The Natural Churn Rate and more SaaS Startup Metrics
Since Bizelo is a Software-as-a-Service (SaaS) company, we often spend time measuring our business and comparing it to others in the space — not just competitors, but also peers who we can observe their business and their metrics. Anyone building a SaaS business knows that there are a few core metrics that govern their daily lives:
- Subscriber growth rate (G for “growth”) – The month-over-month growth rate in total, paying subscribers, usually calculated as the current month paying subscribers divided by previous month paying subscribers
- Subscriber churn rate (A for “attrition”) – The month-over-month reduction in subscribers, usually calculated as percentage of cancellations in the current month divided by the previous month’s total paying subscribers
- Trial to Subscriber conversion rate (C for “conversion”) – The percentage of trial users who convert to new paying subscribers
- Customer acquisition cost (CAC) – The amount of money that it takes to get new, paying customers. There are a variety of ways of calculating this. You can include trial users or not in the calculation and you can include total subscribers or just new ones. We feel that the most accurate CAC is dividing all the money that is spent that month in customer acquisition activities and dividing it by only the new subscribers acquired that month. So, if you spend $5,000 and you get 50 new subscribers, your CAC was $100 per subscriber. Some include the trials too, but this is misleading because they may not convert.
- Monthly Recurring Revenue (MRR) and Annual Recurring Revenue (ARR): SaaS companies making money generally on a monthly basis, this is why they are called subscription businesses. Our business only has a monthly payment plan, although we might consider a yearly plan. Regardless, even a yearly plan can be calculated on a monthly basis. As such, we believe the MRR metric is most important. This is especially the case if the other metrics, such as CAC are also calculated on a monthly basis. MRR can be tracked as either a per-customer average cost (total subscription revenue by the month divided by total # of subscribers) or as a total. We track it on a per-customer average so we can compare MRR and CAC, which is also calculated on a per-customer basis.
- Total Cost to Serve (TCS) / COGS – In order to make sure that at the end of the day, you’re making money, you need to also account for any costs that are allocatable on a per-subscriber basis. This is not all your business costs, but is certainly those costs that necessarily scale on a per-user basis. This includes credit card subscription fees, subscription service fees, scaling component of infrastructure costs, customer support costs, development costs associated with subscriber-driven bug fixes and enhancements (not general product development).
- Average Customer Lifespan (ACL) – This is the average total number of months that a subscriber stays a subscriber, factoring in cancellations, but not factoring in trials. This is a tricky thing to calculate, but you should maintain a history for all your customers and average them together to calculate the current ACL. So, if one customer signed up and canceled later, that customer had a 3 month lifespan. If you have a bunch of customers you signed up 12 months ago and are STILL signed up, then those customers have a 12 month lifespan. You can see that over time the numbers will be erratic, but stabilize as your customer base expresses their lifespan preferences.
- Lifetime Customer Value (LTV) and Annual Customer Value (ACV) – We wrote a lengthy post on this subject. In general, it is very difficult for early-stage SaaS companies to accurately predict LTV. This is why companies should either use the ACV metric or simply measure things on a month-to-month basis to make sure that all the metrics are in alignment. Given the complexity in calculating LTV, we suggest multiplying the Average Customer Lifespan (ACL) with the Monthy Recurring Revenue (MRR) average.
So, with all those metrics, how do you know if things are going well? Here are a few rule of thumb measurements that should sanity check your business:
- Your Growth Rate (G) should be greater than your Churn/Attrition Rate (A). If A > G, then you’re losing customers faster than you’re getting them. If G > A, then revenue (but not necessarily profits) will increase
- Your Customer Acquisition Cost (CAC) should be less than your LTV (as calculated above). If you are spending more acquiring your customers then you are getting from them in value, you are losing money.
- Your MRR – TCS – CAC should be greater than zero. If you are spending more money in servicing your customers than you are getting from them in revenue, you will also lose money. Basically (MRR – CAC – TCS) is your per-subscriber profit. This profit is what you use to grow your business, pay your salaries, and cover your non-scaling operational costs. You should calculate a Net Subscriber Profit margin by dividing the total susbcriber profit by total subscriber revenues. In a growing business, this should be 20% or greater. This means you need to price your subscription service appropriately, manage your churn, and keep your customer acquisition costs in control!
The Natural Churn Rate
As you can see, one of the most important metrics to manage is the churn rate. Every business needs to retain their customers, but subscription-based businesses are more sensitive than any other business to fluctuations in customer retention rates. There are a lot of things you can do to improve your churn rate:
- Improve customer service
- Make “on boarding” of your customers easier. I.e., make it easier for them to start and continue to use your product
- Continually reach out and “touch” your customers. Figure out if they’re getting value from your application, if they are frustrated, what problems they are having, what things are working, and if they can refer you to their friends.
- Make sure that your marketing matches your product. Most often, customers cancel because their expectation of what your product does differs from what it actually does. You can tell this is happening when people cancel right away or within a day or two of using your product.
- Stay abreast of what the competition is doing. Even though switching costs may be high in some SaaS businesses, you should not depend on that to keep your customers “captive”. You need to keep in touch with what the competition is doing and look for signs that the churn rate is related directly to moving to a competitive solution.
For the above reasons, Bizelo uses a cancellation survey, done at the time the user cancels, to identify the primary reason why they are cancelling and take steps to fix those. However, there are many times that the customer is cancelling for reasons entirely out of our control that have nothing to do with our, or a competitor’s product. For example, a customer might cancel because:
- They go out of business
- Their business focus has changed
- They don’t have enough money to afford your service
- The third-party service with which you are integrating has changed to eliminate the need for your offering
Every industry has a segment of its base that’s going through at least the top three of the four bullets listed above. Some industries naturally have a greater percentage of their market base regularly churning “out” because of uncontrollable reasons such as the above. We call this the “Natural Churn Rate”.
No matter how great your product/market fit is, how effective your marketing, how wonderful your customer support, there is always a percentage that will churn as a result of the industry’s Natural Churn Rate. If you can do better than the industry’s Natural Churn Rate, thank your lucky stars because you’re beating the average (and likewise, there are companies that are probably doing a lot worse than the average). But in the long run, the greater a percentage of a total market that a SaaS company is able to acquire, the more and more that the company’s churn rate is going to approach the industry’s Natural Churn Rate. There’s nothing you can do about it — that’s just the way that industry and its market participants naturally go in and out of business.
Different Industries and their Natural Churn Rates
Trying to ascertain an actual Natural Churn Rate for an industry is a very difficult proposition. After all, it involves, among other things, figuring out which new companies emerged in a market, which still exist, and which closed shop. This is complicated to do. And not necessary. Yes, it would be great to know that a particular market’s Natural Churn Rate is 12% and your churn rate is 7%. That means you are “winning”. Instead, a good proxy for that would be to know whether your market has a Low or High Natural Churn Rate. Any market with a Natural Churn Rate over 10% should be considered a High Natural Churn Rate, and anything below that a Low Natural Churn Rate.
From that perspective, our observation is that certain markets definitely exhibit High and Low NCRs:
- Medical offices, doctors, and veterinarians: Low NCR
- Online retail: High NCR
- Residential real-estate related Saas Businesses: High NCR
- Commercial real-estate related Saas Businesses: Low NCR
- Restaurants: High NCR
- Insurance brokerages: Low NCR
- Banks and Financial Institutions: Low NCR (although who knows lately)
The Natural Churn Rate is just one of many factors to consider in running a SaaS business, but it’s surprising how little (if at all), this topic has been discussed. If you’re grappling with churn rates, it’s obviously good to know how much you can improve that on your own, and how much your lot is cast with the industry and market you are in.