Why SaaS startups should care about churn
Churn can take many forms - the dreaded email that's never returned, or worse, the pre-emptive "we are dropping your service" note. But fear not, there are ways to respond to and work with churn which will help you scale and grow.
What is Churn?
Software as a Service (SaaS) has a number of advantages over traditional enterprise software license models, but there are also some disadvantages, the main one being that customers are in a better position to take their business elsewhere if they're not getting value. That is sales churn.
I like to take the optimistic "glass-half-full" approach to this aspect of SaaS. Rather than it spelling doom, experiencing churn in your startup could be an opportunity to improve. Churn in SaaS is real-time feedback. There's nothing like losing customers to get you focused on fixing your business.
There are two kinds of churn: gross and net. And two metrics with which you use to measure it: revenue and logo. Your baseline should always be measured in revenue. So, first I’ll look at the two types of churn using the revenue metric.
Gross churn is typically the first to be measured:
- %Gross Churn = (Cancelled business / ARR) x 100
- Example: if you lost $20k in cancelled business in 2018, and your total ARR was $900k, your gross churn is 20 / 900 * 100 = 2.2%
Net churn looks at what happened within your existing customer base, which could include expansion, upsell, cross-sell, renewal, contraction and cancellation.
- Net ARR churn = (Annual cancelled business - annual expansion - annual upsell) / ARR
- Example: If you lost $20k in cancelled business in 2018, and earned $5k in expansion and $6k in upsell, and your total ARR was $900k, your net churn is (20-5-6) / 900 = 1%.
The calculations for gross churn and net churn are for their annual versions; you can measure using any time period of recurring revenue you like - monthly, quarterly, etc - but remember to multiply by the relevant factor if someone asks you for your annualised net churn. For instance, if you measure your net churn by quarter, multiply by four to get the annualised number.
In a healthy, growing enterprise business, net churn should be close to zero. Top quartile companies tend to have negative net churn. Yes, it's possible to have negative net churn! It means your expansion is greater than your cancellations.
Gross churn and net churn are both important, because net churn can mask what's happening with your customer base, even if it's a negative number overall. If you have a positive net churn but your gross churn is low, that might actually indicate an opportunity: you could be leaving expansion or upsell opportunities on the table. Consider investing more in your customer success teams.
Now we can look at the other metric:
Logo churn is simply the number of customers you're losing without taking into account actual revenue they bring in. It's also helpful, but in a different way: generally, you want to be focused on revenue, but there are important types of customers that your revenue numbers alone can't point out.
- Lighthouse customers are usually your early adopters, the ones who showed you the way into your market.
- Reference customers are your big names, the players in your market that everyone knows, trusts, and values.
If you're losing reference and lighthouse customers, that's more apparent from looking at logos rather than numbers.
Why does churn matter?
There are many reasons why churn matters but the two main reasons are that it helps you scale and gives you real-time customer feedback. When I talk about scale, it’s important to keep in mind sales efficiency.
New customers cost a lot of money. Caring about sales efficiency only matters in the context of limited churn. Sales efficiency assumes that you're trying to keep customers -- in fact, it's predicated on it: remember that sales efficiency takes into account how much you spend landing a customer relative to their Annual Contract Value (ACV).
No matter how great you are at acquiring customers, you can't grow with a high churn rate. If you're not thinking about churn, you're just spinning your wheels. If you want to grow, you're counting on your SaaS business compounding; the only way that works is if you're holding onto your base. What's more: without that base, you can't upsell, which is usually an important component to most businesses -- the old "land and expand" strategy.
Churn tells you what isn’t working. This is one of the great aspects to SaaS churn: its feedback on your product directly from your customers. If you have customers who churn, find out why! Not paying attention to it is like lighting dollar bills on fire.
Some churn is fine -- for example, if it's costing you more money to support those customers than the revenue they bring in, or if your company is going in a different direction and therefore focused on a new ideal customer profile.
Also, customers themselves can change directions, go out of business, merge with other companies, etc. Some churn is simply inevitable and unavoidable. But how much? What counts as acceptable churn? The truth is, it varies. When we talk about acceptable churn, we mean gross churn; it's very hard to compare net churn, since there are so many dependencies. Churn rates vary depending on sector focus. That said, the general rule with churn is that churn tends to correlate to ACV: the higher the ACV, the lower the churn rate.
Churn rates are generally higher at lower price points. This makes sense, as you probably didn't spend as much to acquire your customers to begin with. Conversely, in the enterprise space where your customers are paying $100k and you spent much more time and money trying to land them, you should be focused on making them happy.
My ballpark for acceptable churn rates breaks down as follows:
- businesses: up to 20%
- 10% or less
Of course, less is better in any category. Some benchmarks I've seen show five percent annual gross churn as their top quartile. Some investors will tell you to avoid churn at all costs; in my opinion, that's unrealistic. I believe churn is absolutely critical to understand, and no matter what category you're in, above 15% (annual) is a serious issue.
As is the case with every metric you could use to evaluate your business, churn has nuances, and there's a lot of room for edge cases, so for now I'll keep the math simple: if your customers are on annual contracts (meaning they can cancel after a year), looking at annual recurring revenue (ARR) churn is more helpful than Monthly Recurring Revenue (MRR) churn. If your customers pay monthly, MRR churn is probably better. You could look at any interval that makes sense; you just have to match it to your business.
The key is to stay on top of your churn. For instance, if you're looking at ARR, you want to be paying attention all year to get a rolling average of your churn calculated daily and project future churn based on a given past time period. But you don't have to stop there. Try looking at different averages, for instance: monthly, quarterly, semi-annually, etc. Split your customer base by country/region and see if anything jumps out at you. If you have multiple price points or products, segment your customers that way and see if churn rates differ between them.
Whatever you do, just remember that you need to keep track of churn, and that it can be fixed.