The Compounding Effects of Churn

3 Ways to Budget for Customer Success

One common challenge that customer success leaders are often faced with is how to budget for the function. It may be that Customer Success is a new discipline that you are championing at your company, and you’re trying to establish the business case. Or maybe you’ve already “made the case” and are looking further down the road to forecast how your team will need to grow over time. Perhaps you’re just trying to get a sense of how your team compares to others in the industry…benchmarking as a “sanity check,” if you will.

Regardless of your motivation, I like to tackle this problem by drawing inspiration from the way that investors and financial professionals approach valuing a business. What you’ll find is that there are several common ways to put a price on a company. They each have pros and cons, each is more or less reliable for certain uses, and certainly, individuals tend to have “favorites”.

Because of this, what you’ll find is that the “best” way to value a company isn’t to choose the one “best” method, but rather to use several different methods to confirm that the results “agree” with each other. Or if they don’t, dig in to understand why they don’t! This is where one method’s advantages can shine a light on flaws in other methods.

With that in mind, let’s turn back to customer success, and walk through 3 methods you can consider, and then wrap up with an example at the end.

Rule of thumb

I’ll start here, because this is the easiest method, and odds are you’re familiar with it already. The common number you’ll hear is that you should have 1 Customer Success Manager for every $2 million in ARR. I like this method as an initial gut-check metric in that it’s helpful in *rough* sizing of a team, and in quickly identifying if a team is significantly under-invested or over-invested.

But it has its flaws.

First, it’s blind to the stage of your business. As Nick Mehta of Gainsight points out here, that ratio may be more like 1 CSM / $250k ARR if you’re early stage & high growth, vs. 1 CSM / $2m ARR for later stage & low growth.

Second, it doesn’t factor in the variety of organizational structures and Customer Success charters out there. Are your CSMs responsible for on-boarding and adoption? Renewals and retention? Up-sells and expansion? Support? All of the above?!? Your answer to this question certainly influences how many CSMs you need.

Lastly, this method only estimates the number of CSMs you need. It won’t tell you how many Support folks to plan for, doesn’t account for investment in technology for the team, etc.

Expense benchmarks

When it comes to benchmarking just about any SaaS metric, I’m a big fan of the annual Pacific Crest SaaS survey. It’s full of useful points of comparison. For this post, you’ll want to scroll all the way down until you find “CAC Ratio on New Customers vs. Upsells vs. Expansions vs. Renewals”. You’re looking for this image:

CAC Ratio on New Customers vs. Upsells vs. Expansions vs. Renewals,

What this metric provides is a measure of the amount that the benchmark companies invest to acquire $1 of ACV from new sales, up-sells, expansions, and renewals.

This method will take a bit more math to see where your company falls relative to the benchmarks, but it does address some of the gaps of the Rule of thumb approach in that it provides different measures depending on the responsibilities of the CS team. It’s also an “all in” cost number. Since CS is often responsible for renewals, I tend to use the Renewals number of $0.13 / $1 ACV as a starting point. Totango has published a good primer that goes into more detail on what costs to include when calculating the Renewals CAC Ratio (or Customer Retention Cost as they call it).

What’s it worth?

If you’re a CFO or VP of Finance and made it this far, you’re likely seeing a lot of expenses and wondering where the benefit is in making these investments. Fair question. Enter the third approach to budgeting for Customer Success — quantifying the potential upside.

Gainsight did a useful study that found that as companies invest in their Customer Success programs, and evolve from reactive to predictive in their operational maturity, there are significant gains to be realized in gross and net revenue retention. In other words, there is a meaningful ROI to Customer Success.

It’s been said that “Customer success is where 90% of the revenue is,” an acknowledgement that as your business grows, the vast majority of your Customer Lifetime Value is in the out years after the initial sale. There’s a compounding benefit to improving revenue retention, and this is where a sophisticated Customer Success program can materially benefit a company’s financial performance, cash flow, and valuation.

Using this approach to budget is great in terms of quantifying the “so what?” of Customer Success investments. It helps communicate a clear result and reason for investing. The challenge with this approach is of course that improving retention rates is not something that Customer Success can do on its own. It often involves collaboration across the entire company. Customer Success alone can’t “fix churn”, as churn is a symptom, not a cause. But that’s a post for another day. :)

An example

Ok, let’s tie these 3 methods together with a simple example. First, for the example, let’s assume…

  1. Your company has $20m of ARR
  2. Gross dollar retention is 85%
  3. Net dollar retention is 95%
  4. The fully-loaded cost for a CSM is $100k / year (Gainsight and Totango both have good benchmarks if you need to model other roles.)

Rule of thumb

This one is the easiest to calculate. $20m of ARR / $2m = 10 CSMs.

10 CSMs * $100k = $1m CS investment

But remember that you’re missing other costs like someone to lead those CSMs, not to mention other roles like Support, technology & tools, etc. You might also make the case that you should use a lower ratio if you’re in high growth mode, or building your CS programs.

Expense benchmarks

Let’s use that Renewals CAC from above, and apply it to our assumptions. We’re going to need to renew that $20m ARR, so doing the math here we get…

$20m * $0.13 Renewals CAC = $2.6m CS investment

This number is quite a bit larger than what the Rule of thumb produced, but this isn’t surprising since it’s an “all in” number vs. just estimating CSM headcount. The challenge with this approach is in determining the “right” Renewals CAC Ratio. We went with the median of $0.13, but the 25th percentile and 75th percentile were at $0.32 and $0.05, respectively. Go with either of those, or other numbers in between, and, well, actual mileage may vary.

Note also that for the sake of a simple example, I’ve chosen to go “top down”, starting with ARR and the Renewals CAC. I’d recommend that you also tackle this model “bottoms up” and tally up all of your Renewals CAC costs (headcount, technology, etc.) and divide that total expense estimate by your ARR to see how it compares to the $0.13 benchmark.

Value the upside

We’ve got two measures, so let’s round this out with a third perspective while also assessing the potential upside.

With $20 ARR and 85% gross dollar retention, we’ll have retained $17m of that original $20m. Upsells bring our net dollar retention to 95%, or $19m.

Now let’s factor in some improvement. Let’s assume that we’re at that Stage 1 (Reactive) position described above. We won’t go from Stage 1 to Stage 4 over night, as it takes a while for these sorts of investments to produce results. According to Gainsight’s research, this shift from Reactive to Predictive yields an average of 9 points in gross dollar retention and another 9 points in net dollar retention.

Excluding the impact from new sales, that transforms our business from one that is experiencing a net churn of $1m / year, into one that is generating $2.6m

$20m ARR * [(85% + 9%) + (10% + 9%)] = $20m * 113% = $22.6m

Now, does this mean that the extra $3.6m is your CS budget? No. Obviously, with this model, to make the investment worthwhile, you don’t want to spend that entire surplus. Retention improvements compound though, so factoring in growth on top of that $20m business, and net revenue retention of 113% gets really exciting at $50m, $100m, and beyond.

For argument’s sake, let’s split the difference and say you budget half of that for your CS program, resulting in…

($22.6m — $19m) / 2 = $1.8m CS budget

Granted, that “ / 2” is arbitrary, and the most obvious flaws with this model are in assuming the benefits will be achieved, and pulling those future benefits into the present year budgeting process. But, these are the types of results you’re looking for a sophisticated CS program to produce both directly and through its influence on the company’s approach to ensuring the success of its customers.

So…now what?

We’ve now produced three results from three different approaches…

  • Rule of thumb: $1m
  • Expense benchmarks: $2.6m
  • Value the upside: $1.8m

Each of the models has its pros / cons, so how do you use these varying results? Just take an average? Do a ton of analysis to minimize the flaws with each of the models?

I suggest a third approach. Step back, and take a look at what you’ve learned from going through the process. Pulling these numbers together likely forced you to think about your team, your processes, your tools in some new ways. You probably realized that achieving those upside targets will require a number of changes…some on the product side, some with the types of customers you’re selling to, etc.

Now, combine those different approaches together to formulate a holistic approach to your budget, and use the different models to validate that approach.

Start with the Expense benchmarks method, and see what your total costs come in at. Is your number inline with the benchmark ranges?

Compare your Expense benchmark to your Rule of thumb model to see the implied number of CSMs you’ll need. How do those ratios compare to those of other companies at your stage / maturity?

Now, with this budget in place, what sort of impact can you drive for the company? What’s the upside you can achieve next year, the following year, and beyond?

Summarize your analysis across the 3 models, and you can now have a much more informed and actionable discussion with your CEO, CFO, and Board.

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