Why Churn is SO critical to success in SaaS

Monday May 21, 2012 by David Skok - General Partner, Matrix Partners

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).

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.

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).

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):

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:

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:

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

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

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.
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.)
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.
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.
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.
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.

David Skok is a General Partner with Matrix Partners. You can find this post, as well as additional content on his blog called For Entrepreneurs. You can also follow David on Twitter (@BostonVC) by clicking here.

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