The success of any business is to create a product that people value. While a creative marketing campaign can get users through the door, it won’t get them to pay continuously for your product.
Hence, a good indicator for that success is measuring actual revenue growth, which is dependent on three main factors in this order of importance:
- Good monetization: The ability to generate more revenues from your existing customers.
- High retention (or low churn): Keeping your customers paying for a longer period of time.
- User acquisition: Getting more paying customers into the funnel.
Retention and churn often mean different things to different people.
When most people refer to retention or churn, they refer to “customer retention” or “customer churn,” meaning the percentage of customers that decided to stay or leave during a period of time. While that may be a great indicator of product value, at the end of the day, businesses are measured not by the number of customers they attract or retain, but rather by the revenues they generate.
There is a way to measure the rate at which revenue is staying or leaving a business over time, and it’s known as “net dollar retention” or “net dollar churn.”
Net dollar churn numbers in most cases would be very different from customer churn numbers.
Not all customers are created equal
What if we lost the “bad” customers who were not going to pay much anyway, and retained the “good” customers who pay you more and more money for your incredible products and services?
In this case, the net dollar churn would be lower than customer churn, in some cases, it could reach zero or even negative churn. This is exactly what net dollar churn comes to evaluate.
What is “net dollar churn”
Net dollar churn is the rate at which dollar value is leaving the company this period compared with the last period, looking at the same customers, over time.
We look at the “net” value as we also take into account the increased value from upselling or cross-selling to those customers who stayed. Obviously, we would want to increase our net value over time, not lose value over time. If we indeed gain net value over time from these same customers, this is called negative churn. In turn, that would imply net dollar retention of above 100 percent.
For example: If the net dollar churn is negative 15 percent, that means the net dollar retention is 115 percent, which is a good place to be. It is obvious we could not have reached 115 percent customer retention rates, but it is possible with net dollar retention.
How do we measure “net dollar churn”?
We start by following customers who came in a certain period, say a month if we have monthly subscriptions. Then take the customers who joined in January and track those same customers over time and see their dollar value, this is also known as a cohort.
We can take the same company that earns $3,000 every month from new subscribers, and with a 5 percent monthly customer churn rate, and see what happens if the company does not know how to monetize the 95 percent of customers that do stay every month, and what happens to the same company that monetizes well.
Scenario 1: Company that does not know how to monetize and retain customers
In this scenario, if we lose 5 percent of our paying customers, that would mean we also lose at least 5 percent a month in revenues, I would argue even 10 percent loss of revenues per month, because this scenario does not monetize well, meaning we have a double negative effect:
- Customers leaving
- Customers paying less over time as we do not manage our existing customers well, so they use the product less, and pay us less.
This would result in a higher net dollar churn rate, of say 10 percent monthly net dollar churn, or 90 percent net dollar retention.
The effect of the positive net dollar churn on the total revenues is clear: our total revenue growth is slowing down to a halt and flatlining. In this case, spending a lot of money to attract new customers would be a waste of resources. We should first figure out how to monetize and retain our customers, and then invest in new customer acquisition.
Scenario 2: A company that does know how to monetize and retain customers
Now let’s visit a company that knows how to retain and monetize its customers. In this scenario, the total value of those customers who came in January increases over time, despite the fact that 5 percent are leaving us every month. This is possible if the 95 percent of monthly customers who stayed are being monetized well, by up-selling to a premium plan thanks to an increase in use, or cross-selling other products and services.
In this case, we would have gained net value, then net dollar churn would be lower than the customer churn of 5 percent, it could be zero or even negative, meaning our net dollar retention could be above 100 percent, in this case 110 percent.
A good benchmark would be to exceed 115 percent in net dollar retention, meaning dropping below negative 15 percent in net dollar churn.
If we manage to monetize our existing 95 percent of customers every month and are able to increase their total revenues every month by 10 percent, this would result in a negative 10 percent monthly net dollar churn, or 110 percent monthly net dollar retention. The impact on the total revenues would be huge as we will have a double positive effect resulting in exponential revenue growth:
- We are getting more customers.
- We monetize our existing customers better.
Understanding when NOT to use net dollar churn
Do not use net dollar churn in lifetime or customer lifetime value calculations.
For example, if we have extremely low net dollar churn rates, close to zero, that would distort our lifetime calculation to infinity (lifetime = 1 / churn), or start to become a negative lifetime, (Back To The Future anyone?), which doesn’t make sense.
Lifetime value calculations would not work either. This would continue to mess up our LTV / CAC ratios and so on. Read the full article on the various Unit Economics benchmarks. The source of the issue is that LTV’s formula was created with customer churn in mind, not net dollar churn.
As a reminder LTV formula is as follows:
Thus we would still want to calculate both customer churn and net dollar churn, but not mix dollar churn with lifetime or lifetime value (LTV).
To summarize, what is the importance of net dollar churn?
Net dollar churn is a more value-driven way of looking at churn, which in certain cases I hope it will prove your business is a lot healthier than you originally thought. This is great for internal purposes and also external purposes when fundraising.
Itay Sagie is a guest contributor to Crunchbase News and a lecturer and strategic adviser to startups and investors. Sagie is also the Israeli adviser at Allied Advisers, a boutique investment bank from Silicon Valley. And founder at VCforU.com. You can connect with him on LinkedIn and follow him on Twitter at @itaysagie.