Churn Rate: Beyond Simple Benchmarking
At Value Your Startup, we work a lot with startups and with investors, helping each side make strategic decisions that are rooted in data, analysis, and finance. We are big fans of the use of KPIs, as they give a handy snapshot of a company, but we also frequently see misuse and abuse of these same KPIs. In the best case scenario, founders and investors use them to benchmark. In the worst case scenario, founders and investors use them massage the numbers to bolster one aspect or another, typically at the expense of other problems.
But in almost all cases, neither founders nor investors are unlocking the full power of KPIs. In that vein, we turn to one of the most common metrics in the startup ecosystem: Churn.
The importance of understanding your business’s churn should not be understated. According to a study done in conjunction with Harvard Business School states, “The bottom line: increasing customer retention rates by 5% increases profits by 25% to 95%.” Diving deeply into understanding your churn can help entrepreneurs make operational changes that increase your profitability.
As Clement Vouillon points out, it is important to understand the difference between revenue churn and user churn, on both annual and monthly levels. It is also important to understand your industry’s churn rate to give yourselves a rough benchmark.
But even this can be improved on.
Let’s take a B2B SaaS company with an annual user churn rate of 10%, which is perfectly in line with industry benchmarks. Let’s also pretend this company has a good track record of growth and is projected to increase users in the future as well.
But…
Who are these churned users?
What if I told you that the churn rate for large enterprises was 25% per year, while the churn rate for small customers was 3%? What if the churn rate for companies that signed up in the past six months was 25% and the churn rate of legacy companies that have been using the service for more than 12 months was 3%?
Benchmarking average churn rate is an important gut check, but it does not provide insights into the health of the business.
The two scenarios above make you think about the company in an entirely different light and can be early indicators of the long term sustainability of the business. In the first example, if key large enterprises are churning at a much faster rate, it is an indication that the concept of the product is appealing, but they are not satisfied with the product once they use it. This is an indicator of problems in long term sustainability of the company.
From the founder perspective, it is important course-correct and make product adjustments accordingly. From the investor perspective, it is important to work with founders to address this problem, or maybe hedge further investments.
In the second example, a high level of churn for recent customers indicates that maybe there is a newer, better product on the market that is winning potential customers. Again, founders and investors should adjust their behavior accordingly.
Let’s take this a step further and look at how these things affect NPV and Valuation. I took a model for a former client in the consumer e-com space. I divided their users into two fictitious groups; cohort 1 spends $500 a month on purchases, cohort 2 spends $50 a month. Initially they both have the same monthly churn rate of 35% and the same long run sustainable churn rate of 3% per month. For simplicity, I assumed the CAC for each group was the same (though it rarely is), and that both groups are accessed through similar marketing methods (though they typically aren’t).
This is what happens when churn rate decreases uniformly across both cohorts:
As to be expected, the total project NPV (8 year monthly model and terminal value), increases as user churn decreases. As does the pre-money valuation (this specifically company is heading toward a fairly large Seed round based on of a sizable angel round and very good traction).
But what if the churn is different for each cohort?
As can be scene above, decreases in churn for the more valuable cohort of users are substantially more impactful on NPV.
More interestingly, changes in churn across the two groups affect the pre-money valuation as well:
What we see is quite drastic.
In both groups, a 5% drop in churn rate, from 35% to 30% monthly, is equal to 25% more users at the end of three months (you do the math yourself).
But, those 25% more users have a vastly different value if they come from cohort 1 or cohort 2. If they are from cohort 1, they increase the pre-money valuation by over 70%. If they are from cohort 2, they increase the pre-money valuation by 30%.
In other words, in this hypothetical scenario, decreasing the churn rate for the more valuable cohort of users is worth 2.5X more than the less valuable cohort of users (you do the math).
The point is this: KPIs are only as smart as you make them. The smarter the KPIs, the better they can be used in planning operational strategies and gleaning important insights about the future of the business. Churn alone can have a big impact on a company’s prospects and, as in the example shown here, real-world implications for valuation.
Therefore, if you are a founder, take some extra time to dig into your churn and understand the significance of what you see and plan your business strategy around your findings. If you are an investor, take some extra time in the due diligence process to dive deeply into KPI’s, such as churn, to understand their overall impact on valuation.
