Let’s say you are a CEO of a rapidly growing startup (or a VC deciding whether to invest in a rapidly growing startup). All the numbers look up and to the right. How do you know how big this company will get?
When looking at subscription-based companies (or any company that is based on Lifetime Value vs a one-time transaction) a few simple equations can help you predict your maximum engagement levels, maximum revenue or (in a future post) maximum EBITDA or profit.
In this post I’ll describe the equations first (sorry – have to go into a little math) and then discuss the repercussions.
The simplest equation is figuring out your peak or maximum engagement.
Equation #1 – Maximum Sustainable Engagement = 1/CHURN x NEW GROWTH
To figure out the maximum sustainable engagement, take the reciprocal of your churn (i.e. 1/CHURN) and multiply it by your average new growth.
For example: If you lose 25% of your customer base year over year and get 1000 new customers a year, your max customer size will be 1000 times 1/.25 or 4000. At 4000 customers you will be losing 1000 (or 25%) each year due to churn which is exactly the same amount of new members you get.
You can use a similar equation to determine your maximum revenue.
Equation #2 – Maximum Revenue = 1/(ARPU CHURN) x GROWTH x (INITIAL ARPU)
To determine your maximum revenue, instead of churn, use ARPU churn (Avg revenue per user) churn or the fraction of money you make per cohort in year 1 vs year 2. For example, if you make $1000 from 100 customers in their first year and $800 from those same 100 customers in year 2 you have an ARPU churn of 20%. ARPU churn accounts for not only churn in terms of inactive members but also churns in terms of less revenue per customer due to less engagement or declining purchases over time. So if you are growing at 1000 new customers a year with a $10 ARPU (Average revenue per user) in year one and a 20% ARPU churn, without any other changes your company’s maximum possible annual revenue would be $50,000 or (1/.20 * 10 * 1000).
In both of these equations, the reciprocal of your churn (i.e. 1/churn) is your multiplier effect. If you have a churn of 50% you maximum size is 2X your annual new membership. If your annual churn is 10%, your maximum size will be 10X your annual new membership.
So why do these equations matter? First, by understanding your max sustainable revenue you can start to predict how big of a company you are actually building. Second, if you play around with the model you will start seeing some key take-aways. Specifically:
- Churn – not growth – is the key metric to building a long-lasting great business. Increasing your growth or your revenue will linearly increase your market-size potential, but reducing your churn can grow it exponentially. If 50% of your existing customers drop off each year, you have to make up for 50% of those customers each year before you can start growing. On the flip side, if your customers stay 99% active a year later retention rate, you only need to make up for 1% of your existing base before you can grow your audience. You can cover up the churn problem in the short term by growing quickly but eventually it will come back to haunt you. (Note: this is one of the reasons I am so bullish on building fantastic long-term engagement. Long-term engagement of existing customers is the key to long term profits – even more than new membership growth)
- Churn is the combination of both people who stop using the product AND a decrease in revenue. Companies often think of churn as the % of customers they lose completely each year. But real churn is the amount of % of revenue you lose each year from each customer. This is particularly true for ecommerce-based and entertainment-based companies where customers may still be active but just buy less in year two than they did in year one.
- All else being equal, all companies that have churn in a steady state have a maximum size. If you are losing customers (or revenue per customer) each subsequent year, you will have to make up for it. Eventually the existing customer base will get so large that the company can only replace its churning revenue and basically be running to stand still
I find it interesting that a large number of investors, press and potential employees considering companies overlook these numbers and just look at the hockey-stick rate of growth. In my mind they are missing a key component that may eventually come back to haunt them.
In future posts, I will delve into more of the details on how you can more accurately estimate churn, and growth rates and eventually start predicting the max sustainable EBITDA.
- The Max Revenue model is a simplified equation. In particular, it assumes long term industry growth is similar to the discount on future revenue.