For technology companies, there are only two ways to grow a subscription business―you can either increase new Annual Recurring Revenue (ARR) or reduce churn, that’s it.
What really matters is growing the ARR base. Any reduction from churn needs to be made up by new ARR if the business is going to grow. Despite the importance of churn, there isn’t a consensus over how to define it. This article lays out 10 rules for developing a water-tight definition.
- Customer Churn or ARR Churn
- ARR Doesn’t Equal ATR
- Timing of Churn
- Renewals For Less Than 12 Months
- Change in Product
- Change in Partner
- Dealing with OEMs
- FX Changes
Having a measurement to calculate churn is increasingly important as COVID-19 makes it harder to build new customer relationships, increasing pressure to avoid churn from existing customers.
1. Customer Churn or ARR Churn
At the simplest level, you can define churn in terms of the number of customers who leave you (i.e., customer churn) or the amount of ARR that isn’t renewed (i.e., ARR churn). Customer churn is an important indicator of customer loyalty, but tends to over-state the impact on financial performance, as smaller customers churn more than larger higher-spending customers. To manage underlying business performance, it is better to focus on ARR churn.
2. ARR Doesn’t Equal ATR
Many Enterprise customers buy multi-year contracts, and when you are calculating ARR churn, you could choose to either include or exclude the out-years of these contracts in the Renewal ARR base. This can materially understate the true churn rate, as the out-years of multi-year contracts are not really ‘available-to-renew’ (ATR). The customer has already committed to paying for these out-years, so by including them in the base, any actual churn looks lower as a percentage of the total base. It can be helpful to track both measures, but churn based on the ATR pool is more accurate for managing your business.
3. Timing of Churn
Customers might let you know in advance that they aren’t going to renew, or they might renew later but at a lower amount. To accurately reflect performance, you should align churn with the period in which the associated Renewal was available to renew. Early churn shouldn’t be counted until the period the renewal was originally due. For late churn, you need to first define an allowable slippage period (e.g., three to six months) during which time the opportunity is still deemed ATR (e.g., sales are still in negotiations). Beyond this, the Renewal is ‘force churned’ and any subsequent renewal booking is seen as a ‘win-back’ and represents negative churn for the period in which it books.
4. Renewals For Less Than 12 Months
Customers sometimes want to renew for less than 12 months (e.g., to allow time to migrate to a different solution). As the Renewal amount is less than the ATR amount, companies could choose to recognize this reduction as churn. A better way to report this is to look at the impact on ARR. If the customer is paying the same amount on an annualized ARR basis, then there shouldn’t be any ARR churn, even if the Renewal is for less than 12 months.
Enterprise customers often want to consolidate multiple different contracts across different time periods, into a single contract with the same start and end-date. This can lead to Renewals that are above or below the original ATR amount. Churn should only be taken if the total aggregate ARR is declining across the different contracts.
Sometimes you don’t like what you’ve bought, and want to exchange it for a credit note to spend on something else─ that’s a re-rack. If the customer commits to an ARR subscription that is greater than or equal to the original purchase, then there should be no churn on the account.
7. Change in Product
A similar situation occurs when a customer decides to churn their original product subscriptions, but offsets this by purchasing different products. This might happen if one division of a company stops buying a subscription, but this is made up by a new subscription from a different division. This is effectively “re-sale” ARR, as opposed to net new incremental ARR at a customer level, so there shouldn’t be any churn recognized on the account.
8. Change in Partner
Customers often buy technology through partners, and can decide to change the partner they buy from without changing the underlying technology they are using. In this case, the customer hasn’t really ‘churned’ ─ they are still buying the subscription, just through a different channel. For this reason churn should be tracked at a customer level, not a -partner level.
9. Dealing with OEMs
For OEM subscriptions, the software vendor typically has no visibility into who the end user is, which makes it difficult to track churn. You can address this by treating the OEM partner as the customer, and track any ARR increase or decrease at the OEM partner level. This means that the base of ARR coming into a fiscal year becomes the baseline, and any decline in ARR year-on-year is classified as churn.
10. FX Changes
The exchange rate for churn can be set to when the subscription was originally purchased, when the annual plan was set, or when the churn actually happens. It makes sense to call out the FX impact of churn separately in each of these cases. For example, a £100 renewal might be worth $130 when the plan was set at the beginning of the year, but might only be worth $120 when the renewal actually books. There is no £Churn in this scenario, but there is FX churn of $10 against the plan, which should be reported separately.
Growth in the base of ARR is the most important metric for any subscription company, and this is only impacted by increasing new ARR or reducing churn. This makes it critical to develop a standard definition of churn, to allow ARR growth to be accurately measured, tracked and improved. There are likely more extreme corner cases to those described above, but this list of 10 rules will help as a starting point towards building a consensus definition.
Authored by The Alexander Group, Inc.®