Churn Might Get You Burned
A quick pop around the web will turn up a fairly consistent set of key SaaS metrics. Churn is always present and consistently defined. Churn definitions are pasted on thousands of web pages.
Like much of the content on the web today, the “churn” concept has been grossly simplified so it can fit easily on a list of bullets on a search engine-optimized web page or a slide deck. (Everyone is entitled to make a living!)
Churn is all about SaaS Renewal Rates
Basically, churn is a measure of the clients, contracts, or renewal bookings you lose. Churn rate is a rate measure of those losses, the opposite, so to speak, of your renewal rate or various renewal rate metrics.
If you are managing a SaaS business, churn might get you burned. What experienced SaaS people know is that churn is not a single number, but one or more “Life Cycle Renewal Rate” curves. The basic definition of a Life Cycle Renewal Rate Curve is the plot of the renewal rates throughout the customer contract life cycle for a like group of contracts. Typically, the like group is a “class of” group, meaning sold in the same time period or in the same relative term.
To illustrate the fundamental differences between churn and renewal curves and the problem with churn, let's produce two revenue schedules.
Schedule 1 uses a churn rate of 12%, which translates to a simple 88% renewal rate.
Schedule 2 uses a lifecycle renewal rate curve with a first year renewal rate of 70%, and second, third, and fourth year renewal rates of 96%, 93% and 92%. This historical data would calculate into a simple renewal rate of 88% and a churn rate of 12% using the typical spreadsheet at most SaaS companies.
The Assumptions for our example are:
- A year over year growth rate of 100%
- Straight line, 12-month revenue recognition
- Renewal rates are applied over a five-year period with no changes in prices
- New contract bookings are as follows
| Q1 | Q2 | Q3 | Q4 | Total FY1 | Q5 | Q6 | Q7 | Q8 | Total FY2 |
$18.00 | $23.00 | $27.00 | $32.00 | $100.00 | $38.00 | $42.00 | $50.00 | $70.00 | $200.00 |
How different are the two revenue schedules, one generated using a churn renewal number and the other using the Life Cycle Renewal Rate Curve?
- The churn-produced revenue schedule totals $1,276
- The lifecycle renewal rate curve-produced revenue schedule totals $1,778
- The difference is over 8.3%, or about $98
Add a few zeros to the contract bookings numbers to make this realistic for you, albeit maybe painful. If your revenues were on the scale of $1.2 million, “churn” produces a forecasting error of almost $100K. If your revenues were on the $12 million, the error is almost a million dollars. You over-forecasted. Look out earnings!
Oh, and it gets worse. In this simple illustration, we only calculated for two years of new bookings and generated revenues for those two years over a five-year period. Hopefully in your business, you are still generating new bookings in years 3, 4 and 5, and if so, the problem compounds.
The life cycle renewal rate curve used in this example is a classic curve for a lower-priced SaaS solution where the cost of sale is low and burden of buying and discovery is on the buyer. In this model, many new customers cancel after year one, but thereafter stick around.
A more selling-intensive SaaS model could have a different renewal curve. Using a first year renewal rate of 93%, and second, third, and fourth year renewal rates of 90%, 97% and 94%, again equating to a simple xls-generated 88% renewal rate and 12% churn, you have now under-forecast by 2.8%. But its worse because ij this example, again we are only assuming two years of new bookings in the five year revenue schedule.
What if your renewal prices change? In either model, this obviously compounds the accuracy problem.
A simple churn number is relatively easy to crank out of a spreadsheet. And, since renewal rates ARE critically important to decision making in a SaaS business, you use what you have. By contrast, a SaaS life cycle renewal rate curve is much more complicated to generate from a spreadsheet and even harder to apply to to generate revenue schedules.
The markets place constant forces on your Saas pricing, packaging, selling, and services practices. Because you are an on-demand company, you are nimble and responsive to the markets, making rapid changes in all facets of your business. So, your curves are moving all the time. You probably have distinct "class of" curves, industry curves, geography curves, and other important business segmentation curves that you might not even be aware of.
What’s the best metric to use to help you tune your pricing, product packaging, contracts, services, support and operations to optimize revenues across different segments and markets? It’s not churn.
With SaaS Optics, a simple click of a button provides easy and automatic generation of life cycle renewal rate curves. You can generate trends and renewal curves by any number of segmentations - industry, geography, or even by sales rep or sales manager. Use the churn for butter, get SaaS Optics, and start making the most informed business decisions you can make.