Insights into Value Creation and Exit Trends for Technology Companies
This Edition's Question
How does customer churn impact valuation?
Customer churn is a hot topic for leaders and experts in the subscription software industry. It is also a key metric that is evaluated by investors and buyers of these companies. This issue of Exit Insights explores how churn can impact the valuation itself.
The Quick Answer
Churn has a significant impact on the valuation of SaaS companies
and its effects are compounded over time.
The Longer Answer
The most common valuation model for subscription software companies is:
Annual Recurring Revenue (ARR) * Multiplier
The Multiplier is derived from the current public company cloud index, with a discount applied for private companies, and additional discounts and premiums applied based on several relevant metrics such as intellectual property, addressable market, competitive landscape, growth rates, margins, and churn.
The analysis in this report focuses on just one of these metrics: churn.
The examples are intentionally simplified to isolate and assess the effect of churn on valuation.
Impact of Churn on ARR and Valuation
In the first scenario we look at the impact of churn on the ARR and company valuation.
In this case we assume a 30% increase in new revenue (from new subscriptions and expansion of existing subscriptions), three different churn rates are applied, and the multiplier is held constant.
After 5 years the 15% churn scenario resulted in 39% less in ARR and Valuation.
At the 30% churn level there was a 65% impact.
Impact of Churn on the Multiplier and Valuation
The churn rate and trends over time will drive the valuation multiplier up or down because of it's effect on revenue growth, costs, customer lifetime value, and the strength or risk of future financial projections. In the second scenario we take this into consideration and use 10x, 9x, and 8x multipliers as the churn increases.
In this example a 15% churn rate reduced the valuation by almost $13M and
a 30% churn rate reduced the company valuation by over $20M.
Conclusion: Each dollar of churned revenue reduces the future valuation by a significant factor.
Gross Churn, Net Churn, Negative Churn - The Debate Over What To Measure
The focus of this analysis is on gross churn - the actual lost revenue due to cancelled subscriptions. While net churn is regularly measured, and negative churn is set as a goal, we chose to not consider them in this analysis because these two measures ignore the value and cost of actual lost recurring revenue itself.
Recommendations from Intermediaries and Value Creation Advisors
There are many factors that impact valuation and to say that churn is the only driver is an over simplification. However, the analysis shown here and done by other industry experts demonstrates that churn is a critical component that can have a substantial impact on valuation in the near term and a compounded impact over time. Following is a short list of recommendations to minimize the impact of churn on valuation.
1: Monitor Gross Churn: Keep track of the actual number of accounts lost and the corresponding contract value.
2: Gather Churn Reasons: Determine why accounts churn and calculate the associated revenue impact by reason.
3. Start Early: Begin gathering this data with the first lost account to measure trends over time.
4. Take Action Immediately: Address churn early to minimize the cumulative impact on valuation.
5. Perform Regular Impact Analysis: Create a model to show how churn is impacting company value and share with the team to demonstrate the importance of customer retention to the overall mission.