KPIs are invaluable in decision-making. One KPI (metric) which is specifically useful for SaaS companies is churn. Let’s investigate.
Whether are bootlegging a SaaS startup company, or running an established multi-million operation, you need facts and figures for making the right decisions. However, with the huge amount of data available, it’s quite easy to drown in a sea of data.
Back in the 1960s, a couple of McKinsey consultants sat down to think. They came up with the concept of KPI: Key Performance Indicators. The idea is that KPI measures the things that really matter. This helps decision-makers focus, leading to improved decision-making.
For decades, companies focused on KPI’s like revenue growth, revenue per client, and customer satisfaction. While these indicators are valuable for SaaS companies, they simply do not cover all bases. A SaaS company isn’t a cookie factory. SaaS is a (relatively) new context, requiring specific KPIs.
One new KPI which is specifically valuable to SaaS companies is churn. But what is churn? How to use it?
So what is churn?
If you are thinking that churn has something to do with dairy farms, you are not mistaken. Originally, churn refers to a machine that turns milk or cream into butter. In our context, however, churn is a metric that shows the percentage of your SaaS customers that cancel their recurring subscription. Obviously, the lower this number, the better.
To determine your churn, you need to look back and determine how many clients canceled their subscriptions. Divide this number by your client base, and you’ve figured out your churn.
In 2020, you started the year with 50,000 customers. 4,000 customers canceled their description. Your churn over 2020 is 4,000/50,000 = 8%
This method of calculating churn is useful, but still rather simplified. Many SaaS companies have gone beyond the simple churn, calculating churn at the level of specific customer groups, per product or subscription model, or based on the value of all clients (Missed revenue of canceled subscriptions / total revenue).
Difficulties in determining churn for your SaaS
If you want to determine the churn of your SaaS companies, you will be facing a few challenges. The most obvious challenge is that churn is based on historical data. Hopefully, this historical data does not properly represent your company’s future. After all, you aim to grow, introduce new products, attract new customer types. All these (positive) trends may result in a gap between the churn you calculated and the real churn. But even if you would not change a single thing, your churn may vary. Your competition may try to win over your customers, or your customers’ needs may change.
As a result of all these complicating factors, churn isn’t really a single number, but a representation of a statistical probability.
But, fear not: even though it is pretty much guaranteed that your calculated churn will be different from the realized churn, it can still be used to improve your decision-making.
Using churn for your SaaS company?
With all its flaws and limitations, churn is a very valuable metric for strategic planning and decision-making.
Make revenue forecasts
When looking ahead, you need a revenue forecast. It helps you decide if you need to (and can afford to) hire extra staff, invest in training, and so on. A revenue forecast is also an essential ingredient of your pitch deck). Using churn, you can estimate the revenue generated by existing contracts.
Churn needed to track progress and growth
You can not do without churn it if you want to know how well you are doing. Let’s face it: we all love to see the number of new clients, especially when it shows growth. But, painful as it might be, looking at the number of new clients attracted is only part of the story. You definitely need to know how many clients leave, too.
Compare the following two situations.
- In 2019, we gained 10,000 new clients. In 2020, we gained 15,000 clients
- In 2019, we gained 10,000 new clients. 2,500 subscriptions were canceled. In 2020, we gained 15,000 clients, 9,000 subscriptions were canceled
Situation 1 feels like a success. You managed to get 50% more new clients in 2020. Time to celebrate. However, situation 2 tells a truer story. In 2019 your userbase grew by (10,000 – 2,500=) 7,500 subscribers, but in 2020, your (net) gain was only 6,000 subscribers. Time to investigate!
Churn can be described as a limiting factor to growth, directly affecting the profitability and valuation of your SaaS company.
Also, know that churn tends to increase as your customer base grows. The more clients, the more recurring subscriptions get canceled.
Churn helps you make marketing decisions
It is easy to spend a load of cash on marketing. But is your marketing investment worth it? Every customer has a certain value to your company. If you want your company to be around for the long run, you need to ensure your customers generate more value than cost. So, how long is your client going to stick around?
You can calculate your average customer lifetime by dividing 1 by churn (1/churn). Multiply this number by the annual value, and you know the lifetime value of your clients.
Your churn rate is 15%. A client generates $ 500 worth of value per year. The average lifetime of your clients is 1/0.15 = 6,67 years. This results in a lifetime value of $ 500 x 6,67 =$ 3,333
Churn draws attention to customer retention
Churn is an awesome early warning system. If you notice your churn rising, it’s time to take action to improve customer retention. After all: keeping your client is a lot cheaper than having to win over a new one.
Advanced Churn for your SaaS-company
Now that we’ve covered all the basics of churn, we can dig a little deeper. This is some advanced stuff. Grab a coffee, and read on.
What do you need to calculate a churn you can use?
We regret having to inform you that calculating a churn you can use means you need to get a few requirements met. These requirements are derived from the field of statistics:
- Uniform customer population:
Calculating a churn is only useful when your clients are sufficiently similar. The probability of canceling the recurring subscription (during the measurement interval) should be the same.
- Matched customer populations:
Should your userbase consist of different groups of clients, make sure you can match the cancelations with the original population of the same group. For instance: if you notice small businesses cancel less often than multinationals, compare small businesses with small businesses and multinationals with multinationals.
- Choose the right measurement interval
Make sure the interval you measure is long enough to ensure you have sufficient cancellations to derive a meaningful metric. If your interval is too short, your outcome might be statistically insignificant, biased, or random. Simply put: a measurement interval that is too short, will result in rubbish data.
- Keep MRR and churn separated
Many SaaS companies have different subscriptions. The monthly recurring revenue (MRR) can be different for each subscription model. Cancellations might differ for each subscription too. Make sure to keep MRR separated from churn, as they tell a different story. And in the end, it’s all about revenue, right?
- Some stability
As mentioned earlier, churn is calculated with historical data. Huge changes in your business process will affect your churn. If your SaaS company is going through a new phase in its development, perhaps focusing a little less on churn might be a good idea. Or you can use churn on established products while paying less attention to it with newer products.
Practical tips to calculate a churn you can work with
The requirements above can be quite tricky. Use the following tips to calculate a churn which not only is easy to use but also statistically useful in decision making:
Choose a measurement interval that leads to a 1-10% churn
No, it’s not because you want to present a nice low figure, but because you want your churn to adequately reflect reality. Due to the exponential character of churn, the shorter your interval, the more accurate your predictions.
Example: say your monthly churn is 20%. You have 100 customers. After 1 month, you are left with 80 customers, after month 2 with (80 x 80% =) 64, month 3: (64 x 80%=) 51. The same numbers on a quarterly measurement would yield a churn of (51/100) = 51%.
Now, if you use both numbers to calculate how many customers are left after a year, the monthly churn would result in 6,87 clients left at the end of the year, whereas the quarterly rate comes up with 11,76. The shorter interval is the accurate one.
Match the average contract length
It is a good idea to use the length of a contract to calculate churn. After all, someone with a 2-year contract can’t cancel until those two years are over. If you have annual contracts, your churn can mathematically not be higher than 1/12th. Using the average length of contracts ensures that you measure churn as a percentage of the customers that CAN actually cancel their subscription.
Only calculate churn based on contracts up for renewal
If the two tips above don’t work for you, consider only looking at the contracts which are up for renewal. Use the average contract renewal period to make a solid estimate.
The formula to use:
number of contracts canceled in the month / (average contract renewal period x number of contracts up for renewal in the month)
Create customer churn cohorts
Do you have different types of non-uniform customers? Divide them into segments and calculate a churn for each segment. Doing this gives valuable information that helps you adequately address the different needs for each client segment.
Calculate MRR churn
In the end, it’s not about the number of contracts, it’s about revenue. To calculate your monthly MRR Churn rate, use the following formula: MRR(begin) – (MRR end) / MRR(begin).
MRR churn shows the effect of downgrades (same number of contracts, but less revenue), so it really adds something to your discussions. It would be smart to segment MRR churn, just like you did with different types of clients.
Churn: powerful when used right
As you can see, churn is a powerful metric for your SaaS. There are, however, a few requirements and pitfalls you need to be aware of. Calculating churn the wrong way may do more damage than good. But if you manage to properly harness the power of churn, you have got a powerful tool.
Use it wisely!