By Gen Furukawa
Introduction – getting things correct from foundation is critical.
Do you want to feel a morsel of pity for some of San Francisco’s wealthy elite? It turns out that residents of a downtown highrise have spent millions purchasing stunning condos….only to realize that the 58 story high rise building is tilting and sinking.
“The loftier the building, the deeper must be the foundation laid” – Thomas a Kempis. Perhaps the builders of the SF high rise should have consulted with Kempis, a a 15th century theologian.
The failure to build a sturdy and safe building is a good analogy for the requirements to build a successful and stable business. The fundamentals, or the foundation, needs to be well-established before either the business or the building can grow to withering heights.
For subscription businesses, the solid foundation includes a solid product, marketing, sales, support, and more. One proxy for verifying that the company has reached Product-Market Fit is to look at the customer retention rate: how many customers continue to pay month after month? Because these recurring revenues are the lifeblood of a SaaS business, getting a handle on retention rate is a critical first step to laying a solid foundation.
What Does A Good Customer Retention Look Like?
Up and to the right–it is the direction that every high growth company points itself to. And in a perfect world, this is how things go, with month over month revenues increasing both from new customers and existing customers.
Let’s assume that a company has 1000 customers, each with an Average Revenue Per User of $50.
This cohort therefore contributes $50,000 in revenue in the first month, as each of the 1000 customers pays $50.
Now let’s assume that for the next 36 months, no one in the cohort churns out. What a beautiful situation: the revenue every month from this cohort stacks up, and by the end of the 36 months, there is $180,000 in total revenue from this original cohort of 1000 customers. The graph of revenue over time looks like this:
You can follow along and look at the spreadsheet that I created here:
For simplicity’s sake, we are only looking at one cohort over time, and not accounting for new sign ups, revenue expansion or contraction.
But, alas, nothing in this world is perfect. And it is the unique company that can maintain a 0% churn rate (or even the holy grail of negative churn, when upsells and revenue expansion increase the monthly recurring revenue of a cohort).
Now let’s take the same cohort, and see how revenues are impacted by a consistent monthly churn of 2%, 5%, and 8%:
As is expected, churn has a significant impact on revenue, with the impact increasing over time.
The impact of churn is nearly negligible in the early months.
For example, in month 1, the churned revenue at 2% monthly churn is $1,000.
If churn were 5%, the first month’s churned revenue would be $2500. Not necessarily a code-red problem.
But fast forward to month 36, and the churned revenue is $25,332 if at 2% and $40,026 for the 5% churned company.
As we move along the X axis, representing time, the impact of churn magnifies.
Subscription businesses rely on pulling in recurring revenue from its existing customer base. So if that base dwindles away, there is a greater pressure to replace the revenue with new customer acquisition and revenue.
In short, the problems stemming from churn get harder to solve as the company grows.
Despite the percentage staying the same, the absolute size of the pie that needs to be replaced grows, and that becomes very hard over time.
Here is a simple image to help illustrate this:
A churn rate of 5% when the company is at $50,000 Monthly Recurring Revenue equates to $2500. But if in several years, revenue has grown 10x to $500,000 MRR, while maintaining the 5% churn rate, churned revenue grows to $25,000.
The math is straightforward: keeping the percentage of the pie constant, the size of that slice will get bigger as the overall pie gets bigger.
However, functionally, when operating a company, it is increasingly harder to replace those customers and revenue repeatedly, every single month.
And that is a lot of pressure on a marketing and sales team to sign up more customers to fill the void of churning customers.
How does churn impact customer count over time?
Here is a visual of Total Customers for a cohort of 1000:
Over a 36 month span, the difference in churn’s impact on customer count is glaring. Starting at 1000 customers, we see the following:
- A 2% monthly churn results in 483 remaining customers (48% of the cohort)
- A 5% churn results in 157 customers
- A 8% churn leaves only 49 customers (5% of the original cohort).
Though the 8% churn is 4 times worse than a 2% churn, the difference is amplified over time due to the compounding nature of churn. That is why there are nearly 10x the number of customers remaining from the 2% cohort than the 8% cohort.
Loss of Lifetime value of customers
The underlying nuance here is that the churned customer and churned revenue is not just a loss for the month in which they churned, but in reality it is a loss of the future earnings from that customer.
Once a customer churns, they have reached the limit of their Lifetime Value (not accounting for any reactivation).
How can you Extend Lifetime Value and Reduce Churn?
One of the most simple paths to quickly reducing churn is by addressing involuntary churn, also known as delinquent churn: those customers who churn out due to failed payment transactions.
Failed payments could be the cause of 20%-40% of your existing churn.
That is a significant portion of churn that should be addressed immediately. You can read more about strategies to reduce delinquent churn here.
Not having a handle on your customer churn leaves your subscription business sitting on quick sand. It is only a matter of time before the foundation of the business, your existing customers, disappear and leave your business wobbly and slowly sinking. Don’t be like those San Francisco high rise dwellers, wondering when the bottom (of the business or the building) will fall out. Because without a solid foundation, it can only be a matter of time.