This is the second article in a series on novel ideas for SaaS metrics, which started with The unprofitable SaaS business model trap.
You’ve probably know that cancellations kill growth in scaling SaaS companies. You probably know this is because as you get large it’s hard to continue growing fast enough to cover the amount of customers you’re losing by cancellation.
I have a better, clearer way to think about this financial effect, one that makes it more obvious why this “headwind to growth” is larger than you think, and an stronger way to compute exactly what the effect is.
The cost to earn a dollar of MRR
What does it cost a SaaS company to add $1 of new monthly recurring revenue?
Using the typical acronyms:
CAC (Cost to Acquire a Customer) is the total, all-in cost to get a full customer in the door. Marketing and Sales costs, plus the fully-loaded salaries of the folks in those divisions, including commissions and everything.
MRR (Monthly Recurring Revenue) is the revenue you get every month from a customer, averaged across all customers. Thus, MRR = R / N, where R is your total revenue, and N is your total number of customers.
Since it costs CAC dollars to get MRR dollars of revenue,
p = “cost to earn a dollar of MRR” = CAC / MRR
p is also “pay-back period”
Students of SaaS business model metrics will recognize p as the “pay-back period,” meaning “the number of months before a customer ‘pays back’ the cost to acquire that customer.” That’s why I picked the variable p — as in “payback period.”
It’s fun that these two interpretations of p are both accurate.
COC — the Cost of Cancellations
Suppose your monthly cancellation rate, in terms of MRR, is c. For example, if 2% of your monthly revenue cancels in a single month, c = 0.02.
Now, just to stay even in revenue (forget about growing!), you to have to replace c dollars of MRR. And each dollar of MRR costs you p dollars to acquire.
Hence the formula for what I call COC (the Cost Of Cancellations) — the fraction of revenue you must spend merely to keep your revenue flat:
COC = pc
Some examples make the utility of this metric clear:
If your cancellation rate is 2%/mo (c=0.02), and your marketing pay-back period is 6 months (p=6) — typical for a healthy SaaS business — then 12% of your revenue every month will be spent just keeping revenues even.
That’s a tremendous percentage of revenue just to keep from shrinking! That doesn’t include cost to serve (customer support and servers), that doesn’t include overhead costs, that’s don’t include spending to actually grow revenues, that’s merely to stop shrinkage.
Enterprise SaaS businesses often have lower monthly cancellations but much longer pay-back periods. 1.5% cancellation and 18 month pay-back period means a whopping 27% of revenue is spent replacing cancellations.
A no-touch SaaS business driven by word-of-mouth marketing might have lower pay-back periods due to efficient acquisition costs, but have higher cancellation rates due to the lack of human touch. I know a prominent SaaS business with a pay-back period of 2 months but a cancellation rate of 5% — that’s 10% of revenue to stay even.
That’s actually pretty good if you think about it. 5%/mo cancellation means 50% of their revenue cancels each year — crazy high! — but a very low cost-to-acquire means the company is still spending only 10% of revenue to stay even, and of course an additional 10% of revenue spent on marketing causes them to grow at a reasonable clip.
Important COC Lesson #1: Three metrics matter, not one
The massive size of COC for most SaaS businesses should be a wake-up call. COC expense can often be as high as R&D or G&A — that’s an insane, unprofitable, and therefore untenable expense-line.
A SaaS business must work constantly to reduce COC. Because the definition is so simple, it’s obvious that reducing COC means decreasing cancellations and decreasing p, and decreasing p means decreasing CAC and increasing MRR.
This is a key insight to many SaaS operators, because typical metrics literature focuses only on reducing cancellation rate, which is only a third of the story. Furthermore, unless you haven’t yet reached product/market fit, cancellation rate is often hard to shift compared to reducing CAC (smarter campaigns, optimized landing pages, self-serve sales/on-boarding) or increasing average MRR (different pricing tiers, add-ons for new product or service).
For example, my company WP Engine’s cancellation rate is under 2% per month. That’s low for the hosting sector. Furthermore, when we poll customers who cancel after the first 90 days, the most common reason for cancellation is “project ended.” Meaning, it’s not something we can affect by changing something internally.
Therefore, pay-back period is a smarter place for us to focus in terms of reducing COC. In fact our CAC is also already very low, due to tremendous word-of-mouth that our lovely customers bestow upon us. (And now you see how much we appreciate that!) But maybe we should do more to increase word-of-mouth activity while we continue to optimize our paid advertising campaigns. And what about MRR? We’ve started selling SSL certificates to customers who want secured sites, which results in incremental revenue (and a better customer experience, because we handle that mess for the customer, including renewing and re-installing the certificates each year).
As another example, take the company above with the 5% cancellation rate that traditional metrics literature would say creates “impossible headwinds for growth,” and yet they have a better COC than a typical enterprise SaaS business, demonstrating that a very good pay-back period can overwhelm a crappy cancellation rate.
Important COC Lesson #2: Zero net churn trumps both CAC and MRR
The standard SaaS metrics literature does give an important way to combat “headwind” from cancellations: Up-selling existing customers. If you have 2%/mo cancellations, but if on average you increase MRR by 1%/mo with things like customers graduating to larger tiers, adding more “seats,” buying add-ons, buying premium support, etc., then effectively you’re only losing 1% of your MRR per month, not 2%.
Thus, c above is not really cancellation rate, but rather what is called “net churn,” meaning cancellation rate minus up-sell rate. The strongest SaaS companies have negative net churn!
You can see the effect of approaching zero net-churn in COC: If c is zero, COC is zero, which means “getting back to even” costs nothing at all. Phew!
Another fact pops out: In terms of “not shrinking,” suddenly p — and therefore CAC and MRR — doesn’t matter at all! Of course they do matter for healthy revenue and inexpensive growth, but at least in the “headwind” sense they fall away.
This highlights the fact that getting to zero net churn is the strongest thing you can do in terms of COC. And since we just talked about “cancellation rate” having a floor, that means you must develop paths for up-sells.
Of course negative net churn is a bonus. It sends COC negative too, which can be interpreted as adding directly to profit margin, just as a positive COC sadly takes a tremendous bite out of profit margin.
COC: A new standard SaaS metric
Typical SaaS metrics literature characterizes it this way: “As a SaaS company scales, growth rate diminishes, but cancellation rate doesn’t. That means it gets harder stay ahead of the headwinds created by cancellation. So you need to work on getting to zero net-churn and, if you don’t, you cannot build a large SaaS company, and certainly not a profitable one.”
That’s true, but thinking about it in terms of COC is an easier way to understand how to define “headwinds,” exactly how big your “headwind” currently is, the true components of “headwind,” and thus points the way to how you will reduce the headwinds besides reducing net-churn.
Special thanks to consummate SaaS-metrics blogger Joel York (go read!) for reviewing drafts of this post.