What is negative churn and why do we like it?
As early stage investors, there is typically very little historical data that can support our analysis of a company, and a static view of a company’s financials tells us very little about its future. This is why the main types of metrics we like to look at are those that reflect the customer as the basic unit of analysis. This applies to later stage investing as well, but understanding the relationship between a customer and the business is what truly tells about the future value of a company.
The first metric, contribution margin at a customer unit, is relatively simple to grasp — just consider how much revenue at a given unit of time a customer is generating minus the cost to generate those revenues over that same period of time. The second metric, how long a customer stays in a company before churning, however, is trickier to measure. The best analogy to explain churn is to think about companies as leaky buckets. The rate at which the bucket empties depends on the size of its holes. That’s the churn rate.
To keep the water in this leaky bucket at the same level, the company needs to bring in new customers at the same rate that it’s losing them. If the company wants to increase the level of water in the bucket, it needs to be very good at signing up new customers, which is usually not sustainable if you’re trying to compensate for a high level of churn, or at improving the retention rate for current customers.
The main trap behind an uncontrolled churn rate is that your churn, usually measured as a percentage of your client base, grows nominally along with your business. For example, a company that is growing fast and has had the same churn rate for a long time will be churning an ever-increasing amount of clients each period as the client base continues to grow. Two implications arise from that: (i) this company will exhaust its audience much faster as it tries to keep up with the level of water in the bucket, and, as a consequence, (ii) its CAC will most likely go up as its client acquisition dollars are being spent on a saturated base of potential clients, thus reducing efficiency, especially as these clients will likely churn even faster or spend less on your products than your initial target base.
Companies with negative churn, or positive dollar retention, are at the other end of the spectrum. These companies are able to increase their revenue generation from a given client cohort in an order of magnitude that more than compensates for the revenue lost from churned clients. That means that even if the company doesn’t grow its client base, it can still grow its revenues because existing clients are spending more.
At ONEVC, we are proud to have backed many companies with negative churn, and we have identified the main dynamics that allow for that:
- The company leverages its clients’ growth. Take Swap or Caju as examples. Both companies benefit from serving startups that are growing their user bases. When Swap starts issuing cards and processing transactions for a client that’s growing, it leverages the growth efforts of its client and tags along on it. Same goes for Caju — when Caju gets into a company that’s growing its number of employees, it will automatically continue selling more to the same client.
- The penetration of the core product grows inside the same client. Pipefy is a great example of a product that functions as a virus in organizations. Offering a process orchestration platform for workflows, Pipefy usually starts being used by a single team in a company and, as the company wants to increase collaboration among teams, more and more teams start using the product. Another great example is Clubbi. Grocery shops usually start testing their product by ordering smaller baskets that represent a fraction of their weekly or monthly procurement needs. Over time, however, after testing and seeing the product work, Clubbi continues to gain share of wallet, increasing both the order frequency and the average order value for the same clients.
- The company is able to upsell and cross-sell adjacent products. That means that the company may have a go-to-market strategy in which the first product that they sell is actually a “Trojan horse” that allows them to start serving clients (that are not usually easy to penetrate and have a longer sales cycle, specially enterprise clients) and then continue selling other products that could be more expensive or have higher margins, or just increase their average revenue per client. idwall is a great example. The company starts selling one product — for example, background checks — and then starts cross-selling others that are part of the same SDK, such as face match, documentoscopy, etc. As Clayton Christensen discussed in his Disruptive Innovation theory:
[…] “Disruption” describes a process whereby a smaller company with fewer resources is able to successfully challenge established incumbent businesses. Specifically, as incumbents focus on improving their products and services for their most demanding (and usually most profitable) customers, they exceed the needs of some segments and ignore the needs of others. Entrants that prove disruptive begin by successfully targeting those overlooked segments, gaining a foothold by delivering more-suitable functionality — frequently at a lower price. Incumbents, chasing higher profitability in more-demanding segments, tend not to respond vigorously. Entrants then move upmarket, delivering the performance that incumbents’ mainstream customers require, while preserving the advantages that drove their early success. When mainstream customers start adopting the entrants’ offerings in volume, disruption has occurred.
Curious to learn more?
https://hbr.org/2020/01/how-to-value-a-company-by-analyzing-its-customers
