2023: Year of Customer Success & Gross Churn
We are experiencing the first significant economic headwinds since SaaS became mainstream. For over a decade we have been in an unnatural zero interest-rate policy (“ZIRP”) fueled economic bull market. What we are experiencing now is a lot closer to normal.
As we enter this re-balancing stage, what does it mean for SaaS companies?
Using some wisdom from Uncle Warren, there are a lot of SaaS companies that have been swimming naked and we are going to see them exposed soon.
2023 will be the year of customer success because companies that can efficiently retain their customers during significant economic headwinds will be the ones that survive (and hopefully thrive).
Gross churn is the best financial measure of how successful these companies are at retaining their existing customers.
Net Revenue Retention (NRR) is a powerful metric, but it’s a compound metric (includes both expansion and churn). High expansion can hide high churn. Also, expansion revenue might not be as easy this year as it was before. I want to focus on churn because the implications of churn are significant and churn levels are likely to change significantly (at least temporarily) in 2023 for lots of companies in this new environment.
Churn is the greatest destruction of value for most SaaS companies…and people significantly underestimate it.
The Leaky Bucket Analogy is Flawed.
In the leaky bucket analogy, the bucket of water represents your existing customers. The holes in the bucket cause water to leak out, which represents customer churn (i.e. customers not renewing). Companies want to be able to pour water into the bucket (add new customers) significantly faster than customers leak out, so the bucket becomes fuller.
My issue with the leaky bucket analogy is that it implies that there is a one-to-one relationship between churned customers and the amount of lost ARR. This is NOT true. Churned ARR causes a much larger impact.
Welcome to the “Churn Snowball”
I think a better representation of churn is what I am calling the “Churn Snowball”. In this analogy, SaaS companies are stacking snowballs (customer ARR) at the top of a hill. If they aren’t careful a snowball will slip away and roll down the hill.
What happens when a snowball rolls down a hill?
The snowball builds momentum and accumulates snow and gets bigger. As more snowballs roll down the hill they take more and more snow away to be able to build more snowballs!
A dollar of churn does not equal just one dollar of lost revenue. The impact of churn is much greater than the year’s churned revenue.
Below are the three most significant impacts of churn.
1) FOREVER Lost ARR
I added emphasis to the “forever” part because churned ARR isn’t something companies can magically make up for by selling more next year. A lot of people talk about churned ARR as if they can make up for it with more sales.
Yes, companies can add more ARR, but sales reps would have theoretically closed those deals regardless of the churn because they only have so much capacity. A sales rep isn’t going to say “Hey, we churned a lot last quarter so I am going to work a little bit harder and close an extra deal this quarter to make up for the churn!”.
ARR is a double-edged sword. It is recurring so the revenue can repeat for many years, but if companies churn a customer then that is multiple years of lost revenue that is lost forever.
2) Lost Expansion Opportunities
When a customer churns, companies lose the opportunity to expand that customer. Expanding existing customers is significantly easier and cheaper than selling to a new customer so churn means companies don’t get that efficient revenue growth.
For example, if a company’s annual expansion target is 30% then that revenue is also lost FOREVER.
3) Lost Second Order Revenue
Second-order revenue consists of:
Sales that come from existing customer referrals
Sales from customers changing employers and buying the product again at their new employer
It’s hard to quantify this but in the tech world, these costs are very real and likely more significant than most people realize.
As an example, if Bob buys SaaS widget from Company ABC and doesn’t have a good experience (deployment is bad, features were oversold/lacking, etc) then when Bob changes jobs there is a high chance he doesn’t purchase from Company ABC at his new company. Not only that, but Bob likely will tell his friends about his bad experience and that Company XYZ is much better.
Companies don’t fully realize the impact of these indirect costs, but I have been in many finance leadership groups where these vendor discussions happen. Referrals and word of mouth can significantly influence buying decisions for lots of potential buyers based on one person’s experience.
Not All Churn is Created Equal
Companies are going to see churn trend up next year while things normalize, which is going to make a lot of customer success teams panic and try to solve everyone’s concerns with the same level of urgency.
Customer success teams need to go into triage mode and determine which customers are really worth trying to save. Not every customer is worth saving and that is going to be a hard pill for a lot of customer success professionals to swallow.
Customer success teams can gracefully let customers churn and keep good relationships. While companies will lose their ARR and potential expansion ARR, they will hopefully keep more future second order revenue intact. Second order revenue potential can be massive, so making sure not to screw that up is critical.
In 2023 there will be lots of companies cutting back on their software spending because of budget cuts, not being funded, over purchased in anticipation of growth, etc. Churn will trend up in 2023 for the majority of SaaS companies.
Companies that can minimize churn and create positive customer outcomes with high ROI will be much better positioned to not only survive the looming recession but thrive.
How companies prioritize customer success will determine how these companies come out on the other end of this recession.
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