Many entrepreneurs are focussing on customer acquisition. It is no secret that customer acquisition is associated with high costs and is part of the business model, especially with SaaS company. The customer growth which is achieved by the investments is then proudly presented in the company presentations and in the investment memorandum, which I as an investment analyst then get to see. Needless to say, the number of newly acquired customers is an important indicator for my analysis and evaluation of a potential investment – after all, growth is one of our central investment criteria at FLEX Capital.
But what interests me more when looking at the due diligence process is the answer to another question: After a few months or years, what happens to those customers who the company had worked so hard on and invested so much in to gain in the first place? A mostly critical number of them migrate or grade down. In the following, I have summarized why the rate at which customers churn, the so-called churn rate, and the reasons for churn are important factors in our investment decisions.
1 – The powerful effect of churn on growth rates
Many entrepreneurs see the acquisition of new customers as the central drive of sales growth. It should be noted that customer loyalty is an equally important factor. The ‘leaky bucket’ is a popular analogy to illustrate the effect of churn on customer numbers and, consequently, sales. Every month, software companies dump new customer sales into the sales bucket. However, there is a leak in the bucket that drains sales when customers churn. The fuller the bucket, the more pressure acts on the leak and the turnover runs off even faster. At some point, an equilibrium will be reached, during which as many sales flow into the bucket as sales run off. At which point this equilibrium is reached depends on two factors – the size of the leak (churn rate) and the speed with which new sales flow into the bucket.
Of course this is a very simplified representation, but it shows how important the churn rate is. This is because the growth in sales of a company, in other words how quickly the filling volume of the bucket increases, is highly sensitive towards the size of the leak, meaning the churn rate. This graphic shows how high this sensitivity is:
This means, two companies with identical acquisition rates of new customers (the speed at which sales flow into the bucket) can result in large differences in sales (the filling quantity of the bucket) due to different churn rates (the size of the leak) after just a few years. In the graphic, each of the companies is growing by 5% per month due to newly acquired customers (MRR growth). Due to the different churn rates, however, after 3 years there are differences in the ARR of almost EUR 15 million. The churn rate thus has a decisive influence on the scalability of a software company, which is an important criterion for our investment decision.
2 – Churn rates have an important impact on cash flow
High churn rates also increase the repayment period for Customer Acquisition Costs (CAC). This in turn has a negative impact on the development of cash flow in a company. Especially the increasing but at the same time strongly fluctuating churn rates within the cohorts can lead to instability in the cash flow. As a private equity investor, the stability and level of cash flow are crucial factors for us when making an investment decision. Particularly, software companies that have a high repayment period for the CAC due to their business model and market focus, low and / or falling churn rates are important for a positive investment decision.
3 – Churn as “Hidden Box of Information”
However, the churn rate tells us much more about a company than just the assessment of scalability and strength or stability of the cash flow. For example, high churn rates can also indicate a poor product-market fit, problems in usability, strong competition or general “stickiness” of customers in this market. In order to get a better understanding of these dimensions, it is usually necessary not only to look at the monthly or annual sales churn rates, but to look at the developments in the churn rates across the individual cohorts and what the reasons for the churn are or might be.
In the case of B2C SaaS companies, for example, which generally have a higher churn rate than B2B SaaS companies, the decisive factor is how many of the customers have emigrated “involuntarily”. Involuntary here means that customers do not actively cancel, but they are being classified as churned, for example due to missing or failed payments. In many cases, this involuntary churn can be reduced in a short period of time through targeted measures and is therefore less relevant to our investment decision. The churn caused by customers who, out of habit, cancel immediately after completing their software subscription only plays a subordinate role for me as an investment analyst.
However, if the churn rates are relatively high in the first few months even after considering the “involuntary” churn, this indicates problems in usability or in the product-market fit. If, on the other hand, the churn rates are stable over a longer period of time and then suddenly increase, this could be an indication of increased competition or the entry of a competitor with a better product and / or price-performance ratio. The churn rates tell us which areas we should analyze in particular in the due diligence process.
For us, as an investor, churn is a key figure that has a decisive influence on the cash flow stability and scalability of a company. Due to the strong sensitivity of sales growth towards the churn rate, this number also has a decisive influence on our company valuation. In addition, the churn rate gives us indications of further strengths and weaknesses of the company, which we must analyze more precisely in the due diligence process. If, for example, it turns out that one reason for customer churn is caused by problems in the usability of the product, then higher costs for product development can be expected in the next few years. These costs must be taken into account in the business plan and can thus also influence the company valuation.