By: Karam Elharami, SEG Analyst

“How much customer churn did you have last year? What was gross churn?”

“How do you expect churn to change in the current year? How can you reduce churn?”

As a follow-up to my colleague, Diamond Innabi’s blog, “Understanding ARR: Terms You Need to Know,” we thought we should put pen to paper on how to properly calculate churn.

Let’s start with the most important question: “What is churn?”

This is a very simple and fair question, but it’s also a broad question that requires clarification. Are they asking about customer logo churn or ARR churn? If ARR churn, are they interested in lost customer churn, gross churn, or net churn? Even more basic, how do they define a lost customer and when the customer was lost?

For most private equity and strategic buyers, a lost customer is considered lost in the month the customer’s MRR goes to $0. Let’s look at the following scenario of four existing customers (i.e., no new customers) depicted in the table below.

Customer A and Customer C pay a monthly subscription, Customer B has an annual subscription, and Customer D a quarterly subscription. Since Customer A pays monthly, Customer A’s MRR is simply $15 January through June. Customer A downgrades in July, so their MRR is $5 July through September. Customer B has an annual subscription renewal of $144. Therefore, Customer B’s MRR is $12 ($144 per year divided by 12 months). Customer C’s MRR was $20 early in the year but declined to $10 by year end. Customer D pays $30 per quarter. Customer D’s quarterly payment increased to $100 at year end.  Customer D began 2017 with ARR of $120 and ended 2017 with $400. To make things interesting, assume Customer B gives notice of cancellation and stops using the software in November 2017.

2017 Customer Subscription Billing Data
Dec-16JanFebMarAprMayJunJulAugSepOctNovDec
Customer A$15$15$15$15$15$15$15$5$5$5$0$0$0
Customer B$0$0$144$0$0$0$0$0$0$0$0$0$0
Customer C$20$20$20$20$20$20$20$20$10$10$10$10$10
Customer D$30$0$0$30$0$0$30$0$0$30$0$0$100

Based on this information, Customer A is lost in October 2017, and Customer B is lost in Feb 2018. Again, a lost customer is considered lost in the month the customer’s MRR goes to $0. While Customer B gave notice in November 2017, Customer B’s MRR did not hit $0 until Feb 2018.

Knowing the lost dates allows us to start answering some questions about lost customer churn.

Q: What was Lost Customer Logo Churn in 2017?

A: One customer lost. Customer A was the only lost customer in 2017. If these four customers comprise all the Company’s customers, lost 2017 customer logo churn was 25%.

Q: What was Lost Customer ARR Churn in 2017?

A:Customer A is the only lost customer in 2017. Customer A had ARR of $180 in December 2016 and $0 ARR by the end of 2017. If these four customers comprise all the Company’s customers, lost 2017 customer ARR churn was 26.3% (i.e., $180 divided by December 2016 total ARR of $684).

So what about churn? Investors and buyers will often ask about churn. Unfortunately, it’s a vague term and most people will include lost customer churn in their answer. For the majority of investors and buyers, churn excludes lost customers. Churn is the amount by which existing customers MRR declines/contracts during a period. In our opinion, the better word for churn is contraction. Customer C in the table above had $10 of MRR contraction between December 2016 and December 2017. If we were measuring MRR contraction quarterly, Customer A had $10 of MRR contraction between June and July 2017. However, on an annual basis (i.e., December 2017 to December 2018) Customer A had no contraction, as Customer A was lost.

The opposite of contraction is expansion. Just as a customer may reduce their seat count or module usage, which drives contraction, existing customers will also increase their usage of a product by buying more modules or increasing usage (e.g., seats, square footage, payments processed, etc.). This is best described as expansion MRR. Similar to lost customers not factoring into contraction, new customers do not factor into expansion MRR. New customers would be captured as new customer MRR. In 2017, Customer D’s MRR expanded from $10 to $33.33.

Q: What was Churn (i.e., contraction) in 2017?

A: $120. Customer C saw ARR contract from $240 to $120 between December 2016 and December 2017. If these four customers comprise all the Company’s customers, 2017 churn was 17.5%. Percent churn is churn (i.e., $120) divided by prior year ARR (i.e., $684).

This leaves two more terms: gross churn and net churn. Gross churn is the sum of lost customer ARR churn and contraction. Net churn is gross churn minus expansion.

Q: What was Gross Churn in 2017?

A: $300. Gross churn is the sum of lost ARR churn (i.e., $180) and contraction (i.e., $120). If these four customers comprise all the Company’s customers, 2017 gross churn was 43.9%.

Q: What was Net Churn in 2017?

A: $20. Net churn is gross churn (i.e., $300) minus expansion (i.e., $280). If these four customers comprise all the Company’s customers, 2017 net churn was 2.9%.

Confused? That’s not surprising. Even with such a simple example, a churn analysis can be confusing. To make things easier, convert the billing data to MRR and ARR data (see SEG’s post, “Understanding ARR: Terms You Need to Know“), then analyze December to December ARR data. Here’s what the MRR and ARR tables look like for the data set above:

Customer MRR Data
Dec-16JanFebMarAprMayJunJulAugSepOctNovDec
Customer A$15$15$15$15$15$15$15$5$5$5$0$0$0
Customer B$12$12$12$12$12$12$12$12$12$12$12$12$12
Customer C$20$20$20$20$20$20$20$20$10$10$10$10$10
Customer D$10$10$10$10$10$10$10$10$10$10$10$10$33.33
Customer ARR Data
Dec-16JanFebMarAprMayJunJulAugSepOctNovDec
Customer A$180$180$180$180$180$180$180$60$60$60$0$0$0
Customer B$144$144$144$144$144$144$144$144$144$144$144$144$144
Customer C$240$240$240$240$240$240$240$240$120$120$120$120$120
Customer D$120$120$120$120$120$120$120$120$120$120$120$120$400

For most SEG clients serving mid-market to enterprise customers, we see gross churn, lost customer ARR churn, and net churn in the range of 8%, 5%, and -5%, respectively. Flipping these to retention numbers, gross retention, lost customer ARR retention, and net retention is in the range of 92%, 95% and 105%, respectively.

Looking for more comparable benchmarks? Head over to our research page as we assess software market trends across public markets, industry verticals and product categories.