October 27, 2016
Why Funding Can Hurt Your Business Fundamentals

Some businesses might have an erratic content strategy, but you can be sure that there is one blog post every company (that can) will put out: the funding post. Companies love to show that they have persuaded someone to put millions into their business. It's a sign they are already a success and a unicorn-in-waiting.

But should they be quite so happy about their new found wealth? We recently published the world's largest study on SaaS churn. Using data compiled from 941 SaaS companies, we showed the trends of churn within SaaS, along with analyzing how churn correlates with other important business metrics. There were a ton of interesting findings from that research, but one that stood out was this: Churn is 20-30% higher in companies with VC funding.

That means that companies that have been tipped for success have worse economic fundamentals than companies going at it alone. To see why this might be, we decided to take a deeper dive into funding and churn.

How Funding Impacts Churn

Let's go back into our data and look at exactly what is happening with funded companies and their churn:
image (06ED23FD-B854-42D8-A7D4-01EF01193B31).png

We segmented our data into companies that are in the early stages, under $100k MRR (data points on the left) and those in more developed stages of $101k+ MRR (data points on the right). In both early and later stages, churn is higher in companies with funding:

  • <$100k MRR:

    • No funding median churn: 8%

    • Funded median churn: 11%

  • $101k+ MRR:

    • No funding median churn: 5%

    • Funded median churn: 7.5%

These might not look like big differences, but these are monthly churn rates. When you calculate this over the span of a year, this numbers can become crushing. For instance, funded companies in the under 100k MRR bracket have a median churn of 11%:

1-(1-0.11)^12 = 0.753

That means that the average funded company in the early stages of growth is losing 75% of its customer base per year. These are all customers that it has to replace to just break even. The companies in this bracket with the highest churn of ~16% monthly are losing 9 out of every 10 customers they acquire each year.

That isn't a realistic business model.

The small piece of good news for the funded companies in this study is that the lower bounds of churn in each bracket are comparable. That means it's not endemic. Some companies are getting it right, and you can take funding and still control churn.

But a lot are taking those sweet, sweet Benjamins and letting their business fundamentals run riot. Let's look why.

Why Funding Makes Fundamentals a Low Priority

So what's happening here? In our graphic we identified two possible reasons that companies with funding have high churn rates:

Companies that get funding (instead of bootstrapping) possibly focus more on top-line growth and less on the right customers.

 

Focus More on Top-Line Growth

Startup = Growth. Companies and founders go after funding because they want to grow, and grow fast. Having cash to burn means you can hire more employees and acquire more customers. Most importantly, it means they can crush the opposition.

With funding you don't have to wait to build your position in the market. You can immediately plant your flag as the preeminent business in your industry, then widen your funnel to capture that critical mass of customers. Everyone else is left trailing in your wake. So the focus for these companies becomes acquisition.

But this fixation on acquisition as the main channel of growth is often to the detriment of the other two pillars of SaaS growth: monetization and retention.

  • Monetization: The effects of funding on monetization are obvious. When you have cash in the bank, there is less imperative to earn more. Though working on pricing is no doubt something that all SaaS companies have in their backlog, funding allows you to push this problem further down the road. It also leads companies to overuse the bane of SaaS monetization: discounts. In an effort to get more customers, companies will push discounts.

  • Retention: The problems with retention are intrinsically linked to the push for acquisition. Our SaaS churn study showed that quicker growth correlates with worse churn. With more money invested in acquiring customers, less is committed to customer success. Instead of looking after their current customers, the internal processes of the company are geared towards new customers.

This push for growth really confounds the bottom-line economics. Companies that have been funded need to use their money to achieve growth and quick market dominance.

 

Focus Less on the Right Customers

This drive to win at all costs is called competitive arousal. It is a common psychological feature in any competitive area. But it particularly rears its head in sport and business. In sports, it is your competitor that comes second. In business, it is your customer.

To justify investment, funded companies need customers. Lots of them. When companies try to increase growth through acquisition, it is inevitable that they “widen the funnel,” loosening the parameters of their ideal customers.

These non-ideal customers don't find value in the product and churn out quickly. So in this way, these companies increase their acquisition numbers but also increase their churn numbers. Garbage in, garbage out.

This decrease in focus can be witnessed in three places:

  • Buyer personas: The right customers should be delineated by the buyer personas that a company has defined. If a customer is trying to acquire customers outside of these parameters then churn is likely to increase.

  • Qualification: For companies with sales teams, a decrease in focus can be seen in the widening of the qualification criteria for leads. This is linked to the buyer personas, and could see the sales reps pushing through deals with customers who don't fit the product.

  • Customer Success: Because there is no real incentive to help your customers, the success team is an afterthought. This leads to even more churn and fewer upgrades.

These companies are effectively spending CAC on nothing, which is a real killer for long-term growth.

How This Can Crush Your Business

You Build on Bad Unit Economics

Your LTV:CAC ratio is a fundamental component of your business success. Funding can screw both your LTV and your CAC, putting this ratio completely out of whack for long-term profit.

  • Lifetime value: As churn is the denominator in your LTV equation, higher churn leads to less revenue from customers. Effectively, taking money in the short-term from investors means you are getting less money from your customers in the long-term.

  • Customer acquisition costs: One of the main reasons that companies take funding is so that they can spend more to acquire customers. The thinking is that they can spend more in the short term to bring in customers, gaining traction in the market and potentially crowding out competitors.

 

You Can't Grow Out of It

If you've got funding, you will grow. But so will your churn problems. Consider this. If you are a $100k MRR company with 5% churn, then you have to replace 46% of churned revenue each year. This is $552,000 of revenue that you need to find even before you grow. But with funding behind you and plenty of space to expand into, this could be feasible.

Fast forward a few years into your growth success. If you do grow and become a $100m company but don't address your churn, just treading water becomes a nightmare:
image (BCDD2B92-7CEE-4759-B9E6-533F5E111D56).png

The pie is now bigger thanks to your funded growth, but so is the slice of pie that is churning each year. Every year you need to find $50m+ just to stand still, and this has to come from a diminished customer base.

You can't grow your way out of bad unit economics.

 

It Makes You Less Attractive

In early rounds you can raise capital on the back of a novel idea and some basic projections. In later rounds, investors want a lot more proof they are backing a winner.

As Mark Suster, Partner at Upfront Ventures puts it:

“I believe firmly in capital efficiency in the early days of a startup. It forces innovation. It forces the founder to spend time in front of customers. It forces teams not to expand too quickly.”

If you've been profligate, that is wholly unattractive to other VCs. Rather, most top investors are looking for efficiency within the business. This means prioritizing current customers and a focus on monetization and retention alongside acquisition.

Watch Your Churn

This isn't all to say that funding is the devil. Funding works for many, many companies. But funding doesn't cause success. A good understanding of business fundamentals does.

Funding can exacerbate critical problems. If you already have a churn problem, the funding can push this to the breaking point. As you grow, it will grow. Therefore, no matter whether you are self-funded in a garage, or have millions in investment in your SoMa loft, you need to make sure you are offering the right customers the right value, and concentrating on building a strong business from the bottom up.

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CEO and Co-Founder
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