The Four Ways to Calculate SaaS Churn
Hi again! Natalie Czyzowicz here. Back again for a Part 3 of my SaaS Distilled series.
It’s time to churn things up a bit 😏 by distilling David Cumming’s The Four Ways to Calculate SaaS Churn.
I found this article particularly useful in breaking down how “Churn calculations can be done a variety of ways, and therefore manipulated.”
Let’s jump in. You can also see Part 1’s Core Metrics and Part 2’s Customer Acquisition Cost to catch up.
Importance of churn rate
Churn, be it logo or revenue-based, is arguably one of the most important SaaS metrics to track for companies and one of the most important issues that companies face.
In a SaaS business, churn measures the percentage rate at which customers cancel their recurring revenue subscriptions.
To survive, companies can’t afford to lose customers and the revenue associated with them. Although it’s inevitable that companies will experience churn, it’s important to minimize it and to dive deep into why customers leave. Getting valuable information from customers on any issues they faced while they were an active customer can prevent future customers from churning.
Different ways of calculating churn
When we speak about churn, it’s important to distinguish whether we’re talking about revenue churn or customer churn. Companies should be tracking both as they mean different things.
Revenue Churn – the dollar amount that we lose when a customer leaves
Customer Churn – the number of customers that left
It’s crucial to dig into these numbers and understand the economics. As an example, we might have one customer who left but their MRR was $100,000. For a company with <$5M ARR, this revenue churn number would be significant even though the company only lost one customer.
In another example, we have 100 customers that churned, which sounds like a lot, but if their MRR was only $20, the revenue churn ($2,000) is not as significant as the logo churn rate would indicate.
Another way to calculate churn is to look at gross vs. net revenue churn rate.
The formula for Gross Revenue Churn Rate is quite simple: Churn MRR / Beginning MRR.
The Net Revenue Churn Rate formula gets slightly more complicated as we include expansion and contraction revenue in the formula (Churn MRR + Contraction MRR – Expansion MRR) / Beginning MRR.
Both formulas are correct and one is not better than the other but they show us different things.
Gross Revenue Churn Rate shows us the raw revenue churn number whereas Net Revenue Churn Rate gives a more wholesome view of the MRR stack and shows that revenue losses can be offset by growth in expansion (this is really the holy grail of SaaS everyone is after, referred to as net negative churn or net revenue retention).
We can also look at monthly vs. annual churn and ARR vs. ATR churn. ARR looks at all customers and ATR looks only at the pool of customers available to renew.
No matter what, in deciding about which churn calculation to choose, you need to think about what outcome you want to see and what it means for your company as each churn calculation produces different results.
Issues with Churn
The biggest issue with churn is that there are so many methods and formulas to select from to measure it in a host of ways.
When we speak to people about churn it’s not always clear what they’re talking about and how they measure it. Often companies don’t specify what they mean by “churn”. Comparisons with other companies or benchmarks don’t mean anything unless we know they’re using the same methodology.
Another problem with churn is understanding what churn means for SMB vs. Enterprise customers.
Companies with SMB customers generally have a higher churn rate, as switching costs are much lower than for enterprise companies. Enterprise companies often have annual contracts as opposed to monthly SMB customer contracts. Switching to a different product is much more difficult for enterprise companies since they typically pay upfront for the year, contract renewal periods are annual and the implementations are more complex and wide reaching within the enterprise and thus are more painful to move off of. Typically companies with an enterprise customer base experience lower churn rates but, as I mentioned above, losing a single customer can have a significant effect on MRR.
Sometimes we’ll see variability in monthly churn rates that comes from seasonality as companies might experience periods throughout the year when customers don’t need a product, and will churn during those periods only to come back later in the year when they need the product. This is referred to as re-activation revenue, which you’ll occasionally see in the MRR stack. In a scenario like this, it’s better to look at annual churn rates.
Net Negative churn goal
In my opinion one of the most fascinating (and encouraging) things to see is net negative churn.
Net Revenue Churn Rate = (Churn MRR + Contraction MRR – Expansion MRR) / Beginning MRR.
When Expansion MRR is greater Churn and Contraction MRR, we’re at negative net revenue churn.
This comes from companies getting more revenue from existing customers than they are losing from customers who leave for good (churn) or switch to a lower paying plan (contract).
This should be a goal of every SaaS company as churned revenue can be more than offset by this sweet, sweet expansion revenue.
Here are some things that drive expansion revenue to contribute to reducing the revenue churn rate:
- increasing pricing
- making the product more robust and gating features so customers move to a higher priced plan
- expanding reach within a customer with them adding more seats/licenses
These sorts of revenue growth initiatives are oftentimes less costly to implement and more sustainable to control than simply relying on getting New MRR by acquiring new customers, which is of course also very important.
At the end of the day, Net Negative Churn can be a great indicator for the overall health and sustainability of a SaaS business.
Churn vs. Net Dollar Retention (NDR)
I’ve come across multiple articles talking about Net Dollar Retention being a superior metric to churn. I can see why people would think that and I don’t agree or disagree with this statement.
I do agree that churn can be easily manipulated (see how many ways and churn formulas there are!)
I do agree that NDR can’t be easily manipulated as there is only one formula and NDR uses the same cohorts and time periods.
However, my problem with NDR is that detailed customer/cohort reporting is difficult to obtain. As a lender we rarely get access to this type of reporting. The formula to calculate NDR is simple but it’s not easy to get good quality, organized data for longer periods of time.
So! When calculating churn, don’t massage the math to your “benefit” by picking a churn formula that will produce the lowest rate. You’re not doing yourself or anyone involved with your business any favors by hiding your flaws. In fact, monitoring churn and tracking it regularly will help you come up with better customer retention strategies and grow your SaaS business.
If you care to chat about churn or anything else SaaS ops/financing related, we love to help!
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