Sunday, February 22, 2015

Why (most) SaaS startups should aim for negative MRR churn

If you've followed my blog for a while, you know that I have a bit of an obsession with churn. Having significant account churn doesn't necessarily have to be a big problem and can't be avoided completely anyway. MRR churn sucks the blood out of your business though. That's why I think that SaaS companies should work very hard to get MRR churn down, as close to zero as possible, or even better achieve negative MRR churn.

Before I continue, here's a quick refresher on the terms that I'm using. If you're a SaaS metrics pro you can skip the next two paragraphs.

Your account churn rate, also called "customer churn rate" or "logo churn rate", measures the rate at which your customers are canceling their subscriptions. If you have, say, 1,000 customers on February 1st and by the end of the month 30 of them have canceled, your account churn rate is 3% p.m. in Feburary. Note that this assumes that all 1,000 customers are on monthly plans and can cancel that month – if some of your customers are on annual plans, you need to calculate the churn rate of that customer segment separately.

Your MRR churn rate, sometimes also referred to as "dollar churn rate", is the rate at which you are losing MRR through downgrades and cancelations. If you have, for example, $100,000 in MRR on February 1st, and by February 28 you've lost $4,000 of these $100,000 due to downgrades and cancelations, your gross MRR churn rate is 4% in February. Assuming you have $6,000 in expansion MRR in the same month – i.e. an increase in MRR of existing customers, e.g. due to upgrades to more expensive plans or additions of seats – your net MRR churn is minus $2,000 and your net MRR churn rate is minus 2% in that month. For more details on these and other SaaS metrics, check out ChartMogul's SaaS Metrics Cheat Sheet.

Thanks for your attention, SaaS metrics newbies, and welcome back pros. The following two charts show the disastrous effect of MRR churn, using an imaginary SaaS startup (let's call it with $100,000 in MRR that has a net MRR churn rate of 3% p.m. and is adding $10,000 in MRR from new customers each month:

MRR development of - click for a larger version

MRR development of - click for a larger version

The first chart shows how much new MRR from new customers is adding (light green), how much MRR it's losing due to churn (red) and what the net change is (dark green). The second chart shows the resulting MRR (blue) and the ratio between new and lost MRR (orange), inspired by Mamoon Hamid's great "Quick ratio" of (Added MRR / Lost MRR), which I recently learned about.

As you can see in these two charts, not only does the net new MRR of go down every month. It actually asymptotes to zero, which means that the company is hitting a wall at around $350,000, at which it stops growing.

The math behind this is of course trivial, since the assumption was that the company is adding a constant dollar amount of MRR every month, while churn MRR, being a constant percentage of total MRR, is growing. So what happens if instead of acquiring new customers linearly, you manage to add new MRR from new customers at an ever increasing rate?

Here's another imaginary SaaS startup, let's call this one Like, has $100,000 in MRR in the beginning of the timeframe that I'm looking at and has a net MRR churn rate of 3% p.m. Unlike, is adding new MRR from customers at an accelerating rate, though: In the first year it's adding $10,000 per month, in the second year $15,000 per month, then $20,000 per month, and so on. Let's look at the charts for

MRR development of - click for a larger version

MRR development of - click for a larger version

The MRR development of this company looks much less depressing, and after ten years it reaches close to $1.5M in MRR. However, as you can see in the first chart, as well as in the declining orange line in the second chart, churn is eating up an ever increasing part of the new MRR coming in from new customers. If doesn't manage to decrease churn, it will have to acquire more and more new customers just to offset churn, and keeping net new MRR growth up might become increasingly difficult.

OK, but what if you're acquiring new customers at an exponential growth rate? Let's look at a third imaginary company called Weed, Inc. Like and, Weed starts with $100,000 in MRR and has a net MRR churn rate of 3% p.m. The big difference is that Weed is adding new MRR from new customers at an exponential rate. Starting with $10,000 in the first month, the company is growing new MRR from new customers 10% m/m in the first year; 8% m/m in the second year; 6% m/m in year three; 4%, 3% and 2% in year four, five and six, respectively; and 1.5% from year seven onwards. 

Here are the charts for Weed, Inc:

MRR development of Weed, Inc. – click for a larger version

MRR development of Weed, Inc. - click for a larger version

Not much to complain about: After ten years, Weed, Inc. has more than $19M in MRR. The big question, though, is if a development like this is realistic. In order to offset ever increasing churn amounts, Weed needs to acquire new MRR from new customers at an extremely ambitious pace. In the last month of the ten year model that I'm looking at, Weed adds about $870,000 in new MRR from new customers, almost 5% of the company's total MRR at the beginning of that month. To acquire so many new customers, Weed needs either a viral product (very rare in B2B SaaS) or extremely scalable lead acquisition channels.

I'm not saying that it's impossible, but I believe the much more likely path to a SaaS unicorn is by getting MRR churn to zero or below – which means you have to make your product more and more valuable for your customers and acquire larger and larger customers over time.

Update / September 17, 2019: Bonus tip, we recently invested in a company called Brightback that helps you reduce churn by making it easy to implement sophisticated, personalized "churn deflection" pages and workflows. Have a look! :)


Abraham Thomas said...

The key insight for me is this: acquisition rates always decline over time, because no matter how viral or exponential your growth strategy, you eventually hit the point of diminishing returns. The larger your user base, the harder it is to generate a given percentage of new users.

Churn rates show no such tendency. Left unattended, they will always be a constant fixed percentage of your user base [*].

Hence no matter how good your raw acquisition strategy, sooner or later your MRR growth will stall. You may be able to postpone that day like Weed Inc in the above example, but it's inevitable. *Unless you can unlock negative churn.*

[*] In fact as you widen your user base it's likely that your churn rate will actually increase, because you're now hitting slightly less optimal customers. Bill Gurley's great post on ARPU captures this and other non-linearities in SaaS metrics:

chrija said...

Agree, well said!

Kenny Fraser said...

For me this shows once again that looking after existing customers is a vital part of the SaaS business model. Valuable metric for tracking effectiveness in that respect.

Dominic said...

Excellent post on how "MRR churn sucks the blood out of your business" - when it happens you need to act fast. Just a few thoughts to add:

I think it's important to qualify churn rates on the basis of income rather than new name accounts, particularly if your SaaS pricing model contains "useage based variables" (eg. per seat licences, transactional elements etc.). Many SaaS businesses can improve churn by 'farming' existing customers to offset customer losses without necessarily increasing risks due to fewer customers. A customer with a much deeper need paying $1,000 can be more valuable and less risky than five customers paying $200.

As a SaaS business matures through the adoption curve your sales/revenue generation team usually evolves, primarily using 'hunting' tactics to tackle the 'early adopters' and the first 'early majority' to then adding 'farming' tactics to stabilise revenues during the 'early majority' and 'late majority'. These farming tactics (usually account management) also help solidify customer relationships to improve buy-in, and make it harder for a customer to leave through good product, better understanding, customer service, deeper engagement in core business etc.

Unfortunately 'hunters' and 'farmers' in a sales force are two different animals (and therefore expensive to run both) which is why most companies need to wait until they've reached the 'early majority' before employing dedicated 'farmers'. The earlier you can employ both the better you chances of de-risking customer churn.

Floyd Smith said...

This article brings up some good points. For most purposes, I think it's worth addressing churn (losing existing customers) and sales (getting new ones) separately, though; it then takes only a sentence to say that one mathematically offsets the other.

I recently joined the many people here at Recurly who've written on different aspects of churn:

Geet choudhary said...

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