This is a basic introduction to the relationship between churn and growth in subscription-based businesses — a relationship which is not as simple as you might think.
Let’s start with the definition of churn. At its most basic level, churn refers to the proportion of your total subscribers who leave during a given time period.
Churn can result from any number of reasons: weak customer service, a poorly upgraded product, a better offer from the competition, etc.
Regardless, subscription-based businesses are recurring revenue businesses. In order for revenue to recur, your customers must renew at a rate that outpaces churn.
In the end, your churn will determine just how big your business can be. And, if your customers churn too fast, you don’t really have a business at all.
Therefore, reducing churn by investing in high-quality products, sticky features, and customer success is fundamental to every subscription-based business strategy.
Consider a subscription-based company that acquires new customers at a constant acquisition rate and also has a steady percentage churn rate. Let’s say it gains 100 new customers per year, while losing 10% of them annually. In the early days, absolute churn is not a big deal. Your customer pool slowly rises.
But as the customer base grows, the absolute value of churn increases and soon overwhelms new customer acquisition. Joel York, Founder, Markodojo
In our example, when you reach 1000 customers, your churn rate and acquisition rate both equal 100.
When new customer acquisition equals churn, then the number of customers coming in the door is exactly equal to the number leaving! You can’t grow your customer pool. Not good.
If you want to break free of the churn limit, then you must increase new customer acquisition to compensate. Unfortunately, this places you neatly between a rock and a hard place with respect to profitability.
On the one hand, your customer acquisition costs increase each year, while on the other hand, churn is eating away at your ability to break even on every new customer you bring the door.
And, if either your percentage churn rate or growth rate is too high your businesswill never reach profitability.
How do you know if your churn rate or growth rate is too high?
It all depends on your customer acquisition cost and their recurring contribution.
In a subscription business, you reach profitability when the contribution from current customers covers the acquisition cost of new customers. In the most basic scenario, customer break-even equals company time to profit.
But, if you lose customers to churn on the revenue side while acquiring new customers at a faster rate on the cost side, then it takes more current customers to cover each new customer.
Confused yet? Here’s the takeaway: the faster you grow, the longer it takes to stack up enough customers to cover your new ones. If you grow too fast, you can never catch up, and you’ll never be profitable…unless you stop growing!
Successful subscription companies must drive new customer acquisition at a consistent percentage growth rate from year to year. New customer acquisition costs are paid with the recurring contribution of current customers.
If a subscription company grows rapidly, growing acquisition costs can outpace the build-up of recurring contribution, making profitability impossible.
This creates pressure to reduce total cost of service by lowering either the average customer acquisition cost, or the recurring cost of service (or both).
Because growth is the culprit, the surest and most effective defense is to fight fire with fire. Joel York, Founder, Markodojo
Take advantage of automation and the accompanying economies of scale to reduce total cost of service.
Similar to growth, churn also generates pressure to reduce total cost of service. After all, the recurring contributions of current customers must cover the cost of acquiring new ones.While growth drives up total acquisition cost, churn erodes the revenue base available to cover it, pushing time to profit out even further.
The harsh judgment of this objective metric math seems pretty clear all around. If you want your subscription company to ever be profitable, then lower your total cost of service already!
Only foolhardy subscription companies believe that they can grow their way to profitability. It is the recurring revenue mirage that can never be reached, because profitability will only be achieved as growth slows or stops entirely.
The combination of growth and profitability requires an extreme discipline of lowering total cost of service through economies of scale.
What exactly does it mean to increase average recurring revenue without increasing average customer acquisition cost or average recurring cost of service?
First, no additional customer acquisition cost means increasing recurring revenue from current customers.
Second, no increase in average recurring cost of service means that we must do so in the normal course of business with very little extra effort, preferably through customer self-service (self-selling!).
In other words, subscription companies can accelerate time to profit by upselling and upgrading current customers, but only if they follow an exceptionally low-cost purchase process distinct from the new customer acquisition process.
The bad news is that if you want to grow your company without limits, you can’t just sit back and book a hundred new customers per year and expect recurring revenue to accumulate. Sooner or later, churn catches up with you. You must not only acquire new customers, but you must acquire them at an increasing rate that outpaces your increasing churn.
And the good news? Well, the lower your percentage churn rate, the longer you have to figure it out.
But the unfortunate reality is that churn relentlessly chases the new customer acquisition rate. Therefore, if customer acquisition growth doesn’t outpace churn, overall growth will slow and eventually stop.
Because churn increases in direct proportion to the number of customers, the surest approach is to drive growth at an even higher rate that also increases in proportion to the number of customers. This is the actual definition of the much abused adjective “viral.”
Moreover, investors generally expect companies to increase revenue on a percentage basis year over year. Holding products and prices constant, this again requires viral growth of your customer base. Viral growth can come from many sources, but we can classify it into the following three distinct stages.
Stage One — Brute Force Sales and Marketing
In any given industry,most companies will spend a rather fixed percentage of revenue on sales and marketing, regardless of the size of the company. When the effectiveness of these efforts scales in proportion to the level of spending (which is clearly not always the case), they will drive growth at a rate proportionate to revenue.
In a subscription business, this will also be proportionate to the number of customers. Hence, it is possible to drive growth in proportion to the number of customers simply through nuts and bolts sales and marketing.
This stage is arguably not viral growth in the usual marketing sense of the words, but it does meet the strict mathematical definition, where customer growth is proportionate to the number of customers.
Stage Two – Customer Advocacy
When you are successful at driving word-of-mouth and getting your customers to recommend purchasing your product to new prospects, you have reached the next stage.
Subscribers hold great potential to be advocates, because they confirm their commitment day after day as they continue to use your product and month after month as they send in their renewal payments. Joel York, Founder, Markodojo
Driving viral growth through active customer engagement that turns customers into advocates – and advocates into evangelists – should be high on the agenda of every subscription marketing plan.
Stage Three – Ecosystem Buzz
The ecosystem for your product extends beyond your customer base to include all potentially interested parties. Consider the press, analysts, bloggers, social media hounds, partners, vendors, investors, employees, and perhaps even the general public.
Most companies engage in public relations, tracking down and pitching Malcolm Gladwell’s mavens and connectors in the hopes that they will pass the word on to their respective audiences and networks.
But remember: your success in the third stage of viral growth depends on how well you nailed stage two. True and lasting ecosystem buzz is invariably built upon a strong foundation of customer advocacy.
Unlike transactional customers, subscribers ease into their relationships with vendors through many repeat purchases. Each new subscriber brings a new thread of recurring revenue, which is woven into the larger tapestry of customers to create the vendor’s total recurring revenue stream.
Growing a subscription-based business is investment intensive. Not only must you invest up-front in your product, but you must also invest up-front in your customers. For most subscription businesses, the investment in customer acquisition far outweighs product R&D.
When you invest in your product, you must make trade-offs. Think about quality vs. quantity, new products vs. new features, time-to-market, and so forth.In subscriptions, these same trade-offs occur for investing in customers. Should you invest in higher quantity (more acquisition) vs. higher quality (lower churn)? New customers (acquisition) vs. bigger customers (upsell)? Growth vs. cash flow?
Remember that your recurring revenue over time is nothing more than the sum of its parts. Therefore, the sooner you break even on a single customer, the sooner you will reach profitability as a company. What you decide will depend on your particular market, product, subscription sales model, and financial objectives. Hopefully these tips will help you make the best possible choices for your particular subscription business.