SaaS Business Owners: What to Consider When Analyzing and Interpreting Churn
By: William Short
When working with SaaS business owners, we are often asked which churn metric is most important and what should be considered when evaluating churn. When analyzing the stickiness of a SaaS product, there are various metrics that can be looked at, and it is important that SaaS business operators are aware of and actively tracking these churn metrics. The three most common metrics for churn are customer churn, gross churn, and net churn. Each of these metrics provides a slightly different insight into the performance of a SaaS business, and it is only when the three metrics are looked at in conjunction that the full picture of a company’s performance can be understood.
Customer churn, often referred to as logo churn or unit churn, simply measures the percentage of customers who cancel their subscription during a given period. It does not consider the financial impact of those lost customers and is purely based on customer count.
While customer churn does not provide insight into the revenue impact of a churned customer, it can be helpful when looking into specific customer attributes that impact retention. For example, if a business is serving multiple end-markets, customers in certain industries could show higher retention rates than that of those in other industries. By grouping customers based on different attributes, and analyzing the retention of the various groups, business operators can begin to identify the ideal customer profile that leads to the highest retention rates. This can be very beneficial when making decisions of where to focus customer acquisition efforts and investments.
Not only can a detailed analysis of customer churn provide insight into customer attributes that lead to optimal retention performance, but this analysis can also help operators optimize business processes that impact churn. For example, consider the potential value of tracking customer retention based on the onboarding rep that was responsible for implementation. If the customers onboarded by a specific employee are consistently showing higher retention rates than those onboarded by others, this could indicate that there might be best practices that need to be implemented across the onboarding team. This analysis could also be done for sales reps and customer support reps to ensure quality performance across customer-facing teams.
Unlike with customer churn, not every churn is created equal when considering gross churn. Rather than just considering the number of customers who cancel their subscription during a given period, gross churn represents the revenue that was lost from those churned customers. This is a much stronger indicator of the financial impact caused by churn.
For most businesses, high contract value customers will be stickier than low contract value customers. This results in gross churn being less than customer churn. If gross churn is higher than customer churn, pricing packages should be reevaluated, as this would indicate that higher contract value customers are not getting as much value from the service.
Data from multiple studies has shown that the cost to acquire a new dollar of recurring revenue is much more expensive than the cost to retain an existing dollar of recurring revenue. This is why a company’s gross retention rate is so important. Every dollar that is lost to gross churn can only be replaced by a sale to a new or existing customer. Businesses with high gross churn will struggle to grow quickly and profitably.
While both gross churn and customer churn provide meaningful insights into a company’s retention performance, net churn is often viewed as the best churn metric to consider when evaluating the financial health of a SaaS business. Businesses with high customer churn can still have attractive retention profiles if the customers they are losing are primarily low contract value customers. Similarly, businesses can offset gross churn by upselling to their existing customers. However, there are no factors that can offset high net churn, and that is why it is typically viewed as the most important churn metric.
Net churn starts with gross churn and then factors in the impact of subscription upsells and downsells, also referred to as expansion and contraction revenue. Consider the example in which a company starts a period with $1,000 in subscription revenue. During the period, the dollar value of gross churn is $100, upsells were $120, and downsells were $20. In this example, gross churn would be 10%, and net churn would be 0%.
In the example above, gross churn is offset by a positive net upsell amount, resulting in a net churn of 0%. Businesses that can consistently produce net churn of 0% have an advantage over those that cannot, because these businesses have less of an uphill battle to produce growth. Consider company A with an annual net churn of 0%, and company B with an annal net churn of 20%. In order to grow at the same rate as company A, company B will need to produce significantly higher sales volumes in order to offset the 20% revenue loss from churn. This requires additional investment in customer acquisition, which ultimately results in lower profitability.
Churn is one of the key metrics used to evaluate the quality of a recurring revenue stream. Businesses with low churn benefit from a higher lifetime value of every new dollar of recurring revenue that is acquired. This results in more cost-effective growth with higher returns on the investments made in customer acquisition.
Quality recurring revenue streams can be very valuable to investors who are looking for predictable returns on their investments. However, the value of a recurring revenue stream is significantly diminished, or even lost completely, if the retention of the revenue stream is too low. To maximize the value of recurring revenue streams, SaaS business operators should be keenly aware of the trends for these three primary churn metrics, and they should always be evaluating potential ways to optimize retention performance.
If you or someone you know have questions regarding anything discussed, or the general SaaS marketplace, please feel free to reach out to William Short, Vice President at Founders Advisors.