Customers and Product-Market Fit First, Raising Money Second
Whether your business is just starting to focus more heavily on product-market fit, or if the goal is to raise money so you can continue to grow, today’s market is proof that customer focus will remain a critical element in success. Whatever stage in the game you’re at, here’s some wisdom you can take to the bank: don’t get tunnel vision when raising money.
Speaking to Business News Daily, Lighter Capital CEO BJ Lackland summarized a common mistake startup entrepreneurs should avoid when hitting the fundraising trail. He advised:
It’s a mistake focusing on raising money instead of customers and product-market fit. Once companies have a product, many focus on raising money. But they should focus on customers and product-market fit, making sure their value proposition and offering resonates with a market and will get traction.
Metrics Help Validate Product-Market Fit
Truth be told, if you’re gearing up to fundraise, investors and lenders will not only want to review your financial reporting, they will want to see how your company is performing based on key SaaS metrics; for instance, monthly recurring revenue (MRR), customer churn, and MRR churn. These metrics are important because they validate your company’s revenue stream, product-market fit, and most importantly, the ability to achieve profitability. Investors and lenders use this data to see if your company is a sound investment.
So before you go on a quest to fundraise, focus on your customers and product-market fit.
In the guide below, you’ll learn how to establish product-market fit and why it matters. We’ll show you how to calculate and track two key SaaS metrics that validate product-market fit, which investors use to determine whether your business is a good investment.
Why Product-Market Fit Matters for Startups
Tap into any startup community discussion and you’ll quickly discover that product-market fit is one of the hottest topics. The buzz around this concept can be distilled into a simple phrase: make things that people want. While it seems obvious that you need to find a market for your product, the number one reason why startups fail is lack of product-market fit, according to CBInsights. From the report:
“Tackling problems that are interesting to solve rather than those that serve a market need was cited at the No. 1 reason for failure, noted in 42% of cases.”
Creating a product that has a strong market demand is especially important when raising investor money. Venture capitalists and debt lenders are willing to take a chance on your company only if they think they can get a return on the investment. If your product is not in high demand, the chance of getting good returns on their investment is slim.
Product-market fit is the only thing that matters and companies should strive obsessively to achieve it until they do.
So how do you ensure that you’re building the right product for the right market? And how do you convince potential investors you have nailed it? There are many different models for measuring product-market fit, yet in our experience the process can be more qualitative than quantitative. Many startups never achieve product-market fit, while others have to do multiple pivots to get there.
What SaaS Metrics Help Establish Product-Market Fit?
SaaS businesses rely heavily on gaining and retaining customers to grow their recurring revenue stream. There are two commonly-used SaaS metrics that indicate how well you’re doing in this respect: customer churn and MRR churn.
These metrics can help you and your potential investors determine if your offering is well-received by your customer base and may help highlight some masked performance indicators. Having a well-received product is the first step to a strong and profitable company.
Beginning with customer churn, and then moving to MRR churn, read on to gain a better understanding about these SaaS metrics and why they matter to investors and lenders.
What is Customer Churn?
Customer Churn is the percentage of customers that cancel their subscriptions in a given time period.
Why Customer Churn Matters
Customer churn offers important insights into how well you’re meeting your customers’ needs. In the early stages, when you’re first reaching out to your potential customer base, your revenues and total number of customers can be growing while you are still hemorrhaging a large percent of existing customers every month.
To find out if there’s an underlying problem with customer satisfaction, you need to step away from overall revenue and total number of customers and look at the customer churn.
If founders are only focused on overall growth and not on customer churn, they might believe everything is moving in the right direction when in reality there is a severe underlying problem that’s causing a large portion of their customers to quit using their service or product. If new customer sign-ups were to drop off, the company’s revenue stream would rapidly decline.
How to Calculate Customer Churn
The basic formula to calculate customer churn is as follows:
Customer Churn = Number of existing customers who left during a given period / Total customers at the start of that period.
For example, assume your company has 50 customers at the beginning of the month. During that month, 12 customers left. That would mean you had a monthly customer churn rate of 24% (12/50 = 0.24). Mathematically, this means churn is the inverse of customer retention.
Once calculated, the below chart reveals the impact of customer churn:
Customer churn is usually measured on a monthly, quarterly or annual basis.
It’s also worth noting that this ratio doesn’t account for the gross customer accounts at the end of the period or the value you’re getting from each of the lost customers.
Your CRM software can give you insights into your Customer Churn Rate (CCR). You can also determine this rate by looking in your accounting software for revenue streams from customers that go to zero in a given month.
Ideal Customer Churn Rate
Ideally, a company’s customer churn rate would be well under 10 percent. But this figure can vary depending on industry competition, end customer type, and how mature is your product or service. For companies serving primarily SMBs, the customer churn rate is not as relevant, as small businesses frequently go out of business.
It’s inevitable for some customers to leave now and again, but it’s important to make sure you’re looking at the trends that reveal sustainability. If your business has a high customer churn rate, it’s important to understand what the underlying drivers of the fleeing customer base are — and to take measures to stem the flow as quickly as possible.
Why Cohort Analysis Helps to Understand Customer Churn
A great way to understand customer churn in more detail is to do a cohort analysis, which allows you to analyze customer churn over time. This may allow you to see trends. For example, customers that have been with your company for more than six months may tend to churn at a lower rate than those that have been with you for one month.
Discovering such a trend can be particularly important for B2C businesses or younger businesses that are seeing high churn. You can show that the longer customers stay with you, the more likely they are to remain customers for the long term. This tells you that perhaps you need to focus on improving the initial experience. If you can get customers to adopt your product, they’re going to stick around.
This idea plays right into the Lifetime Value (LTV) of the customer, which we cover in our SaaS Metrics eBook.
Next we'll talk about that other indicator of product-market fit, MRR churn.
What is MRR Churn?
MRR Churn is the monthly revenue lost from canceled contracts during that month. The MRR Churn Rate is the MRR Churn compared to the MRR at the start of the month.
A more accurate picture of MRR Churn can be calculated by including the revenue lost through contract contraction, as well the MRR gained through contract expansion and reactivation.
Why MRR Churn Matters
MMR Churn is an important metric for entrepreneurs as it relates to your customer churn. It can provide additional insights into your business.
Understanding MRR Churn
Understanding MRR Churn can help you determine the magnitude of the impact of lost customers on your revenue. It can also help you understand if those losses are manageable, especially when you compare it to the MRR associated with new customers you are bringing on each period. As you move forward and your business begins to grow, it can even help you forecast future revenue performance.
Following your MRR Churn closely can also serve as a sort of early warning system for your SaaS business. That’s because, initially, your MRR can be growing at a good clip while your MRR Churn is quite high. But over time, if you’re not delivering a product that customers want, eventually this failure to achieve product-market fit will catch up with you.
By tracking your MRR Churn early on, you can identify problems that may not show up right away if you’re just tracking monthly recurring revenue (MRR). This will give you time to pivot or make the appropriate adjustments before your company goes bust.
How to Calculate MRR Churn
First, let’s look at the different scenarios that are possible with a customer:
Do nothing, and leave the purchase the same as before (MRR)
Buy the product for the first time – New Customer (New MRR)
Increase the purchase – Upgrades (MRR Up-sell)
Decrease the purchase – Downgrades (MRR Decrease)
Stop buying all together – Lost Customer (MRR Lost)
With these five things identified, let’s look at how they all work together to get to your MRR revenue levels. MRR analysis is something that is done over time. This means we are either looking at month-over-month, quarter-over-quarter, or year-over-year. In this example we are going to look at month-over-month.
In the beginning of January, our sample company had 100 customers with a total purchase volume equal to $100,000. During the month of January, 10 new customers purchased your product at $3,000 per month, resulting in $30,000 new MRR. Four of your current customers increased their monthly purchase amount by $2,500 each, resulting in $10,000 up-sell MRR. Two customers decreased their monthly purchase amounts by $2,500 each, resulting in $5,000 decreased MRR. Four customers went out of business and therefore stopped buying your product altogether; their purchase was typically $2,500 per month, resulting in $10,000 lost MRR. There were no other changes with the rest of the customers.
So, we end up with the following:
How to Track Your MRR Churn
Now let’s look at the percentage change for each respective area.
New MRR Percentage: $30,000/$100,000 = +30%
Up-sell MRR Percentage: $10,000/$100,000 = +10%
Decrease MRR Percentage: $5,000/$100,000 = -5%
Lost MRR Percentage: $10,000/$100,000 = -10%
By combining all of the above numbers, we are able to look at the Net MRR Increase/Decrease. This can be done by summing all of the above percentages, or working from the original values.
Net MRR Increase/Decrease: +30% + 10% – 5% – 10% = +25%
Net MRR Increase/Decrease: ($30,000 + $10,000 – $5,000 – $10,000) / $100,000 = +25%
Like with MRR, the data you need to calculate MRR Churn should be recorded in your accounting software.
Achieving Product-Market Fit
Use and track the SaaS metrics identified above to hone in on your customers and achieve product-market fit. By focusing on your customers and product-market fit — making sure your value proposition and offering resonates with a market and will get traction — you’ll be in a much stronger position when you present to investors. With this information, investors will have a better idea how your company is performing.
Want More SaaS Metrics?
This eBook explains the core metrics used to measure SaaS company success. Using simple examples, we’ll show you how to calculate each metric, and describe why specific indicators are important to investors.