SaaStr attendee favorite Dave Kellogg recently shared with us his thoughts on why churn is dead, and what’s driving many companies to turn to net dollar retention.
In today’s B2B world, one thing so many companies struggle with time and time again is understanding how to grow their SaaS business — for real. Why is this?
Understanding a SaaS Business:
The usual suspects for confusion include…
- Sales commissions amortized
- Public companies don’t disclose ARR engine
- Revenue is a lagging indicator
- Must impute “billings”
- ARR needs to be implied
- Churn is not disclosed
However, the main culprit is it’s usually two different businesses:
- Recurring business (existing customers)
- Customer acquisition (bringing in new customers)
One main way Kellogg likes to think of SaaS companies is “a leaky bucket full of ARR”. Once you can see and understand the ARR engine of a company, then calculate core SaaS economic metrics. Be sure to include Metrics such as…
- CAC ration
- Lifetime value
- LTV to CAC ratio
- CAC payback period
Three Fatal Flaws of Churn:
Kellogg, along with many other business owners, has become increasingly skeptical of churn rates within the last few years. Churn is not quite dead YET, but definitely wounded.
#1 Too many ways to calculate it
There are four ways to calculate churn rates:
- Gross vs. Net
- ARR vs. ATR
- Will produce very different results
- The net problem
#2 Churn rates blow up LTV
Four different churn rates, mean four different LTV rates. A warning sign this may be happening is if the churn rate falls below .02
#3 Churn ARR itself can be non-obvious
Not only are their four different rates, but even defining the numerator is ambiguous.
A helpful way to look at this is “ARR is a fact, and churn rate is an opinion.”
The solution? Zoom out.
A perfect problem that cohort analysis can solve
How do you do it?
- Grab a cohort (typically all customers)
- What were they worth a year ago in ARR? Now?
The best part of using this method is it’s easy to calculate, easy to understand, and hard to game. However, beware of the bad apples. There are a few deceitful companies who will exclude customers who chose to no longer do business. This is essentially looking at what customers were worth a year ago and ignoring the now.
You want to make sure your net cohort expansion is put into a single, benchmarkable, regression-able number. Having a good net dollar retention is crucial, and the average good NDR rate falls around 115%.
Three Quotes to Ponder
As you move forward, you may want to reflect on these inspirational quotes provided by Kellogg.
- “If you cannot measure it, you can not improve it.” -Lord Kelvin
- “What gets measured gets managed”. -Peter Dracker
- Goodhart’s Law: When a measure becomes a target, it ceases to be a good measure.
Where should you go from here?
Moving forward, pay attention to multi-year contracts, and RPO. It’s always best to get ahead of the curve.
- Build-in net dollar retention to multi-year contracts:
- Offer your customers a three-year plan, for example, with a 10% buffer. They’ll be saving money, and you’ll be securing it. Double win!
- The next frontier is RPO:
- The remaining performance obligation gets second billing after revenue. Kellogg predicts this will be one of the next most important measurable aspects.
Did you get all that? Just in case… we’ve summed it all up!
- A SaaS company is the sum of two businesses (recurring, acquisition)
- SaaS unit economics are great for understanding SaaS business
- But churn rates can be problematic and often lack credibility
- Flawed churn rates impact LTV and LTV/CAC ratios
- The solution is to do cohort-based analysis which take you above the fray
- Net dollar retention is a cohort-based customer expansion/shrinkage metric
- A good NDR is around 115%
- If NDR is so important, why not build into multi-year deals?
- Going forward, startups will increasingly track RPO