In this blog series we profile three core metrics for SaaS companies: revenue growth, churn and margin, from startup to $200 million dollar business. These metrics define a target profile that a SaaS company can use to compare their own performance.
Best In Class Customer Churn Rate - Using the Quick Ratio
Churn, aka customer attrition (the opposite of retention), is the rate at which customers (by volume or by revenue) are lost on an either a monthly or annual basis. It is a key metric that correlates to the value of the product or service the customer is receiving. The higher the churn, the less relevant the product to the target customer. The lower the churn, the higher the value that the customer perceives they are receiving.
The Churn Rate is the churn represented as a percentage of growth (not revenue). It can be used as a pure customer count (subscribers added versus subscribers cancelled) or revenue (recurring revenue added versus recurring revenue cancelled). Most B2B SaaS companies look at revenue because pricing tends to vary by customer. B2C companies often use subscribers because the pricing is so stable.
In an article in 2019 (1), Ryan Law explored the use of the Quick Ratio (created by Social Capital co-founder Mamoon Hamid) to determine if there was a threshold for SaaS companies at which churn could be considered "healthy". That is, where churn does not inhibit the growth of the business.
The Quick Ratio is a division between accretive recurring revenue (new recurring revenue from new or existing customers) divided by lost recurring revenue (complete or partial cancellations from customers). Ryan's analysis shows that the threshold for maintaining "healthy" churn is a Quick Ratio of 4. That is, new recurring revenue >= 4 x lost recurring revenue.
We can apply this Quick Ratio threshold of 4 against our best in class Mendoza Line revenue growth model (see Part 1) to define an annual churn rate model that would look attractive to investors. The chart below shows the result of this analysis, going from a churn rate of 19% at $10m to 3% at $200m.
Churn is a tricky "partner-in-crime" for growth. Typically, an early startup will ignore churn in an all-out pursuit of growth. As the early days of a product are all about understanding and tuning value to a target market, it is logical that churn is meaningless because the concept of the product is incomplete. Who cares that you lost 100 customers if you don't believe your product or target market was right? However, once a company grows to a size (say, above $50m in revenue), the need to manage churn is equally important as revenue growth, as it now has a magnifying effect on profitability. Above $100m it is paramount - as revenue growth starts to trend toward 10%, every 1% reduction in churn goes directly to the bottom line.
It takes a lot of focus on the customer experience to manage churn - and without establishing a culture and framework of customer experience early it is a heavy lift to insert it later in the growth curve. Especially when a culture of "growth at all costs" has already been established with a focus on sales. Prioritizing an investment in customer success early in the company lifecycle is necessary to set the foundation for managing churn as it gains in importance over time.
The Quick Ratio links growth and churn together to create a model for best in class SaaS revenue health. The next metric we will evaluate is margin.
(1) The underlying ratio and threshold of 4 used in this post are credited to Ryan Law and his article "SAAS QUICK RATIO: HOW TO MEASURE YOUR STARTUP'S REVENUE HEALTH", Cobloom, 2019. The original Quick Ratio formula was developed by Mamoon Hamid, now at Kleiner Perkins.
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