are short on funds, it is no harm. If a customer leaves because they are pissed off, the collateral damage they do to your reputation can prevent a large amount of business from ever happening. It is important to understand your churn and put it in one of three buckets: lost due to funding issues(money), lost due to competitive product, lost due to unhappy customer. 

    At scale it is very hard to manage, but any loss of a customer if a bad thing.

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

    Very good point Dan. Particularly if you are working in a tight community where that does word-of-mouth damage.

  • http://twitter.com/NoahLampert NoahLampert

    A very insightful article. Thanks for that, David.

  • http://twitter.com/purlem Martin Thomas

    Thanks for the great post.  It inspired me to look into the churn rates for my startup.  Something that I will definitely be paying more attention to moving forward
    http://www.purlem.com/blog/2012/05/churn-rate-the-most-important-metric-for-a-monthly-revenue-business/

  • Iatropoulos

    David, thanks for another great post. Seeing things graphically really hammers the point of how critical it is to keep churn low.  

    As someone else mentioned, you are focusing on revenue churn.  However, I was wondering if you’ve come across an easy way to be looking at gross profitability churn instead of revenue.  For example, I’m pretty sure that if HubSpot had account managers spend an hour with each of their customers (as opposed to only their larger customers) each week, they would reduce revenue churn.  What’s a good way to find the balance?  This is not a hypothetical question, we are actually faced with that decision and any ideas would be appreciated.

  • http://about.me/mikeschinkel MikeSchinkel

    Good article David, as always.

    However I think focusing too heavily on expansion bookings can result in unexpected churn for some. For SaaS vendors where I feel I’m constantly being coerced to spend more (like Salesforce) I get a sour taste and leave for other solutions where the vendor continues to add features without adding cost. I feel much better about the latter vendors than I do the former ones.

    And once a vendor starts to taste the results of upselling it can be a potently addictive drug causing them to route all new features to upsells. 

    Frankly I think the upsell approach is a more palatable for SaaS vendors targeting enterprises than for those targeting small-to-medium businesses. For example I could see expansions being a viable option for SilverPop but not for MailChimp where the former focuses on addressing enterprise needs and the latter grows because they focus on making sure SMB customers absolutely love them.

    FWIW. :)

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

    Hi Martin, great progress so far. Best of luck with the next phase of churn reduction!

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

    Mike, you make an excellent point. This all has to work in a way which leaves the customer feeling good!

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

    Depending on your accounting systems, it might be fairly easy to track Gross Profit churn instead of Revenue churn. The trick is finding out if your accounting systems are up to the task of telling you Gross Profit by customer. Even if you didn’t get to an accurate number for each customer, but an accurate guess for each class/size of customer, that would be good enough to help you run the business better. The goal of these metrics is not perfect metrics, but actionable insights. And they don’t have to be perfect to give you those insights. I am not sure if this answered your question fully, but let me know if I didn’t.

  • Rory McCallion

    Hi David—long time reader, first time commenter!

    I think that the way that you framed “negative churn” confuses a few issues. First of all, since the mechanisms underlying churn are completely different than those underlying the upsell process, I don’t find it useful to call upsell “negative churn” and then compare those metrics proportionally. Both rates should be tracked, but not directly compared. Secondly, if you assume different growth rates than the ones you assigned to your metrics (like linear vs nonlinear new customer growth), then many of your generalizations would have to be re-worded. For example, Joseph Fung brought virality to the table, which suggests that bookings from new customers might be superlinear.

    Churn may be among the most important SaaS statistics, but I would have appreciated less assumption-making in building your case. Many of your conclusions and recommendations hold without them.

    Thanks for hosting this excellent forum.

  • Iatropoulos

    David, thanks for the reply. Yes, our accounting system supports this, but we haven’t yet implemented the procedure to track per-customer profitability. The biggest challenge is getting individuals to log the time they spend with each customer’s issues. This will be particularly challenging for our support team. You’ve provided us with another reason to go down this path, though. Best, Nikos.

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

    I would be really cautious about adding a lot of work to overloaded people for a metric. Unless you are really clear about the benefit of getting to the insight, it might be better to find a way to use a judgment call. Alternatively come up with some super simple way for support to give you the insight you need without adding too much to their workload. Best, David

  • Iatropoulos

    Thanks David, much appreciated. I think it would be a longer-term plan. We are too small for the return on this investment to be worth it at this point in time. Thanks again, Nikos.

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

    Hi Rory, thanks for joining the dialog. Atlassian is a great company, and one of the few to be able to crack low cost customer acquisition through an excellent product. I appreciate your point of view about nomenclature. Upsell is very different in form to “negative churn”.
    There was really only one assumption that I made in the numbers, and that was what rate to use to grow bookings. I did try a few variations on that, and they led me to the same conclusions. The one possible exception here might be if a company had truly viral acquisition for paying customers. I have worked with a few companies that have gotten truly viral customer adoption, but in all cases this was for a free version of their product. When it came to converting those customers to paying, there was never the same non-linear acquisition curve. That doesn’t mean to say it isn’t possible, but I think it will be a rare occurrence. Are you aware of one that we could use as an example?
    I hope my reply doesn’t sound too defensive. And please keep adding your thoughts here. I am sure you will have some great insights given where you are working. Best, David

  • http://www.CROmetrics.com/ Chris Neumann

    One thing I’ve seen happen with my clients is that they focus on customer acquisition and not on churn, and wonder why growth slows.  I think it would be helpful to have a “net revenue” line on the first chart in your post to illustrate the fact that despite good customer acquisition numbers, once you get to a certain level, all of that new customer acquisition goes away through churn, leaving the company in a zero growth situation.  That would lead you directly into the main point of the article, which is as the company matures and growth slows, the focus needs to shift to preventing churn.

    One other tip for companies that sell to SMBs is to push annual plans – there is probably 1% churn in simply having credit cards bounce, and annual plans avoid that.

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

    Chris, your second point is invaluable information. Thanks for adding.
    On the Net Revenue line, you’re dead right that would have been a good add. I considered it while writing the post but worried about overloading the reader.
    Thanks David

  • Harley Finkelstein

    Really great info here David! Thanks for sharing and providing an incredible analysis.

  • Tom

    Very good article!  Would you mind sharing the name of the bank that produced the SaaS valuation drivers article you mentioned?

  • Alex

    Why such a small Font – seriously why?

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

    Goldman Sachs.

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

    Strange – I have never had this complaint before. If you hit Ctrl-+ (Command – + on the Mac), your browser will increase the size of the font.

  • http://www.facebook.com/timur.valishev Timur Valishev

    Thanks David, great post, as always!

    Would you be so kind to clarify one point – why you assume that negative churn will always be a function of TOTAL MRR (or total number of customers) and not a function of NEW bookings. Customers are likely to have some distribution of lifetime. I think this distribution combined with number of signups in previous periods should define the number of churned customers. Hence, if new booking is a fixed value ($2000 a month), churn should also be a fixed value, expressed in dollars rather then percents.

    Alternatively, model that presented in this post will work, if new bookings will be also defined as fixed percent of current MRR, but not grow at a fixed value of $2000. In this case churn can be also calculated as percent of current MRR. But in this case new

  • John Lipinski

    Nice blog on net bookings!! I’d say that development sales is “easier” only IF acquisition sales involves prospecting too; otherwise, just different.

  • http://www.facebook.com/chexton Chris Hexton

    Nice article

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

    Timur, The reason to measure churn as a percentage of total MRR is because as MRR grows, you want to get a feeling for how much churn you have relative to the overall number. If you started with revenues of only $10k, and later grew to revenues of $10m, measuring churn as a fixed number would not really be easy to understand. (I realize that my model may have been confusing because I used a simple fixed $2k increment to increase the growth in MRR every month, and that this could have been confusing.) I hope this makes sense.

  • http://www.facebook.com/timur.valishev Timur Valishev

    Ok, I see. So in this case, if MRR grows at the linear proportion, assuming that our product does not become any worse over time (the probability distribution of customer life time does not change), the churn in percent of total MRR must decrease. Or I am getting it wrong? 

    My point is that the effect of churn may be slightly less significant than presented by the model in this post if churn itself does not grow over time due to poor business performance. If I am getting it all right, the model needs to be slightly corrected.

  • http://www.facebook.com/timur.valishev Timur Valishev

    For some reason, “Command +” does not increase font size on Mac Chrome :(

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

    I think you may have missed the fact that in my simple model MRR is NOT growing linearly over time. The only thing that is growing linearly is the monthly bookings number (new MRR each month), which is increasing by $2k every month.

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

    I am sorry to hear that. I use a template for WordPress which makes it hard for me to adjust that font size.

  • http://www.facebook.com/timur.valishev Timur Valishev

    I’ve really misinterpreted new bookings growth with MRR growth. Thanks for explaining!

  • Cathleen Colehour

    David–thank you. Invaluable reminder about the leverage of the churn metric. An extended driver of negative churn for my recurring revenue (non-SaaS) model…referrals. Something else for us to lock in as an ongoing metric…the impact is huge.

  • http://abdallahalhakim.tumblr.com/ Abdallah Al-Hakim

    this is one of my favourite articles on churn rate. I think point about expanding the revenue capacity of customers is where the innovative SaaS companies can shine and where I would be interested to see the different business models.

  • Tim Friedrich

    David, great article! Is there a report that shows the churn rate for different companies in the SAAS industry? Thanks!

  • http://www.emportant.com/ Sandeep Todi

    Aaron, I happened to look at your site earlier and found it to be quite interesting for us. Do you have something for Startups ?

  • http://www.emportant.com/ Sandeep Todi

    David, first time reader and first time commenter ! Great to read this post – the graphs made it so easy to see the point. One aspect to reducing churn rate, is to increase adoption of product features within the existing customer base. As startups we tend to leave a lot on the table by providing more features at simpler price points. In several instances customers either don’t use all the available functionality or are not fully aware of it.

    Either way, getting the internal customer reps to push adoption increases cost but could be well worth the effort in reducing churn. We’re now looking at ways to intuitively suggest the benefits of unused features through in-product messages and targeted / segmented email bulletins to those customers.

  • Dan Steinman

    David, thanks for the article. Good stuff. One thing I think you missed and I didn’t see any comments on, is what I call “partial churn” or “downsell”, It’s quite common at renewal time for a customer to churn one product (if they own multiple) but stay a customer, or to negotiate a lower price because of problems they’ve had or because they threaten to leave. So, the customer does not churn but some of the bookings do.

    Last comment is that the best way to avoid churn is to have real insight into how your customers are, if they are, using your products. There’s a new market growing rapidly to address this need.

  • Niklas Nilsson

    Thanks David! I am building SaaS, B2B companies in Europe. Could you please provide a link to the great report from the investment bank you mention? Thanks again for the great blog

  • Chew

    Hi David, great article. Would you be able to share the excel file with us? Thanks