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