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Fundamentals of acquisition and retention: Part 2 - Customer retention
Knowing how long you will keep customers, and how profitable they will be, is crucial. This blog explores the fundamentals of customer retention, including key metrics and approaches.
So your company is reliably winning new customers? Good news. But do you know how long you expect to keep those customers? And how profitable is the average new customer to your business? If you’re struggling to get clear answers to those questions, it might be time to dig into the fundamentals of customer retention.
This article, part of our mini-series on customer acquisition and retention, is designed to help B2B startup founders to scale their commercial functions. Missed the previous post? Read more about the economics of customer acquisition here.
Customer retention basics: The impact of churn
Customer relationships in most tech companies are initially unprofitable because of the upfront sales and marketing investment needed to acquire new customers. However, businesses should expect to make a return on that initial investment over the lifespan of the customer relationship.
Customer retention strategies aim to drive that return in two ways:
- help companies keep hold of their customers for longer, and
- maximise the revenue earned from each customer.
As far back as 2000, Bain & Company and Harvard Business School observed that retaining loyal customers would be especially important for internet-enabled businesses. And that thinking still holds true for tech-enabled business today: the marginal compute costs once a customer is acquired are negligible, so retaining existing customers is extremely economically efficient.
To hold onto customers for longer, an effective customer retention programme must minimise churn – the rate at which customers are lost – and increase the lifetime value (LTV) of the average customer, because churn can have a significant impact on revenue growth over time.
Let’s imagine a cohort of customers which generates £1 million annually in revenue for your business. With a churn rate of 20%, that £1 million of revenue would dwindle to zero in five years. If the churn rate is cut to 10%, that cohort of customers still contributes £500k of revenue to your business after five years. And between year 5 and year 10, they will contribute an extra £1 million in revenue in total if the churn rate remains consistent at 10%.
As Aidan Simister, founder and CEO of cybersecurity SaaS scaleup Lepide, said in an interview with HSBC Innovation Banking: “From a retention perspective, engagement and satisfaction matters most. Your happiest customers are likely to be your biggest opportunities for expansions and upsells.”
Bad data in, bad data out: How your CRM affects retention
There are several factors that can impact churn, but without clean data, it can be tricky to pinpoint their root cause and impact.
For example, the latest SaaS survey from KeyBanc Capital Markets and Sapphire Ventures found customers on monthly rolling contracts churned at double the overall rate compared to customers on annual or multiyear deals.
Given that details like contract structure can affect retention, it can be difficult for founders and senior leaders to know which levers to pull. The answer may lie in the details of the data within your customer relationship management (CRM) software – but only if you are strict on measuring key data points.
Aidan admits, “It took Lepide a really long time to get our CRM structure right. That means understanding which pieces of data are vital to collect, and it means holding the sales and customer success teams to a high standard in terms of the customer information being collected.”
He also points out that it’s easy for founders to get overwhelmed by the sheer number of metrics flying around, a problem that is amplified when there isn’t sufficient rigour or a focus on data-centricity:
The founder’s job is to understand the whole process, and along with functional leaders decide on a couple of the most important metrics that are used everywhere from all-hands meetings to the boardroom. Those metrics define success and failure for the company and your own performance.
So what metrics give founders the best insight into the effectiveness of their retention strategies? Let’s explore a couple of the most popular data points for startups and scaleups.
Exploring NRR and GRR: Net Revenue Retention and Gross Revenue Retention
Understanding how efficiently your company is growing revenue from existing customers is critical.
The impact of efficient revenue retention compounds over time. In companies with high churn, salespeople are required to compensate for customers lost on a monthly or quarterly basis, while also trying to secure new business wins. That’s why high churn usually means slower overall revenue growth over time.
Net revenue retention (NRR) and gross revenue retention (GRR) are both important metrics that can help quantify the impact of customer retention and its impact on growth. But how do they differ?
Gross Revenue Retention (GRR)
GRR takes the revenue from a group of customers at the start of the period and divides it by the revenue from those customers at the end of the period. Stripe formulates the GRR calculation as follows:
Although GRR is the most effective way to calculate the recurring revenue lost over a given period, it does not cover other aspects of the customer relationship, like upsells and expansion.
Companies looking to account for these changes may be better placed monitoring NRR instead.
Net Revenue Retention (NRR)
Like GRR, NRR is a way to express the change in revenue earned from a cohort of customers over a given period.
However, in addition to churn, NRR includes a range of different metrics related to customer revenue, including downgrades, price increases, expansions and upsells.
NRR of >100% indicates strong performance, because it means that a company’s revenue from its existing customers is growing, even after accounting for all churn, downgrades and so on.
Very few companies achieve NRR of >100% consistently. ChartMogul’s New Normal for SaaS report tells us that in companies with over $1 million in revenue, even the top quartile of performers only hit 95% of ARR on average in the first half of 2024. Median performers showed NRR of closer to 80%. ChartMogul highlights that the companies with NRR higher than 100% grow revenue significantly faster than the average company with NRR lower than 100%.
Focusing on NRR is particularly useful because the success of your customer retention programme is a good indication of the effectiveness of your customer acquisition strategy. Are you marketing to the wrong buyers, who quickly realise your solution isn’t quite right? Or are your sales team overselling, leading to downgrades when it’s time to renew? This data is vital for the go-to-market function to iterate and optimise its performance.
However, as Lepide founder Aidan points out, broad-based NRR or GRR reporting may become less helpful over time, particularly as companies scale.
Instead of thinking about NRR and GRR as a ‘one size fits all’ metric, you should ideally create cohorts or bands for NRR by ACV (average contract value). Every company will have its sweet spots in terms of the type of deal that best fits the ideal customer profile, and you’ll quickly understand which customers are most receptive to your expansion efforts.
LTV and CAC payback
When we focused on customer acquisition in our previous article, we highlighted that a solid benchmark for an efficient go-to-market operation is a LTV:CAC ratio of 3:1. At a basic level, LTV is calculated using the following formula:
This relatively simple formula assumes that LTV is linear over time, but the LTV model may need to be updated to be more nuanced as companies scale.
David Skok of VC firm Matrix highlights the importance of segmenting the number of customers that churn in a given time period from the percentage of revenue that churns over the same period. In David’s blog on ‘true’ lifetime value, he also proposes using discounted cash flow modelling to get to an objective sense of your LTV performance.
Accurately predicting customer lifetime value is always tricky, and the LTV: CAC ratio is only one piece of the puzzle for founders looking to master customer retention. And in any event, Jamie Whitcroft, HSBC Innovation Banking’s Head of Early-Stage Ecosystem Coverage, believes that “in early-stage businesses it’s hard to determine true ‘lifetime value’ with any confidence.”
Unsurprisingly, many founders and customer success leaders choose to track CAC payback, a metric that defines the amount of time before you recoup your upfront investment in acquiring the customer.
According to KeyBanc and Sapphire Ventures’ latest survey1, it took the median SaaS company 20 months to ‘pay back’ the cost of acquiring a new customer. It’s important to note that this payback period is lower than 2022’s median of 25 months, which suggests that the average company’s acquisition and retention efforts have become more efficient in the last couple of years.
Optimising CAC payback starts with a few best practices that, taken together, can have a significant effect on overall retention performance:
First, you need to focus on your best performing marketing channels and deprioritise the channels that are bringing you leads and customers that aren’t in your sweet spot. Once a customer is signed, onboarding speed is paramount, as is offering regular opportunities for customers to upgrade and add new features to their product mix
Observing payback periods for different customer cohorts can tell the customer success team where the biggest areas of opportunity for account expansion are. Christoph Janz of Point Nine Capital encourages founders to measure CAC payback by cohort, rather than on a customer-by-customer basis: “that way, your calculation is based on NDR (net dollar retention) and takes into account churn, expansions [and] contractions.” For instance, is there a correlation between higher product engagement and shorter payback periods in your business?
Final thoughts: Optimising retention is a whole-company effort
Keeping hold of your customers for longer, and growing the amount of revenue you receive from them over time, is a cornerstone of success for any scaling tech company. If retention isn’t working, your growth trajectory could well be affected. As Jamie says, “Spending £15 to acquire customers that’ll give you £10 before churning is a recipe for burning cash and shrinking your runway.”
As we’ve seen, there are a wide variety of metrics that can help to illustrate your relative performance on customer retention. The challenge for whoever is accountable for customer retention – whether it’s a founder, or your head of customer success – is to assess the variety of data points and metrics available and identify the two or three that will define success or failure for your company (taking into account your size, growth rate, sector and so on).
To Aidan, “winning a new customer just means you’ve bought a ticket to the show. The secret to getting a return on your investment is in your approach to customer retention.”
Ultimately, effective customer retention is just as important as your customer acquisition efforts. All that time and money spent closing new deals can be undone if those customers throw in the towel after a few months. Defining what you want to measure, then using that data to direct your retention efforts where they’re most needed, is the first building block of a great retention strategy.
