Looking at lost customers as a percentage of total customers at the beginning of the period understates churn rates for annual pay customers and obscures retention problems in fast-growing enterprises.
To really understand a SaaS startup’s churn rate and revenue retention rate, you need to calculate churn as a percentage of customers up for renewal, not total customers outstanding.
Calculating a SaaS Startup’s Churn Rate
A great feature of SaaS contracts is that many customers will pay in advance for the year—maybe longer! This is by far the cheapest form of financing available and should be strongly encouraged. It also poses the requirement that customer and revenue retention be monitored on a cohort basis. Customers rarely cancel midway through an annual contract if they have already paid in full for the year. Yet, many third-party SaaS metrics providers calculate churn as a percentage of total customers outstanding rather than the percentage of customers up for renewal.
The Importance of Cohort Analysis – An Example
Let’s look at an example that illustrates the problem. Suppose your product launched a year ago. The first 10 customers signed up in month 1. Since then, you steadily accelerated new customer acquisition each month such that in month 12 you added 21 customers. The total customer count at the end of 12 months is 186 customers. In month 13, 3 of the first 10 customers do not renew.
If you calculate month 13 churn as a percentage of customers at the beginning of month 13, 3 ÷ 186 = 1.6% or 19.4% annualized. Sounds good, right? That’s longer than a 5-year average life. This example is perhaps the most common way churn rate is measured, as is seen across many SaaS metrics providers.
Except, in reality, 30% of your customers are lost at renewal, which translates to a 3-year average life. This has major implications for the amount you can budget for customer acquisition costs and what to expect for long-run revenue retention rates.
The divergence between the two measures is widest during high growth periods, but they will ultimately converge as growth rates come down. This will bring on another surprise, that churn rate is increasing as you grow.
It is important and informative for SaaS startups to monitor a variety of churn measures—at contract expiration, by cohort, and by total customer population.