Why startups can’t afford to ignore customer retention
Venture-backed companies must walk the line between fast growth and efficient growth. Even as VCs value high-quality revenue, companies are still held to a minimum growth rate. We think of this threshold as the “Mendoza Line,” a baseball term we’ve adapted to track the minimum growth needed to get access to venture funding. Above this line, startups are generally attractive to investors and even have a good chance for a strong exit.
To achieve sustainable growth, maximizing customer lifetime value is an important component and one that is often underestimated, particularly for SaaS and other subscription-based businesses that generate recurring revenue. It is estimated to cost somewhere between five to 25 times more to acquire a new customer than to keep one you already have. Additionally, Bain research has shown that a five percent increase in retention rates can increase profits by 25 to 95 percent. Even by conservative estimates, retention is a powerful mechanism for growth.
As companies face greater pressure to grow both quickly and responsibly, we are placing more value on customer retention as a barometer for long-term success. And we are seeing smart startups invest in measuring customer happiness in more sophisticated and consistent ways.
In looking at SaaS deals over the past 10 years, we’ve found that a few key metrics and best practices are predictive of healthy business fundamentals. Here’s the advice I give startups looking to achieve smart growth through customer retention.
Create a system for measuring customer happiness
First, measurement must be an executive priority. Ensure you have a system in place to measure retention on a quarterly basis (at least) and meet as an executive team to diagnose potential problems. While benchmarking against similar businesses can be helpful, trending your own metrics is the best way to see how your performance is improving or deteriorating.
You’ll need to identify the specific metrics that work best for your business. I recommend looking at how efficiently you’re putting resources toward customer retention, which gives you insight into customer happiness and predicts the profitability of your growth.
The percent of ARR spent on retention tells you how much you’re spending to keep your customers happy; let’s call it your Retention Efficiency. You can measure this with a simple calculation:
(Quarterly cost of customer retention) x 4
Ending annual recurring revenue (ARR) base
The ability to keep this number low means you’re retaining your customers without burning money. This means you can invest sales resources toward acquiring net new customers rather than replacing revenue from those that have left.
I’d also recommend looking at the Customer Retention Cost (CRC), which measures how much on average you’re spending to retain each customer:
(Quarterly cost of customer retention) x 4
Total # of customers in your base
Note, this number may increase over time if you’re moving upmarket — enterprise customers generally require more resources to retain than small to mid-sized companies. If your retention costs are going up, this per-customer number can help you explain why in the context of your go-to-market strategy.
Don’t just measure churn rate
Most startups measure retention in terms of churn rate: dollars that left in a given quarter divided by total ARR. In my experience, churn is a vanity metric and not particularly accurate because it combines customers that are eligible to leave and those that are not (e.g. contracts that were signed in the past month).
Renewal rate is harder to benchmark, but tells you more about your customer happiness and health of the business overall. Gross Renewal Rate shows you the dollars that renewed as a percentage of all dollars that were eligible to be renewed. Calculate this metric (Gross Renewal Rate) by summing all renewed contracts and dividing that total by the dollars that were up for renewal:
Dollars eligible to renew
Net Renewal Rate is a measurement of the growth of your existing customer base, net of any churn, as a percentage of all dollars that were eligible to renew. Include any expansion dollars with your renewed dollars in your calculation to get Net Renewal Rate:
(Dollars renewed + dollars expanded)
Dollars eligible to renew
Calculating renewal rate by segment is even more helpful in diagnosing issues of customer dissatisfaction. For instance, if your renewal rates are trending down in the SMB segment but not at the enterprise level, you might identify a problem with product-segment fit. Perhaps the product is too complex for SMB customers, while enterprise customers need those features.
Don’t look to customer success as the fix-all solution
If you’re looking to improve retention, the answer isn’t necessarily to pour resources into your customer success organization. Retention is one area that can be impacted by several functions. Look into the factors that play into customer lifetime value, including:
- Product: Increases in churn or retention costs could signal that you’re drifting from product-market fit or that your product faces increased competitive pressure.
- Marketing and sales: Ask yourself the following: Does your marketing accurately message your value proposition? How much is your sales team promising above and beyond what the product can do?
- Customer success: Make sure you’re engaging with customers beyond the first three months of their deployment; the next six to nine months are critical for success. Measure customer success throughout the life cycle to ensure users are getting the most out of the product and understand how to use it.
Define a product engagement metric
Understanding how much your customers actually use and depend on your product is the best indicator of happiness. Engaged customers are more likely to renew their contract — which helps to keep your retention numbers steady. They’re also more likely to tell others about their experience with your product, which improves top-line growth.
Experiment with an engagement metric that works for your business: for DocuSign, it’s the number of envelopes sent; for JFrog, it’s the volume of binaries distributed; for Textio, it’s the number of job requisitions written in the platform.
Your ability to keep customers happy without spending a ton of resources speaks to the value you’re delivering. And if you retain customers efficiently, you can spend more on acquiring new customers. In evaluating a portfolio company, I’d much rather see a business with good growth and high-quality customer retention than one with explosive growth but low retention. VCs will hold you to these metrics — make sure you’re accountable for them.