How Churn Affects SaaS Company Valuations

Whether you are preparing to sell your SaaS company or want to know its worth, churn rate carries significant weight in your company’s valuation.

Investors or brokers will evaluate your SaaS for strength and differentiation. Churn rate is one of the key metrics that differs you from other companies, and one that buyers will look at when valuing your business.

The higher your churn rate, the more capital you need to maintain your revenue. Therefore, a low or negative churn rate indicates your potential for long-term success.

Reducing your churn rate is vital to increasing your dividends, and how a 1-2% reduction in churn rate can increase your SaaS valuation by around 12%.

How is Your SaaS Company Valued?

Valuation is generally calculated using the equation:

Profitability of the last 12 months x  multiple

Let’s first look at benchmarking your profitability of the last year. Your calculation for this will vary depending on the ownership, size and growth of your business:

1. Seller Discretionary Earnings (SDE): Calculated by taking gross income minus the costs of critical (non-discretionary) operating expenses and goods sold. Any salary, dividends, or other income taken by the owner can be added back into the overall profit.

When should you calculate profitability based on SDE?:

• Your business is dependent on its owner, e.g. one or two shareholders who manage operations.
• Your revenue growth is less than 50% year over year.
• Your business generates less than $5,000,000 in revenue per year.

1. Trailing Twelve Month Earnings Before Interest Taxes Depreciation and Amortization (TTM EBITDA): Buyers use this calculation because it gives the full picture of past operating performance by including all transactions made during a year.

As the name implies, this calculation is made by taking gross income, including critical (non-discretionary) operating expenses across a whole year. Any salaries or dividends received by the owner(s), as well as discretionary expenses, should not be included in the overall profit.

When should you calculate profitability based on EBITDA?:

• Your business is independent of ownership e.g. multiple shareholders who employ a CEO/general manager to oversee operations.
• Your revenue growth is over 50% year over year.
• Your business generates more than $2,000,000 in revenue per year.

1. Revenue: Calculated based on sales and current and future growth.

When should you calculate profitability based on revenue? When neither SDE nor EBITDA apply or there are complications e.g., if after calculating EBITDA, your margin is zero. In this case, using revenue as your benchmark for profitability better represents your future earnings potential.

Note: This calculation is based solely on growth. If your SaaS has not grown, you cannot calculate future profitability based on revenue.

The second part of the valuation equation is your multiple.

A multiple is a measure of value compared to various quantitative business metrics (such as churn rate) as well as qualitative ones (competitive moat, market size, etc.,). It allows you to compare the relative value of different companies, regardless of size and other factors.

SaaS companies are generally valued at three to five times their SDE or EBITDA.

Your multiple is broken down to the core drivers of scalability, transferability and sustainability. Operational and market metrics impact these core drivers and therefore influence your multiple.

In addition to the age of your business and ownership structure, these SaaS metrics affect your multiple:

• Churn Rate
• Customer Acquisition Cost
• Customer Lifetime Value
• Average Revenue per User
• Active users
• Growth trends

Your multiplier is arguably the most important factor in your valuation calculation.

An example: two similar companies, Company X and Company Y, are up for valuation.

• Company X has a multiple of three due to top key metrics: high monthly recurring revenue, steady upward growth rate, and low loan-to-value ratio.
• Company X is valued at 3x TTM EBITDA.
• Company Y has the same top key metrics plus a much lower churn rate.
• Company Y is valued at 5x TTM EBITDA.

Churn Directly Affects Your SaaS Multiple

The most important factor affecting your SaaS multiple is growth rate. Churn rate is a multiplier for growth and serves as a temperature control for your business:

Growth = New Revenue - Churn

In addition to profitability, both customer retention and customer revenue expansion are strong secondary factors in your SaaS valuation.

Churn rate serves as a risk component in valuation. Your churn tells investors a lot about the sustainability of your concept, whether it is suitable for your target market, and whether or not it falls short of user expectations.

Churn in valuation may be separated into:

• Revenue Churn: the percentage of revenue lost from customers within a given time period.
• Customer Churn: how many customers cancel their subscription within a certain period of time.

While customer acquisition is an important factor for any business, the cost of acquiring new customers is not overlooked by investors. Some even see a large influx of customers as a potential risk to future growth if churn rate is not decreasing.

Alternatively, decreasing customer churn rate has an upward effect on revenue. That is, even a 1% improvement in the churn rate significantly increases revenue year over year, even ifcustomer acquisition slows.

Consider two companies: one with an annual churn rate of 2.5%, and the other with an annual churn rate of 10%.

Both have a constant inflow of new customers at the same customer acquisition cost. However, after five years, the revenue of the company with an annual churn rate of 2.5% will be notably higher and the growth will be greater. This is because the lower churn rate allows recurring revenue to grow, which increases the growth rate and reduces the risk of long-term value loss.

Just a 1-2% difference in churn rate could increase SaaS valuation by 12% in five years.

What Is a Healthy Churn Rate?

An unhealthy churn rate can even send a public company’s stock prices through the floor. Netflix stock, for example, fell by 10% in 2019 after the company reported an elevated churn in their second quarter.

Defining “healthy” churn rates depend on your customer base: enterprise companies, consumers, or prosumers. Read our article on normal churn rates for SaaS to find out where your company falls on the churn rate scale.

• For larger EBITDA or revenue-valued companies, a healthy range for valuation is between 5-7% annually or 0.42-0.58% monthly.
• For a smaller SDE valued company with an average MRR of $10,500, a healthy range is 32% annually or 3.2% monthly.
• Enterprise companies tend to have the best churn rates, close to 1%, as their customers pay high subscription costs and have more long-term relationships with the business.

Obviously, you want your churn rate to decrease over time. If you are looking to sell your business, tackling churn will pay massive dividends.

Here are simple areas you can focus on to improve your churn rate:

• Customer engagement: improve your customer experience and service. Keep your customers coming back by offering the following:
• Digestible content on the functions and benefits of your product.
• Newsletters and updates on offers and upgrades.
• Opportunities for feedback and transparency on how you deal with it.
• Onboarding and ongoing education: build trust and loyalty from the start and provide plenty of high quality support materials to improve retention.
• Offboarding: use tools to gain insights into why you’re losing customers. With Churnkey, you can significantly improve churn rate at offboarding. Wavve was able to cut churn by 2% within two months and significantly increase their potential growth ceiling.
• Long-term pricing: annual subscriptions lead to better retention and ensure recurring revenue.
• Define and showcase your most valuable features.
• Segment your customers by profitability and go the extra mile for your most valuable customers.

Your churn rate and the valuation of your SaaS solution are inextricably linked. Churn rate is an indicator of growth and a key indicator of future cashflow.

If you want to increase the valuation of your SaaS business, don't neglect the opportunity to improve your churn rate. Invest in tools like Churnkey that help you find out why your customers are churning, what offers they're taking, and who's most at risk.