What is churn?
Churn tells you how many customers you’ve lost. It’s not a standardized metric – you can calculate it however you want, for whatever time period you want.
The first step in calculating churn is always to decide which customers you’re going to include in your calculations. For that, you’ll need to differentiate between “active” and “lost” customers.
How to define active and lost customers
“Can’t I just take a count of non-cancelled subscriptions every month?”
Although this might be tempting, for most SaaS businesses, this will simply not work. You’ll want to normalize for growth. (More on that later.)
A customer who pays is active
This is the most common definition of an active customer, and it has several benefits:
- Trial users who quit are not counted (they’re not your customers yet)
- It’s clear-cut
- It’s easy to measure as you don’t need to collect, store and analyze user activity data
- Defining a lost customer becomes easy
There is one drawback to this definition, which is that your free plan subscribers are not included in active customers. That means you can’t, for example, calculate CLTV for all customers – only for the customers who paid. (Yes, free plan users have CLTV too – it’s negative.)
How do I separate involuntary churn?
Involuntary churners are people that you kicked out. You’ll want to kick out people who have consistent credit card problems, or people who break the law (or usage agreement). In some cases you might want to kick out people who are not profitable.
Companies often want to track only voluntary churn. If you just cancel people’s accounts as you kick them out, they’re going to end up in your churn figures. To keep them separate, you’ll need to give them some other label than “cancelled,” i.e. “expelled”, “fired” or “sacked”.
Definition #2: An active customer is one that shows real customer activity
You can calculate churn for a free plan by measuring real customer activity. But it comes with a price: you’ll have to build a system to measure, store and analyze customer activity data.
Many people who sign up for a trial never come around and actually try out the app. When you measure real activity, those people get dropped out of the calculations.
Your churn rate will look better than it would if you had included all the people who signed up. As you follow up your marketing funnel separately you will not lose any information either.
But a pure activity-based system makes it really hard to communicate your metrics with others.
“Oh no, this is not the amount of signups or paying customers,” you might find yourself telling an investor. “We are only counting people who created a canvas and added at least 5 items to it and attached the tracking codes to their systems.”
For that reason many companies who use activity based system still leave the trial users out of the calculations.
Definition #3: Everyone who signs up is an active customer
This definition looks simple, but it’s not. You’ll face most of the same challenges you do when measuring real customer activity, because you’ll need real activity to measure lost customers.
As the trial users are in the count, any seasonal variations in your trial conversions will be visible in churn. Then you’ll be wondering whether your old customers are leaving you, or if it’s just the season when you lose more trial users.
How do I measure lost customers accurately?
It’s easy to know when a customer is lost when we calculate churn for paying customers. Customers often make the decision to cancel long before they act, but we still get the cancellation pretty soon, unless the customer has a yearly subscription.
When you are calculating churn for a free plan, it’s much harder to say for sure when the customer has left.
Trying to use plan cancellations to measure lost customers doesn’t usually work. People on free plans don’t cancel their subscriptions. They just never come back.
You’ll have to come up with your own means to measure who are your active customers and who are just customers who passed you by.
Before you have enough activity data, you are forced to fall back on benchmarks like “hasn’t logged in within last 90 days.” Eventually, you’ll probably use something like “hasn’t performed key activity within last 45 days.”
But it depends on your product and how your customers use it. In any case it often takes much more time to be certain that a customer has been lost.
Ok, so which definitions should I use?
In general, counting paying customers is a good starting point. The paying customers are the heart of your business, and you already collect the payment data.
Even if you don’t use Kissmetrics, MixPanel or some other tool to track your marketing funnel conversions, it’s easy to dig up trial-to-paid rates separately from your customer DB.
For lost customers, both cancelled+downgraded and non-paying customers are good options. It is a smart move to store the information on why the customer left, even if you would not be using it right away.
You’ll probably want to keep calculating paying churn even if you end up tracking customer activity. Why? Because of the difficulties to recognize lost customers fast enough.
In fact, unless your cost of service is high, you probably won’t build an activity tracking system to calculate churn. You’ll build it to learn more from your customers and to predict when they are going to leave you. Then you can act before they churn.
Whatever definition you use, use it consistently in all customer-related business calculations.
You can’t, for example, decide to calculate churn using paying customers and then try to use it to calculate CLTV for every customer who signed up.
Why do I need 3 different Churn Rates?
Because then you’ll be able to answer questions like:
- “If I lose my main acquisition channel, how long would my business survive?”
- “Am I losing high-value or low-value customers?”
- “Can I trust my Customer Life-Time Values?”
And more importantly – you can be confident that your answers aren’t wrong.
How do the Churn Rates differ?
Subscription, User and Customer Churn should be calculated separately if necessary.
Normalization is also important. It means that the churn rate:
- Only includes customers who had a subscription up for renewal and were able to churn, not everyone.
- Converts the Churn Rate from annual subscriptions into a monthly Churn Rate.
Rule of thumb for using the Churn Rates
Normalized rates tell you about the behavior of a single average customer.
The non-normalized rates tell you about your business as whole.
That means we’ll use Net MRR Churn Rate for financial projections and estimating how the whole customer base behaves.
And we’ll use Subscription and MRR Rates for estimating average customer behavior.
FirstOfficer.io shows Net MRR Churn Rate, MRR Churn Rate and Subscription Churn Rate.
Why can’t I use just one churn rate?
You can – as long as you offer just one plan and no annual subscriptions.
The one churn rate you’d start with is the Net Subscription Churn Rate – lost subscriptions compared to the subscriptions you had at the beginning of the month.
Net Subscription Churn Rate is easy to calculate and can be used for almost anything – but its meaning changes when your business develops.
It gradually stops working for the purposes you initially used it for.
When you add more plans, you should start using MRR Churn Rates so that you can see if people in different plans behave differently.
When you add annual plans, you should start using normalized Churn Rates when you want to calculate unit metrics like Customer Life-Time Value (CLTV).
What happens if unit metrics are calculated with non-normalized rates?
You might get worried that your business performance is crashing – when you just had lots of annual subscriptions up for renewal. Or you may believe that your CLTV values are 3-5 times higher than they actually are.
Why is all of this important?
To show why all of this is so powerful, let’s look at those business questions from earlier:
“If I lose my main acquisition channel, how long would my business survive?”
What if… you stopped getting new customers? How long would it take to lost all the monthly subscription revenue?
This question concerns your whole customer base and you are interested in money (vs. subscriptions). That means we use Net MRR Churn.
Just invert it… (1/churn rate) *100% … and you have the answer in months.
It’s not the most accurate formula, but works fine with rates smaller than 10% and it’s a rough estimate anyway. In practice, you’d use this churn rate to create a projection which includes expenses and your cashflow.
Net Churn Rates are sometimes volatile, so it’s best to take an average churn rate from a longer period and check that the annual customers are evenly distributed throughout the year.
“Am I losing high-value or low-value customers?”
This question is about the average lost customer – so we need the normalized rates.
One of our churn rates measures money, the other, people. If we lose more people than money, we lose low-value customers. And if we lose more money than people, we lose high-value customers.
When we compare the MRR Rate to Subscription Rate and the MRR Churn Rate is bigger, you lost high-value customers. If the MRR Rate is the better one, you lost low-value customers.
“Can I trust my Customer Life-Time Values?”
The simple answer is ‘No.’
The non-profit-based CLTV should always be adjusted with gross profit margin – and even after that it is often not reliable even when calculated right. As you just learned, when your churn rates are low enough, CLTV tries to estimate behaviour years onwards.
That said, if you choose to use CLTV, here’s the key to assess it:
The calculations are for your average customer.
If you mostly lose high-value customers, the CLTV will be overestimated.
If you lose low-value customers, the CLTV will be underestimated.
So you can actually use the answer from the previous question to answer this one.
If your MRR and Subscription Churn Rate are similar, the CLTVs are trustworthy. But also check that the ARPU of new customers isn’t very different from the ARPU of all customers.
Often a single CLTV value for whole customer base is useless unless you offer a single monthly plan. Most SaaS businesses should use plan-specific CLTV values.
It’s also worth to follow up the realized Total Contract Values (TCV) – sometimes even per cohort.