Churn rate, retention rate and LTV, 3 key SaaS metrics that can be deceiving in high growth SaaS businesses

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A quick reminder churn rate definition

If you are familiar with SaaS (Software as a Service) or subscription type business models, you know that churn rate (or retention rate) is one of the key KPIs you need to monitor correctly and try to improve. In short, churn rate corresponds to the number of customers you have lost, over the total number of customers that you have. For more ways to calculate churn you can refer to this Profitwell article.

If the definition is pretty straightforward, its application may be way trickier, and depending on the formula and numbers you decide to use the result may sometimes be misleading. This article will describe examples in which apparent churn rate may be misleading and how to overcome these shortcomings.

The importance of understanding how your target SaaS metrics are calculated

It may sound like common sense advice but working at HoriZen Capital where we specialize in sourcing, analyzing, buying and growing SaaS businesses, I review opportunities on a weekly basis, assessing financials and operating metrics of potential acquisitions and one of the things that I have learnt is that even though every CFO and business owner provides the same standard metrics (eg. Churn, Customer Acquisition Cost (CAC), Customer Lifetime Value (CLTV)), the way each company computes these metrics can vary greatly.

Companies can use different calculation formulas, but also different time period or different base numbers. To form an opinion on a target company that you are looking to acquire, or to improve the metrics of a business you are currently managing, it is essential that you fully understand the specific methods behind the operational metrics that are presented to you.

Understanding churn rate calculation is particularly important in high growth companies

How SaaS owners and SaaS investor generally calculate churn rate

From my own experience, the method most commonly used by SaaS companies and SaaS owners to calculate monthly churn rate is to divide number of churned customers — also called lost customers — over a given month by total number of customers at the beginning of this month (by the way this is the calculation that ProfitWell uses and refers to as “the simple method”). CLTV is then generally calculated as average monthly revenue by customer divided by monthly churn rate. Which means that any mistake or misleading calculation of the churn rate will also have a mechanical direct impact on the Customer Lifetime Value.

It is important to stress that churn rate is meant to give you a statistical indication of how fast the business is losing customers and of how long, on average, it will take a customer to stop paying for the service offered. Or, in other words, how long on average a paying customer will remain a paying customer of the company.

Several factors can render that churn rate calculation misleading for SaaS and subscription business owners or SaaS investors

Now, let’s take the fictional case of a high growth company (let’s say 100% year on year growth for the sake of this example). Let’s assume that we know that on average the customers remain customers for 24 months. 1/24 = 4.2%, which is roughly the monthly churn rate that we would theoretically expect to calculate for that company using a simplistic approach. However, due to the high growth of the number of active customers, more than doubling every year, we can deduct that at year-end more than half of the customers have been customers for less than 12 months. There are several potential reasons why calculating churn rate with the method presented above may be misleading:

· Customers are on annual contracts, hence more than half of them have not reached their renewal date

· Customers are enterprises whose budget are renegotiated each year hence more than half of customers have not gone through that renegotiation phase

· Customers usually give the software a try for a 6–12months period before deciding to drop or continue their subscription hence a significant part of them have not finished their self-imposed trial period

· The SaaS provider may offer discount trial price for the first 6 months / first year hence a significant part of the customers is still under the discount period

If any of these cases apply, your churn rate is likely understated

If any of these assumptions apply to the SaaS or subscription business you are currently assessing, and assuming your churn rate is calculated as defined above, this means that to your churn rate is currently calculated by dividing the number of lost customers in a given month by a number of total customers that includes a significant part of customers who have not yet entered their “churn potential” phase, hence artificially presenting a lower churn / higher LTV. This would subsequently result in a mechanical increase of churn rate once the growth of the company decelerates, which would be quite an unwanted turn of event for an investor or a buyer.

Churn rate in itself is not enough of a SaaS metrics to rely on

We have described above several situations where churn rate would be understated due to the high inflow of new customers. However, there are cases where, on the contrary, high growth could result in an overstated churn rate. For a company whose customers act in a more binary way, ie. either they are unhappy with the product and churn within the first few months or they are happy with the product and remain loyal customers, then having a huge share of new customers would inflate the number of lost customers, hence the churn rate.

What to do then? Rather than focusing on a churn rate, when you analyse or conduct due diligence on a SaaS or subscription business you should really understand the churn pattern and seasonality of the company over time. For example, understand at which point in time churn is lower or higher for a given group of customers from the moment they have been onboarded. To do that, you can use chart like this free Customer retention Chart that will help you understand on a monthly basis how many customers the company retained over time compared to number of customers onboarded in a given month.

This is also called a “cohort analysis” and this type of analysis has been well described by Ed Shelley on the following blog post.

Another good solution is to break down sales and customer by vintage and to calculate monthly churn rate by group. This will allow to calculate a monthly churn rate of “customers acquired in F17” for instance, or of “customers acquired in first 6 months of FY17”. I find this solution to be a good compromise between basic churn calculation and cohort analysis. Grouping customers in categories also makes it easier to visualize trends and derive insights.

In short, churn rate is a good SaaS metrics, but there is more to it than its simple calculation

The simple method to calculate monthly churn rate can be quite handy, but as we demonstrated you should always take the whole context into account before drawing any conclusion. I do encourage you to analyse the churn and retention pattern of your business or target business using the approach presented above, and dive even deeper.

You can for instance conduct this kind of analysis by group of customers, by geography, by customer typology, by acquisition channel or by type of paid plan. This should help you better forecast the company’s revenue and better understand its metrics, but above all, whether you be a buyer or a SaaS owner this should greatly help you detect and understand rooms for improvement in the SaaS operations and products and potentially improve the company’s acquisition channel.

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