The Cost of Bad Fit Customers: The $1.2M Churn and Burn to Learn Mistake

Brazil flagTambém disponível em Português por Superlógica

Do you need to churn and burn customers to learn? A lot of people in startups think so. In fact, a lot of people in companies of all shapes and sizes think so.

Think you need to churn and burn through thousands of customers before it starts to have a negative impact on your growth velocity and costs? I’ll show you why that’s just not true.

If you think churning and burning customers so you can learn is the way to go, sit back and let me tell you a fun little story about an expensive lesson that didn’t need to be learned.

In fact, what I’ll share is why startups need to build-in Customer Success from the ground up, and established companies need to bring Customer Success into their universe ASAP.

First, I have to acknowledge what Steve Blank famously said: “Your startup is essentially an organization built to search for a repeatable and scalable business model.”

This means it’s totally accurate to say that, at first, you don’t know what you don’t know.

The problem is that some people use that startup definition as an excuse; a crutch to never have to make a real decision (“we don’t have the data – yet”).

But there are a lot of things you DO know but simply – and to your detriment – choose to ignore.

Ignorance is not Bliss

You might choose to ignore what you know because you don’t think what you know to be true is valid. Perhaps it’s imposter syndrome or the like getting in your way. But whatever the reason, you just don’t trust what you know to be true.

Some ignore these things because they don’t even realize they know it in the first place, usually because they never stopped to think about it. It’s easy to get caught up in the day-to-day grind that is business and never take a step back to think, which makes it easy to overlook the valuable insights sitting right in front of you.

And of course, some people ignore these things not because they don’t know them, but because they need to make the sale so they can get that money!

Maybe it’s a nefarious money grab (certainly, the last one fits into that category), or maybe it’s a misguided, self-persuaded “take care of stakeholders” stretching-a-bit-more-than-you-should money grab.

Either way, it’s a money grab, and one that has a much higher interest rate than you were prepared to pay. This is where the story gets good, y’all.

How Churning Just Three Customers Hurt Growth

I worked with a company that signed three customers whom they shouldn’t have signed.

Those customers did not have Technology Fit (the most obvious of the five inputs into Success Potential), which should have been a non-starter because there was a 0% chance those customers would be successful when the product they’re using is built on a third-party system they don’t use and won’t acquire.

Non. Freakin. Starter. Or it should be, especially if you claim to have Customer Success as your operating philosophy or model.

But they signed those three bad-fit customers anyway. (If you have bad-fit customers – or just aren’t sure – I wrote a whole post on what you need to do ASAP from a Customer Success Management perspective.)

$25k Annual Recurring Revenue (ARR) deals.

Sounds good, right? Remember that. $75k/ARR total.

Make those monies!

So those customers ended up actively canceling (literally working to get out of their contracts, which, in the early days of a startup, were written on the customer’s “paper” – or in their favor – so the contracts were easy to get out of), taking all of the $75k the company had booked with them.

But those three customers also took with them the $75k/ARR from the future 3 or 5 or 7 years that they’d remain a customer, not including any expansion revenue, plus the money spent to acquire (Customer Acquisition Cost or CAC)and serve them.

Starts to add up, right?

Those customers didn’t just end up not making that company any money, but they actually cost money in CAC and cost to serve.

In fact, the cost to serve bad-fit customers is often much, much higher than the cost to serve customers with Success Potential. Companies generally end up diverting resources from the customers with Success Potential who could actually benefit from their attention to those that, regardless of effort, will not be successful.

Anyway… don’t worry, it gets worse.

Those customers also took with them the potential value of all the customers who – because of the negative sentiment they’d create in the market – now wouldn’t do business with my client in the future.

That stings.

Typically, I like to say that when a customer churns, they also take some unquantifiable number of customers that won’t do business with you because of the negative market sentiment caused by all that churn.

But we could actually quantify this… and it’s bad, man. Real bad.

So those three bad-fit customers are gone now. Lessons were learned, and they brought me in to help from there.

And the first thing I had them do was to operationalize the process of no longer knowingly acquiring bad-fit customers.

Learning from Lost Deals

The second thing we did is leverage an outside party to start interviewing churned customers, customers we won (to determine the real reason we won, like “you were 50% of the closest competitor” vs. what they told us), and prospects we lost to competitors.

And it was in those lost deal interviews that the names of the three customers they signed that didn’t have Technology Fit came up time and again.

In fact, over the course of 18 months, the name of those former customers came up 13 times.

13 times!!!

You see, all three of those customers went to the closest competitor at the time and told them about their terrible experience with my client.

Now, if you think the competitor would say, “Okay, thanks for telling me; that’s our little secret,” then you don’t know how things work in the real world.

Instead, the competitor said, “Tell me more,” and got a ton of intel on the way my client did business and used that against them in the sales cycle. And the companies that were angry at my client? They were more than willing to be advocates against them and then advocate for the vendor they favored.

All of this made my client’s sales cycles longer, increased their overall CAC, and decreased the efficiency of that CAC by lowering the annual contract value (ACV) of new customers because of the provisions and concessions required to get customers to commit.

The competitor’s tactic of parading these three failed implementations in front of prospects continued to successfully knock my client out of the running for at least 18 months after those bad-fit customers churned despite the fact that my client’s business practices were far more customer-positive than in the past.

Just Blame Sales?

It’s easy to put the blame on the sales organization or the salespeople that closed those three bad-fit customers.

And yeah, they likely should carry some of the blame; ignorance isn’t a defense.

But I don’t put the blame just on sales; that’s the easy way out.

I blame the sales leadership for focusing so much on hitting their short-term numbers that they were willing to allow their sales people to acquire revenue that would ultimately REDUCE the value of the company (more on this later).

I blame the executive leadership for allowing the sales leadership to let their salespeople get away with closing bad-fit customers.

In fact, if the same executives are knowingly allowing bad-fit customers to be signed WHILE actively investing in Customer Success Management, they’re bad at their jobs. Why invest in people, processes, and systems to make the customer successful when you’re allowing customers without Success Potential to be signed? You’re just setting everyone up for failure. That makes zero sense.

Salespeople should be educated on what a bad fit customers look like, instructed to not sign them, and perhaps even incentivized on post-sale metrics like retention, activation, expansion, and engagement even if those are (and they should be) outside of the sales person’s control.

Most sales people won’t knowingly sign a bad fit customer once they know the customer is a bad fit; but if they’ve never been told, is it their fault or the fault of management?

Calculating the Damage

If the customers that churned had stayed just 3 years, that would have been $225k in recurring revenue total.

Instead, my client got nothing.

That should be quite upsetting.

If you’re wondering… yes, it gets worse.

Those 13 customers that didn’t sign because of those three that churned and spread the negative word – if they were just $25k/ARR deals (and that’s the minimum; they could have been much bigger) and those customers stayed 3 years without expanding their relationship with my client – that’s $325k/ARR, or $975k total, that was lost because of those three customers they churned and burned.

Let me cipher up the bill so far…

Take the $225k from the three customers that churned ($25k * 3 * 3 = 225k), and add the $975k from the 13 that they didn’t sign ($25k * 13 * 3 = $975k).

That’s $1.2M in revenue over 3 years lost that is 100% attributable to those three bad-fit customers that were signed, churned, and burned.

Remember, these were customers my client KNEW were a bad fit but decided, “It’s okay as long as we learn something.”

$1,200,000.00.

And if the average customer lifetime is more than 3 years – and it is now, BTW – that number goes up significantly.

But at least they learned something, right?

Oh, but it gets WAY worse.

Negative Impact on Company Valuation

So what my client lost with those 16 customers (3 churns + 13 losses) was $400,000/ARR.

I’ve detailed before how Customer Success has a direct impact on the value of a company, and in this case the lack of a focus on the customer’s success means, at their 5x valuation multiple at the time, $2M ($400k * 5) wasn’t added to the value of their company!

But they needed to learn, right?

NO!

No, they didn’t need to learn that a prospect that doesn’t – AND is unwilling to – use the base product upon which their product is built is going to fail.

They knew that. That’s a given.

But they chose to ignore it for the short-term money grab.

So, uh… that $25k they ended up getting from those customers hardly seems worth it compared to the $1.2M in revenue and $2M in company value they lost because of them, does it?

Oh, but it gets even worse!

The Hurt Could Actually be 5x Bigger!

Those third-party interviews where the intel on lost deals came from only have a hit rate – on a good day – of 20%.

That means, for every five lost deals contacted, only one will engage with the interviewer.

That means it’s entirely possible that there could have been 65 (13 prospects interviewed * 5) prospects that were lost because of those three that churned. The real number is probably somewhere between 13 and 65… but it is almost 100% guaranteed that it’s more than what we could directly quantify.

And if those 65 lost deals are assumed to be the minimum ACV of $25k and to stay 3 years (without expansion), then the amount of lost revenue could be $1.625M/ARR!

That’s $4.875M in lost revenue over 3 years.

And if you have a valuation multiple of just 5x revenue, then that lost revenue of $1.625M/ARR would also equal a loss of $8,125,000 in company value!

But it was totally worth it to churn and burn those three customers, right?

If you aren’t sure, know this… it gets even worse.

Now the Valuation Multiplier Takes a Hit

All of that negative sentiment they created in the market by churning and burning just three customers didn’t just cost them in revenue and company value.

No, by negatively impacting key metrics that go into the multiplier investors applied to my client’s revenue to come up with the value of the company (churn, CAC, Net Revenue Retention or NRR, total addressable market, market sentiment, etc.), this churning and burning of customers actually negatively impacted the multiplier!

Essentially, the multiplier is the investor’s confidence in the company (or at least the management); if it’s going down, that’s a really bad sign.

So, sticking with the known 16 lost customers, I guess the silver lining is that the multiplier dropped to 4.5x (down from 5x) revenue, so all they lost was $1.8M in company value, down from $2M.

And if you think that’s somehow good, you’re doing it wrong. All of it.

The multiplier reduction means the overall company value went down, too, given that the multiplier applies to all revenue (and not just that which is lost). If they were at $10M in revenue, their company valuation went from $50M to $45M – a $5M loss in value!

At least they learned, right?

Your Company Could Straight-up Die

I didn’t want to take this post to the ultimate logical conclusion because I didn’t want the super-important message contained herein to be overlooked because of hyperbole and bombastic statements.

I know, right? I actually toned this piece down!

But a friend of mine who’s co-founder of a hyper-growth startup  just went through a painful 18-months where they had to reduce their churn in order to even get their next round of funding; a round, by the way, that came with a significant hit to their multiplier.

Here are his words, anonymized for his protection.

Lincoln, I would add something in the comments about our funding process but I would expose very confidential information so I rather tell only you, so, you can use it in the future without mentioning us.

For us, the hit in the multiplier was absurd.

In the beginning, we were thinking about getting 6x forward rev, after all, Slack got 10x forward rev. Very naive perspective. There is only one Slack and every fund is fighting for their deal, that’s not the case for other SaaS companies.

As soon as we started talking to investors we realized that 5x ARR was already something that only very good SaaS companies get.

And when they started analyzing our churn rate, the valuations dropped to 4.5x past revenue! PAST revenue, not FORWARD.

Meaning they didn’t have confidence in us.

Take that lower multiplier and look at the past 12 months revenue – which for a hyper-growth company like ours is around 60% lower than our current ARR – you can see where the math goes.

But as you say, Lincoln… it only gets worse!

For that level of valuation, you’re honestly risking not getting the money at all. You’re simply not a good deal anymore.

And your company can die if you fail to raise funds.

SaaS companies spend a lot of money in R&D, customer acquisition, Customer Success Management, etc.

Without money, they can burn their cash out and die. Even if they get to the break-even, in the SaaS space, most of the time “winners take all” so who cares. Some companies simply can’t stay alive long without growing fast.

Of course, it was not only bad fit customers that led to those difficulties we had, it was an overall failure to operationalize around ensuring success. Our country was in the middle of the worst crisis in 20 years, so a lot of our churn was because customers were literally going bankrupt.

But the majority of our churn was our fault; I think the only reason why we got our round of funding on more favorable terms was because we could restore investors’ confidence in our future by showing them how we’ve implemented Customer Success Management to ensure our customers get the value from us that they initially thought they would

At the end of the day, churn rate and you customers’ success can be the determining factors not only in your valuation but literally in if you live or die as a company.

Yikes.

Flame on!

The moral of this tale is simple: you don’t have to churn and burn to LEARN THINGS YOU (SHOULD) ALREADY KNOW!

And when you do churn a customer, don’t just think that’s the cost of doing business. Learn from it and try not to let it happen again in the future.

Remember, you don’t have to churn and burn THOUSANDS of customers before it starts to have a massive negative impact; this company did it with three, and the impact was huge.

About Lincoln Murphy

I am a Customer Success Consultant focused on Customer Success-driven Growth. I wrote the Customer Success book which you can buy at Amazon. If you need help applying Customer Success-driven Growth principles in your company or would like me to speak at your event, please contact me. Also, connect with me on LinkedIn or follow me on Twitter or Facebook.

Comments

  1. Interesting read, good points, thanks for sharing the story.

    One thing, though, I think you should not calculate in the potential revenue from the three churned companies ($25k * 3 * 3 = 225k) as “the lost revenue” as your whole point is that they shouldn’t have signed them in the first place. So, even if they did the right thing, (i.e did not sign them because of the bad fit) they would miss that revenue.
    So in both scenarios that revenue is non-existent, which is not the case for the other damages you described caused by the bad decision to sign the bad fit customer. 🙂

    Keep up the good work!

    • I agree 100% with your sentiment, but they had booked the revenue so when they lost it, they lost it… regardless of the reason.

      And, there was a cost to acquiring and serving the customers that was very real; if we don’t acknowledge the revenue they lost – from customers they should not have signed – then we can easily write this whole thing off as a non-event. But it was a huge event with massive repercussions.

  2. Eric Messias says:

    A customer that was not successful with your solution is never a good thing. But, when you could avoid that bad experience and do nothing your business is addressed to fail.

    About The amount of revenue lost, I think it can be higher, because we never know how longer that three customers will spread bad words about the business. I’m sure it will be less effective time after time, but we have no guarantee that they will have no more influence.

    #First law: Sell to The right customer.

    Thanks for share!

  3. How do I get this in front of my executive team without it looking like I’m insulting their competence? Since you call Leadership out specifically in this BRILLIANT article.

    • Thanks for the kind words. You could just forward them the article… let me call them out for you.

      Or you could go through the process of identifying the characteristics of a bad fit customer, look at your existing customers and identify those that match your bad-fit criteria (because those will churn soon), do the same for those that have churned, and if possible identify where you’ve lost deals because of churned bad fit customers. Take all of that, quantify the known – and potential – cost and report that to your executive team to show them that you have a problem.

      More on that here:
      http://sixteenventures.com/customer-success-goals

      No matter how you report this to your executives, if they take it as you’re insulting their competence… you may want to go work for a company with better executives!

Speak Your Mind

*