It is no secret that customer churn hits recurring revenue businesses hard, but what’s its real impact on their long-term health and valuation?
To answer that and more, we invited SaaS Capital’s Managing Director, Rob Belcher, and Software Equity Group’s Managing Director, Allen Cinzori, to join us for a webinar.
During the webinar, we discussed:
- How customer retention impacts the valuation of your company
- The compounding effects that churn has on your bottom-line
- How Customer Success can effectively drive retention
- What data you need to get the investment in your Customer Success team
If you missed the webinar, you can watch it on demand.
- Rob Belcher, Managing Director, SaaS Capital
- Allen Cinzori, Managing Director, Software Equity Group
- You Mon Tsang, CEO & Founder, ChurnZero
Q: Does the importance of retention metrics vary by strategic buyers versus private equity (PE) buyers?
A: [Allen]: It’s very important in both. But, if I had to tell you which one would be more important, it’d be the PE buyer. The reason for that is because they have a financial discipline when they’re looking at the businesses. Whereas, if you think about the strategic buyer, they might be trying to fill a gap in their product offering. They have a hole, and they need to fulfill it. They don’t have time to build the product. In that case, it’s a buy versus build decision. The metrics are obviously very important, and they probably are why they buy “Company A” versus “Company B.” The last thing I’d say regarding strategic buyers, it validates the product. If you’re retaining your customers, then by default that means your customers appreciate your solution and get value from it.
Q: What’s the minimum acceptable customer success/renewal infrastructure you’d require to feel comfortable working with a business?
A: [Rob]: We only work with companies with $3 million in ARR, so they’re not startups. They probably have 15 to 20 employees. The folks who we’ll work with that are like that probably have a larger annual contract value (ACV) and the Account Executives do the renewal work if they don’t have an actual Customer Success (CS) group or lead, so it’s more one-to-one. The companies we come across that have a lower ACV and don’t have a CS group, have probably churned too high for us to work with. Most folks, by the time they talk to us, have someone that at least is aware of it or oversees it, whether it’s the Sales team or a specific department.
[You Mon]: So, in other words, you don’t really take on clients who haven’t invested in that part of the organization.
[Rob]: Here’s an example. We have a $10 million ARR company that has 12 customers. They don’t really have a CS group, per se, because they only have 12 very large customers. Each account rep that is doing sales is also doing renewal management and things like that. If they don’t have a CS group, there better be a reason why.
Q: Data shared in the webinar showed month-to-month billing having no impact on renewal rate compared to annual billing. That surprised people because it seems counter intuitive. Many assume if you get 12 months’ worth of billing, you’re going to get a commitment. What’s your reaction to this?
A: [Rob]: Keep in mind the calculation. If you joined late, we went through definitions. It’s based on customers who were with you a year ago. In essence, the month-to-month folks have 11 opportunities to churn along the way. This is also annual payments only. It doesn’t have anything to do with annual contracts. You could have annual contracts, but monthly-pay folks in that mix or quarterly pay, or whatever it might be. The takeaway is that the risk of those 11 opportunities to churn is no different than the one really big decision to churn at the end. They compound to the same decision amount and the churn ratio of the one-time larger churn. The bigger comment is divorce from contract; it’s just based on payments.
[You Mon]: My angle on that is if you have a product that’s quick to value, onboard, or self-service then month-to-month is a great way to go. You want to make it easy for them to buy. Month-to-month allows users to try it out and only spend a month’s worth.
[Allen]: You bring up a good point, You Mon. Maybe it’s easier to onboard them. If that’s the case and they stick, then that makes perfect sense. If the annual payment is a deterrent, in some ways, that might be better because you’re putting less strain on your organization if they weren’t going to stick around. All being equal, if someone were to come to us, our preference would be to see a three-year contract paid annually. That is going to be my favorite. When it comes time to sell the business, make sure that you’ve gone through renewal cycles. Because that’s a question that buyers are going to ask: “Well, you have it through your contract, but how many of your customers have actually been through a true renewal cycle?”
Q: Do you expect a shift in the value and focus of growth versus retention?
A: [Allen]: At the onset of COVID, we surveyed 50 PE firms and 25 strategic buyers and asked that exact question. The unequivocal response we got back was net retention. Net retention is more important right now. It’s important in a lot of different ways. This is also the first time SaaS companies have ever been tested in a down market. They didn’t really exist in mass during 2008 and 2009, so we’ve never really seen it. The big test is how companies will retain customers during the downturn. The thesis has always been that businesses with high net retention are going to survive. It’s the critical applications. It’s what’s driven private equity because of the ability to lend against that collateral, which is that recurring aspect, so definitely net retention.
Q: What’s your investment stance on businesses that have a low CAC or lucrative affiliate model, but don’t have high retention?
A: [Rob]: I think the sweet spot is $12k to $120k in ACV. The playbook is there for Sales, Marketing, and CS. You can build a scalable, high-growth, +100% net retention business. Those small businesses, it’s the boat, right? You’ve got to plug those holes, and fill it in. It could be cheap or a great business, but it’s tough to lend or invest in one of those from my perspective.
[Allen]: I agree. The industry is just not there. The debt markets did not lend into the software industry up until the mid-2000s, and it was about the collateral of the recurring maintenance and support stream. Now, it’s the recurring stream that’s related to the subscription revenue. We’ve had a hard time with the businesses that sell into the SMB. They may have great customer acquisition cost (CAC), but it’s brutal.
[You Mon]: I like CAC and lifetime value (LTV) as a combination. At some point, and I’ve seen this a lot with small businesses, you run out of leads. There’s a wall you hit. Suddenly, you wake up one day and your CAC goes through the roof. If your next client costs a ton and you don’t have retention under control, that’s when a strong business becomes a weak business overnight.
[Rob]: Or COVID-19 hits. We look at that as part of our evaluation work, and low retention can actually impact your total addressable market (TAM). This goes back into your valuation analysis as well. If you have a total of 100 customers who are potentially a good fit for you, and you have 80% churn, then you really only have 80 customers as your TAM. Whereas, a company that has 100% retention, their TAM is even bigger than 100 customers. It’s just a smaller market that you’re going after and you’ll eventually run through it.
Q: PE firms seem transfixed by companies with +$10 million in ARR. Is that the magic number SaaS businesses need to cross?
A: [Rob]: Up until about 18 months ago, or pre-COVID, $10 million in ARR was the hard line for PE firms to even talk to you. Ten million in ARR is profitable or breakeven, and that has changed in the last couple years. They’re doing smaller deals. They’re more OK with a little bit of burn and things like that.
[Allen]: The market is awash with cash PE firms that have made a tremendous amount of money for their investors. It creates a terrific opportunity for all the software companies. And as a result, they are covering the market exceptionally well. My first experience working with a PE firm was helping Carlyle with large leveraged buyouts. Nobody was interested in buying a company with $10 million in ARR. Now in the current market, the people building PE firms are saying: “Hey, if you have $5 million in ARR, come talk to us; we’re really interested.” That’s a great market. There’s a tremendous number of businesses. There’s less competition. I think $5 million in ARR is really the bogey. Ten million is better, but at $5 million, it starts to get interesting, especially if it’s a high growing company.
[You Mon]: To add my founder/entrepreneur perspective on that, I see a lot of startups stall between $5 million and $10 million in ARR. If you have a great founding team that works hard, grinds away, and kills it, you can by the sweat of your brow, get to $5 million. You need a great team. You need to have something interesting. You can drag the company up the hill to $5 million. To get to $10 million in ARR, now you need a company. You need processes and scalability. That’s often a very different skill set for entrepreneurs and founders. There’s a culture change and a company change. There’s so much failure between $5 million and $10 million in ARR. Once you clear that, then you know the company is worth investing in.
[Rob]: A PE firm might have $500 million or $1 billion that they’ve raised for a fund. They can’t buy a $3 million dollar company for $12 million to $20 million. It’s just not worth their time. They’re not going to do 200 of those deals. They want to do 50 deals and deploy $100 million in a year. I don’t know if that math checks out, but they’re looking at larger companies, so they can deploy bigger checks.
To find out how you rank against your peers based on SaaS retention benchmarks from SaaS Capital and Software Equity Group, watch the webinar on-demand.
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Fighting Churn is a newsletter of inspiration, ideas and news on customer success, churn, renewal and other stuff and is curated by ChurnZero.