Why Customer Churn is a Major Factor in Company Valuation

customer churn is a leaky bucket

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What Is Customer Churn? [Definition]

Customer churn is the percentage loss of customers monthly or annually.  It is a standard metric for subscription-based businesses.  Churn is typically measured as logo churn or revenue churn.

Customer Logo Churn Rate is the Loss of a Customer Name from your List of Active Customers.

It is typically expressed as the percentage of customers lost over a specific period.    If the business lost 7 out of 100 customers during a fiscal year, the logo churn rate would be 7% annually.

Customer Revenue Churn Rate is the Loss of Customer Revenue from your Total Monthly or Annual Company Revenue. 

Customer Revenue Churn is also expressed as a percentage but measures revenue loss.  It uses revenue figures instead of customer counts in the numerator and denominator. 

In the above example, if your average customer produces $10,000 per year in revenue but the 7 you lost last year were large, $15,000/year clients, your Customer Revenue Churn would be  (7 * $15,000) / (100 * $10,000) = 10.5%

Why Is Customer Churn Rate Important?

Churn approximates customer loyalty.  It measures the customers who no longer need or value your products and services.  It is a straightforward measure of the quality of the products and services your company provides and the ability of your sales and marketing departments to target and convince appropriate customers to sign up to receive those services. In a subscription business model, attracting and retaining loyal customers is crucial for future revenue and profitability.

Why is Customer Churn the Most Critical SaaS Metric?

A zero churn business never loses a customer.  A high churn business will lose all of its customers in a short period.  For most companies, the reality is somewhere in between.  Churn is the metric that identifies the customer attrition rate over a specific period.  The inverse of churn will show how long a typical subscriber will stay in the customer base.  For example, if a business has a 20% annual logo churn, the average customer can be expected to last for five years.

These subscribers who stay are the ones who keep contributing recurring revenue to the SaaS company’s income statement and are a significant driver of profitability.

Suppose you’re constantly losing your customers, mainly due to poor customer satisfaction. In that case, your customer acquisition cost will eventually become so large that it will be impossible to continue growing the business.

What Is a Good Customer Churn Rate?

For B2C companies, having an annual churn below 20% is considered an achievement.

For B2B companies with SMB sized subscribers, annual revenue churn rates below 10% are considered attractive.

For B2B companies with enterprise-sized customers, annual revenue churn rates below 5% are considered attractive.

Customer Acquisition Cost (CAC) vs. Customer Churn

While churn is typically considered a leading KPI for a subscription-based business, some services cannot be easily explained by the customer churn number alone.  A higher churn rate may not indicate a problem if you serve a large market and have low customer acquisition costs. 

For example, a software application offered under a monthly subscription, which is only used once or twice a year.  Perhaps you record and document a fireworks display.  The application is so great; customers come back every year to renew their subscription on the fourth of July.  But since most people only watch fireworks once per year, they unsubscribe in August.  By next July 1, everyone comes back and signs up again.  If the company spends very little on marketing and customers return every year, perhaps the high churn rate is better explained by the licensing terms (monthly subscriptions) and not the usefulness of the software application or poor customer service.

Churn Rate vs. Growth Rate

High levels of customer churn will seriously hinder a business’s growth rate.  Marketing budgets will be spent backfilling the lost customers at some point instead of adding new customers.  At this point, the growth of your subscription model will stall.

Voluntary Churn vs. Involuntary Churn

Typically, churn occurs for multiple reasons.  A company needs to understand the type of churn to understand the reasons for churn and develop strategies for controlling the churn.

Voluntary Customer Churn

Voluntary churn is where you want to focus your attention.  This is where a customer becomes dissatisfied with your product or service and decides to terminate the business relationship.  Below I discuss various strategies for controlling Voluntary Customer Churn through a process known as churn analysis.

Involuntary Customer Churn

Especially in the SMB market, some customers will leave you for reasons beyond your control.  Churn beyond the power of the vendor is called involuntary churn. 

Some of your customers will go out of business, change their business strategy, and no longer need your product.  Be bought out by a larger company that already has a relationship with a competitive product.  These are all valid reasons to terminate a subscription and are beyond the vendor’s ability to control, hence the involuntary label churn.

Customer Lifetime Value (CLV)

Customer lifetime value is the ‘worth’ of each customer from a gross margin perspective.

If a business has 20% annual churn and each customer generates $100/year in gross margin, then this business has a CLV of $500.  (5 years * $100/year)

Since each customer adds $500 worth of lifetime value, the company should be willing to spend up to $499 per new customer from the marketing budget to attract new subscribers.  

Churn over time
Net Income - Low vs High Churn

Customer Churn over Time

The longer the business operates with high churn levels, the worse the situation becomes.  You can see from the image above that even a modest reduction in annual churn can significantly impact the company’s size in just five years.

The graph tells that churn will eat away at virtually all of the achievable growth at some point in time.  A small, barely profitable company without growth is no longer a startup with potential.  It is a small lifestyle business and is valued as such.

Churn’s Impact on Net Income

As shown above, high levels of customer churn have a direct and meaningful impact on a company’s Net Income.  This is due to the increasing amounts of marketing dollars devoted to replacing the customers lost through churn.  You can see from the graph how the cost of churn begins to exert a meaningful impact on Net Income.

Churn’s Impact on Valuation

Churn and the corresponding marketing budget to attract new customers will eventually consume all of the cash-generating capability of a business if not properly managed.  For a typical small company selling for 5x SDE, look at how even a modest increase in churn can drive significant changes in a company’s valuation.  Over time, as the business grows, the difference in valuation can be even more dramatic.

Predicting Customer Churn Likelihood

As subscription-based companies begin to scale, it becomes increasingly important to try and identify at-risk customers to prevent customer attrition.  Many companies develop a churn predictive model. 

Monitor Product Usage

You want to monitor what percentage of employees in a customer account use your product and how frequently.  Inactive and narrowly used products are more likely to be discontinued at the next renewal opportunity.

Monitor New Feature Adoption

Similar to Usage Level, feature adoption indicates how useful new features are to your existing customer base.  Creating high-value features for the largest possible group of customers makes sense.  Unused features carry no value and therefore are a waste of resources.

Document Customer’s KPIs

Understanding your typical customer journey and how they measure successful vendor relationships over the customer lifecycle can help build a culture of low churn and identify the common reasons for dropping a vendor.

Survey Support Tickets

Monitoring interaction with customer service personnel to offer personalized service for unsolved issues.  It is common for a customer service group to provide customized service to key accounts to build a reputation for exceptional customer service levels. 

Monitor Customer Financial Health

Keeping an eye on the financial health of your subscribers can go a long way in predicting unexpected churn.  For consumer-based and SMB type clients, you’ll want to track credit card details, most notably identifying an expired card proactively and updating the credit card details in the billing system before a failed renewal.

For enterprise customers, staying in touch and identifying struggling customers will help minimize churn based on financial considerations.

How to Reduce Customer Churn

Set Realistic Expectations from the Beginning

If your marketing efforts over-promise vital features and your company underdelivers, you won’t be able to keep customers happy for long.  Understand what you are capable of delivering and then seek out potential customers who need that type of product.  

Customer Onboarding Process is Key

A proper onboarding experience ensures the relationship gets off to the right start.  Just spending an extra five minutes on the onboarding process can go a long way to making sure the product is understood by the customer and creating a positive customer experience.  You want to deliver customer success to build a loyal customer base and customer retention rates.  

Have Ongoing Customer Conversations

This might mean an annual or quarterly face-to-face visit for large enterprise accounts.  For SMB or consumer customers, this could be a yearly check-in call or regular email correspondence.  Staying in touch and always soliciting customer feedback allows you to identify issues before they lead to subscription cancellation.

Remind Customers of Your Value

As your team has customer interactions, seek to capture the value drivers for each customer segment.  By asking the ‘why’ question for feature requests and quantifying the benefits, you can remind the customer of your commitment to customer service and value creation with your product offering.

Competitors Can Cause Churn

Keep an eye on your competition and, most importantly, stay aware of their marketing messages.  Think through how to counter their offer by differentiating your product from theirs.  Special offers, new features, and exceptional customer service will all help reduce the loss of customers to the competition.

Collect Feedback from Customers

Actively measuring customer feedback after interactions with customer support will help identify poor service, resulting in a negative experience.  Correcting poor customer service incidents and building strong customer satisfaction scores will go a long way in strengthening the customer relationship.

Market to Both Current Customers and Prospects

New features offer an opportunity to cement the customer relationship and attract premium-level subscriptions.  Send marketing emails to both prospects and current customers.

Uncover Product Weaknesses

Diagnosis is key.  Once you understand why your customers cancel their subscriptions, fixing issues and modifying products is usually possible to reduce churn.

Improve the Customer Experience by Providing Useful Resources

Listing common support inquiries on the website will allow many of your valuable customers to fix their issues.  This can help reduce the number of dissatisfied customers within your current customer base.

In Summary

In a subscription-based business, churn is a crucial driver of profitability and growth potential for the company.  For this reason, many companies devote considerable resources to driving down churn.  Having low churn increases the value of the business.

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David Jacobs
David Jacobs

David Jacobs is a Licensed California Business Broker for Software and B2B Service Companies — Predictable, transparent and orderly exits for business owners across the USA.