If you operate in the Software-as-a-Service (SaaS) industry, you’ve already heard about churn. It's one of the 5 AARRR Pirate Metrics, after all. This article will examine what churn is, how it impacts your business, and how to measure churn as a SaaS provider.
What Is Churn?
Churn is the number of customers that leave your business over a given period of time.
What Does Churn Rate Mean?
Your churn rate examines the percentage of total customers that have lapsed or the amount of revenue lost. Your churn rate calculates the rate at which customers have left the business versus the number of customers you retain or acquire.
Why Is Churn Important to SaaS Startups?
In a SaaS business, churn is the percentage rate at which your customers cancel their recurring revenue subscriptions. Therefore, it is critical when forecasting to use your churn to determine the probability rate at which customers will cancel their subscriptions.
Looking at the definition of customer churn – the number of customers that cancel their recurring monthly subscription – your churned customers represent lost revenue and growth.
In other words, your churn rate is an important metric used to determine the overall health and growth of your business.
Keeping track of your new AND lost customers is as vital as tracking new leads and referrals.
It’s much more expensive to acquire new customers than it is to retain existing customers, which is why businesses should endeavor to keep their churn rate as low as possible.
At the startup phase, your investors will likely examine your churn rate to determine your potential for long-term growth. A low churn rate is an indicator that your business is operating well.
What Is a Churn Analysis and Why Is It Important?
Businesses will regularly measure customer and/or revenue churn to determine how well they perform against operational goals or establish their financial health and forecasts. This measurement is known as a churn analysis. You can do this retrospectively or as a forecast.
SaaS churn harms profitability and company valuation. Churn increases with the size of your customer base (known as negative virality). It is difficult to overcome, and when companies become aware of a downward growth trend, they need to take drastic action.
Startups spend a significant amount of money and time acquiring customers. Extending the lifetime value of your customer is the only way to recover that initial acquisition cost. (If this customer brings on even more referral customers, they are even more valuable).
Calculate your Customer Lifetime Value by inputting your recurring revenue and customer churn. You determine your business value by your churn analysis.
Common Churn Metrics for Subscription Businesses
Before we can establish the churn rate formula you want to use for your business, we need to determine what you would like to measure.
Tracking your leads and conversions is part of the ten commandments of lead generation – and knowing how much revenue those leads and conversions will bring over time is a critical part of churn analysis.
Some of the most commonly used metrics include:
Logo Churn is the number of subscribers that cancel or discontinue their subscription in a given period. Express it as a percentage as part of your Customer Lifetime Value calculation or as an absolute count.
In general, businesses aim to keep their logo churn rate below 3%, although it is much higher for small to mid sized enterprises.
You can calculate your logo churn by dividing your churned customers for a set period by the total number of customers at the beginning of this period.
Recurring Revenue (ARR/MRR) Churn
Your recurring revenue is usually a ratio of your Annual Recurring Revenue or Monthly Recurring Revenue lost as a percentage of renewals or the total number of MRR or ARR value lost to cancellations and attrition. Downgrades may also form part of this calculation.
You can calculate your Recurring Revenue Churn by dividing the sum of your downgraded MRR and canceled MRR by your total MMR at the beginning of the month.
Most companies aim for a gross MRR churn rate of 1-2%. High churn rates will eventually surpass your growth. At 5%, you will lose half of your subscription revenue every year.
Revenue Churn or GAAP revenue churn is a ratio similar to recurring revenue churn and encompasses the loss of non-recurring revenue. GAAP revenue is your income reported in financial statements according to Generally Accepted Accounting Principles in the USA.
Average Recurring Revenue Churn
This metric expresses the average Annual Recurring Revenue or Monthly Recurring Revenue decreased due to lost customers.
Bookings churn is a more traditional but lesser-used way for SaaS companies to measure churn. A booking is an executed contract between you and your customer for a subscription product or service.
Because churn is not only about tracking your lost customers but the net inflow and outflow of customers, bookings should be tracked, including downgrades and upgrades.
How to Calculate Churn Rate for Your SaaS Business
Several methods explore how to calculate churn rate, but you should meet the ideal SaaS churn calculation requirements to get an accurate picture, including:
- a uniform customer population that all have the same probability of canceling during the measurement period;
- a matched customer population, taking into account the clients that may cancel and the ones that do cancel;
- the correct measurement interval, ensuring that the period is long enough to be statistically viable;
- a stable business process, as startups may not have a recurring revenue stream yet.
Assuming that all of these requirements are in place, there are two ways of calculating churn.
The Simple Way to Calculate Churn
Most companies start calculating their churn by:
- Subtracting the number of customers remaining at the end of the month from the number of customers at the beginning of a month.
- Dividing by the number of customers at the beginning of the month.
- Multiplying by twelve to get the annual churn rate.
While this is pretty easy to understand and calculate, it doesn’t account for real-world growth. For example, if your total customers go up, your churn rate goes down – even if more customers churn than the previous month.
This calculation works well if your growth and subscription base are stable and well-established.
The Adjusted Way to Calculate Churn
If you anticipate significant monthly growth or other deviations, you can take the midpoint of the customer count for the month rather than starting at the beginning. If you are about to ramp up your marketing or sales tactics, this may be a suitable measurement.
Simply divide the number of churned customers by an adjusted average of the number of customers throughout the period.
While this normalizes changes in total customers over the period, it doesn’t scale with different time windows. For example, you may get significantly different results when applying this calculation to a daily, weekly, monthly, and annual time frame.
Make sure to repeat the calculation over time to get a more accurate picture.
Common Churn Calculation Problems
Even the most straightforward churn calculation can provide valuable insight, but watch over for the following common churn calculation problems:
The Measurement Interval Is Too Short/Too Long
A small number of customers, a minimal monthly churn rate, or a very high monthly churn rate are lower-tier indicators that your measurement interval is problematic and needs adjusting.
The Unmatched Population
If your contract renewal periods are mixed or longer than one month, or if your calculations are turning up a high monthly growth rate, the population you are measuring is the likely culprit.
It’s also challenging to measure churn if you have different customer types and behaviors, e.g., loyal customers and early dropouts, or high-value customers with multi-year contracts and small SMBs with month-to-month subscriptions.
Correlating MRR to Churn
Upgrades and downgrades, as well as changing renewal periods, may throw off your results. Your customers can’t churn under contract. If you use annual contracts, monthly churn rates may be deceiving.
Many companies choose to calculate churn based on contracts up for renewal and the average contract renewal period.
How to Calculate Customer Lifetime Value (LTV)
As explained earlier, your Customer Lifetime Value (LTV) is the amount of money you can expect to make from a client before churning.
The calculation is pretty simple! First, divide your Average Monthly Recurring Revenue per Customer (MRR) by your User Churn rate. The result is your LTV.
What Is Churn Variance?
We’ve already seen that churn can be challenging to establish and that time frames and differences in your client base can result in variances.
To keep this variance accounted for, you can multiply your results by a percentage representing the cash flow losses you may incur in the future — known as a discount rate.
Most companies use a discount rate of.75.
In mathematical terms, the calculation looks like this:
((Average Monthly Recurring Revenue Per Customer x Profit Per Customer)/Churn Rate) x.75
Scientific Guidelines for Sample Size
We know that small sample sizes will invalidate or throw off your results, but how small is too small?
If you are concerned about the size of your user base, stick to these best practices:
Less than 100 clients
If you have less than 100 subscription clients, count at least 50% of your users in your calculation. If possible, 100% is best.
1,000 to 10,000 clients
Count at least 10% of your user data when calculating churn.
More than 1 million clients
Count at least 1% of all user data to be valid and accurate.
5 Ways to Reduce Churn in SaaS Business
We’ve spoken a lot about calculating churn, but the question on everyone’s minds is: How do I reduce churn?
Image: How can you reduce churn in your business?
Raising Prices: Tiered pricing is valuable. First, a lower-tier pricing plan will get people interested in your company and started on a trial basis. Then, once they recognize the value of your business, they can upgrade to a higher tier with higher prices.
Make It Harder to Cancel: While you should always stay ethical and ensure that clients can cancel, cancellation shouldn’t be a mere click away. Asking your clients to email in a cancelation form allows you to save the account with a courtesy call and follow-ups.
Add a Success Team: Appoint a few team members that can onboard and support your new clients, from sign-up to implementation. Having someone holding your clients’ hand throughout the process will increase their Lifetime Value.
Keep Improving the Product: Continually reinvest in your product based on the reasons provided for cancellation. This not only helps with customer retention but provides a compelling reason for a lapsed client to return to the business at a later stage.
Focus On Selling Annual Deals: Locking in customers for a more extended period will assist the successful team with retention. Month-to-month payments are harder to track and manage.
In this article, we’ve examined churn and how to calculate churn and conduct a churn analysis. We’ve also looked at:
- standard churn metrics,
- customer lifetime value calculations, and
- how to reduce your churn rate.
Keeping an eye on churn rates is a great way to determine the health of your business and growth potential, especially for the SaaS industry.
Add churn rate goals to your KPIs and objectives to ensure that your business keeps growing exponentially.