The churn rate is an essential metric to track during the due diligence process. To successfully acquire a SaaS Company, we need to go beyond just customer churn and loyalty metrics to identify underlying factors that influence customer lifetime value (CLTV). Although we only discuss the churn rate in this article, you should not limit yourself to it.
In this article, we’ll be discussing how to analyse the SaaS Company churn rate during the due diligence. Before we move on, we would like to give you a quick recap of the churn rate definition.
If you are familiar with the SaaS business subscription-based model, you must know that churn rate is an important metric to track. Simply speaking, the churn rate indicates how many customers a company has lost compared to the total number of customers it has.
If you would like to learn different methods SaaS Companies use to calculate churn rate, check out this article.
Although the definition of churn rate is straightforward, analysing churn rate during the due diligence process is a cumbersome task. Depending on the formula or numbers you use in your calculations, results can vary slightly.
This section of the article will describe how our traditional approach to calculating customer churn rate can lead to misleading results. Besides, we’ll also discuss how to eliminate inaccuracy.
Significance of SaaS Company Churn Rate during the Due Diligence
During the SaaS due diligence process, every CFO track the same standard metrics like Customer Acquisition Cost, Customer Lifetime Value, and Customer Churn. The methodologies SaaS Companies use to compute these metrics vary significantly.
SaaS companies use different formulas, base month/year, and periods to calculate churn rate. To analyse the SaaS Company’s churn rate during the due diligence process, it is imperative to know which method and data set a company is using to compute this operational metric.
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Bear in mind that churn rate is an insanely vital metric to track the growth of SaaS Companies.
How do Investors Calculate SaaS Company Churn Rate?
Usually, SaaS investors calculate the churn rate by dividing the total number of churned customers in a month under consideration by an unlimited number of customer a company have at the start of the month.
Then, an acquirer calculates CLTV by dividing each customer’s average revenue by a churn rate. It implies that inaccurate calculation of churn rate leads to inaccurate CLTV.
Moreover, it is pertinent to emphasise the churn rate as it indicates how fast a company is losing its customer base and for how long each customer sticks with the company.
Several factors can influence the calculation of the churn rate of a SaaS business. So investors should be extra cautious while analysing the churn rate during the due diligence process. Otherwise, he will end up making wrong decisions.
To keep that in perspective, let’s take an example of a growth-oriented company. Suppose that a SaaS Company is experiencing 100% YoY growth. Assume that an average customer sticks with the SaaS product for at least 48 months.
In this situation, the monthly churn rate is going to be 2.08%, which we can calculate using a relatively simple calculation.
However, due to the sharp rise in the number of customers, and growing customer base, we can account for this change at the end of each year.
There are many reasons why the churn rate calculation with the example mentioned above leads to inaccurate results. Here are a few of them:
- Customers are more inclined to pursue their annual contract instead of renewing that
- SaaS Company is serving enterprise customers. To retain these customers, companies offer them a substantial discount. Furthermore, few of them do not reach the negotiation phase.
- Companies offer a 6-12 months trial to their customers to persuade their customers to purchase the subscription plan. Some customers give up using the product despite these efforts during the trial period. Therefore, a lot of cash has been burned to acquire new customers. Since these customers are not paying a single penny to the company, considering them during the churn rate calculation leads to misleading results.
- In a bid to stay ahead of the competitor, SaaS Company provides a substantial discount to all its customers in the first 6 months. Consequently, all those customers enjoying discounts on the subscription plan contribute to the churn rate calculation.
If you are experiencing any of the cases mentioned above, you’ll end up with an underestimation of the churn rate.
Furthermore, suppose any assumptions mentioned above apply to the SaaS business you are evaluating. In that case, it indicates you include all those customers in the churn rate calculation who haven’t yet entered the ‘churn potential.’ As a result of that, you’ll end up with overinflated/ considerably lower LTV.
This fallacious approach leads to a meteoric rise in churn rate once the company’s growth decreases, which in turn raises the red flag for an investor or buyer.
Additionally, churn rate should not be the only SaaS metric for an investor to rely on. We have already discussed many scenarios that lead to misleading results of churn rate due to a consistent inflow or outflow of new customers into the business.
However, there are some cases where the churn rate can be overestimated despite high growth.
Customer behaviour cannot be predicted with utmost accuracy. If customers are not satisfied with the product, they leave the product and explore alternatives. Contrary to that, if customers are happy with the SaaS product, they remain loyal to that for an extended period.
Thus, having a broad customer base tends to inflate the churn rate.
Therein the real irony lies. Rather than relying on the churn rate during the due diligence process, you should proactively track the churn pattern and seasonality of the product. For instance, figure out at which point in time the churn rate is relatively highest than the rest of the year.
What to Consider Before Investing in SaaS Business?
Before the onslaught of Covid-19, investment into the SaaS business is growing exponentially. As things are returning to normalcy, subscription-based companies start getting more traction as investors are increasingly looking for a recession-immune business coupled with strong revenue growth and massive upside potential.
SaaS Companies are always the best investment option for VCs due to their ability to generate a recurring income stream. It has been observed that few of the top accounts have the highest contribution in revenue.
For this purpose, investors must consider customers’ concentration risk as some of the top accounts disproportionately impact the EBITDA.
Hence, churn rate is an essential metric for all SaaS investors to track. However, relying on this metric to evaluate the customer relationship seems like watching the flaming car with a side-view mirror.
With this strategy, we cannot identify the real cause behind the accident and look at the past for too long stops us from predicting the future.
Analysing business working on the b2b model, combining churn with the customer loyalty requirements like Net Promoter Score tells a more accurate story.
Combining these two metrics can help with predicting future churn and assist in identifying the extraordinary steps to mitigate any possible shortcoming in the churn rate calculation.
However, in the SaaS industry, churn rate isn’t the only indicator of customer loyalty. It is evident from many examples that there is a relationship between customer churn and loyalty. Because of the exorbitant cost and complexities involved in switching to the new SaaS provider, SaaS customers prefer sticking with their existing one despite their inherent disloyalty.
As we can see that many customers are still using AOL.com email addresses despite the advent of much better and advanced technology simply because they assume switching costs outweigh the benefits.
More than 80% of the customers prefer sticking with their SaaS provider rather than consistent switching. One highly disappointed SaaS customer asserted:
“Once you become accustomed to the technology. It is unviable to give up using that. Changing technology vendors is practically unviable for a business. As we have heavily invested in the technology stack and not all the companies can address our requirements like the ones we are currently using.”
If NPS (Net Performing Score) is a strong indicator of a customer churn, does it mean it isn’t an efficient tool in the SaaS industry? Unfortunately, that’s not the case here. We need to deeply analyse boosters and inhibitors to customer loyalty and customer lifetime value.
Here are a few important questions to take into account while considering the SaaS acquisitions:
- Is the ethics and integrity of the management team reliable and trustable, and are the customers allowed to question these unique traits of the SaaS management team? Had they fulfilled their promises in the past?
- Has the SaaS provider fulfilled customer satisfaction? Where are the gaps in the performance, and does the management team have any viable strategy in mind to bridge that gap?
- Does the company support its plans with proper implementation, training, development, and technical support? Are the problems resolved quickly?
- Does the company have any competitive edge over its competitor? Simply speaking, what are their key selling points?
- What innovation possibilities exist in the SaaS product? Can the company cross-sell/up-sell to their existing customers?
Even though calculating the SaaS Company churn rate during the due diligence sounds very simple at first glance, as discussed in this article, we need to consider many factors before reaching a final conclusion.
That being said, we strongly recommend you calculate churn and customer retention rates using the strategy discussed above. Likewise, you can perform the same kind of analysis for a group of customers categorised by geography, demography, acquisition channel, or payment plan.
With this strategy, you can evaluate the company’s revenue growth and understand all the critical growth metrics. Above all, if you are a SaaS investor or a SaaS business owner, these steps help you identify room for improvement in the SaaS product and improving the product quality.