The success of any SaaS business relies on the power of recurring revenue. As more paying users activate accounts and remit recurring payments on an annual or monthly basis, their combined value to your business grows exponentially.
It's one of the reasons the subscription business model is so popular.
However, it also works the other way: the same conditions that cause this rise can also cause a great fall when existing customers churn out. Experience enough ongoing churn, and your monthly recurring revenue (MRR) will take an exponential hit.
Churn has many sources. A glitchy product, unresponsive support team, or even failed payments can all send customers out the door.
However, another too-common source of churn is simply bad-fit customers.
What is a bad-fit customer?
A bad-fit customer is one who won’t be able to realize the full value of your product or service. This can happen for many reasons:
- Your offering only meets some of their needs. You offer a traffic plug-in; they need a robust, real-time route-planning system. They need what you offer, but also much more. This leads to disappointment, frustration, and/or eventual churn when they find a better solution for their needs.
- They only need part of what you offer. You offer a real-time route-planning system; they just need a traffic plug-in. They’re paying for a lot more product or service that they’re not using, which can lead to resentment, frustration, and eventual churn when they find a better solution for their needs.
- They don’t see–or refuse to see—the value you offer. These hesitant customers may haggle about their subscription cost and ask to pay less since they aren’t using certain features or services. They might benefit greatly from using the whole suite of offerings they’re already paying for, but they can’t or won’t acknowledge that. They have a low perceived value of your offering.
Clearly, none of these situations are great for building future revenue. In a nutshell, bad-fit customers and the churn they cause undercut growth and hobble your ability to scale.
How exactly do bad-fit SaaS customers impact recurring revenue?
Bad-fit customers are a major drag on the bottom line of businesses operating on a recurring revenue model. They also tend to cost more to acquire and onboard than they contribute in payments, sinking your customer lifetime value (LTV) and taking your recurring revenue with it.
Let’s dig into the nitty-gritty details. Here are five impacts of bad-fit customers on your long-term recurring revenue:
1. Increased costs.
Customer acquisition already requires investment. In fact, SaaS businesses generally spend approximately 30% of their annual recurring revenue (ARR) on marketing and sales. If that budget goes into bad-fit customers, however, the spending never stops.
Once you sign a bad-fit customer, what happens?
After activating their account, they need to be onboarded, which costs more money as time and resources are being used. Then, because a bad-fit customer isn’t deriving full value from your product, they’ll inevitably contact customer service and support—more departments that will need a bigger budget if these calls become the norm.
You could possibly invest even more into product development to meet this customer’s needs. Most likely, however, this won’t happen fast enough for the customer. They’ll churn out, taking their recurring revenue potential with them.
2. Poor LTV to CAC ratio.
We’ve already talked a little about how churn affects customer acquisition cost (CAC) and lifetime value (LTV). As a direct result of the situation described above, overall LTV begins to drop when bad-fit customers start churning.
Customer LTV is often simply calculated as the product of average customer spend and average customer lifespan. However, a more accurate formula takes into account CAC. This provides a better picture of recurring revenues and actual profit.
For this reason, many SaaS business leaders and investors look to the LTV to CAC ratio as an indicator of profitability. According to Kilpfolio, an ideal LTV to CAC ratio for SaaS businesses is 3:1. Too much lower, and you’re spending too much. Closer to 5:1, and you’re spending too little.
A poor ratio gives your business a lower valuation and makes it less attractive to outside investors. To keep a healthy ratio, avoid bad-fit customers who churn out and drag this ratio down.
3. Strain on customer success.
The human impact of bad-fit customers can’t be ignored. Your customer success team will bear the brunt of the impact, fielding calls, emails, and chat requests from customers who were never destined to be satisfied with your offering.
This can wear down employee energy and morale, not to mention create a demand for more team members in customer success, potentially even leading to resignations over time. You’ll spend money trying to attract new candidates and make new hires.
Little by little, those costs dig away at profits. At some point, recurring revenue from good-fit customers won’t be able to outweigh these effects.
4. Secondary effects of churn.
High churn rates from bad-fit customers not only affect recurring revenue, but they also have an impact on your SaaS business’s ability to scale.
Much like your LTV to CAC ratio, too-high churn rates make your business less attractive to investors. This prevents your business from making the most of opportunities to grow.
Churn also has other effects, however, eating away at your business from the inside. Brad Davis at ESG explains how churn leads to lowered morale for both employees and managers alike:
“Employees at any level, and from any department, regardless of their relationship to your product or service, can become anxious and quit, or emotionally log out from the effects of a high churn rate. Poor performing SaaS offerings that churn at high rates don’t give employee[s] the warm fuzzies about their year-end review or their career trajectory, and thus customer churn can lead to higher employee churn, fueling additional company costs.”
If you don’t think that will impact your recurring revenue, perhaps seeing how bad-fit customers affect your audience’s perceptions will…
5. Harmed business reputation.
Review culture is on the rise, and it has financial impacts. Prospective customers rely as much, if not more, on reviews from existing or previous customers to inform purchasing decisions. In fact, 93% of customers read online reviews before buying a product.
If your bad-fit customers end up leaving negative reviews online or telling colleagues about the bad experience they had with your business, that’s going to have an impact, even though it’s not the fault of your employees or product. You’ll see your CAC go up trying to counterbalance the effects of bad-fit customers driving new ones away.
Good-fit customers, by contrast, leave great reviews. This can help influence higher acquisition rates and makes it a lot easier to attract new customers that generate more recurring revenue.
But recurring revenue isn’t the only thing at stake as a consequence of a major hit to reputation—it can also lead to huge customer losses, such as DirecTV experienced after AT&T's lackluster attention.
Tips to avoid selling to bad-fit customers
To conserve your efforts and save on costs, here are a few tips for avoiding bad-fit customers:
- Create an ideal customer profile (ICP). Knowing exactly what a good-fit customer looks like makes it easier to know exactly who sales and marketing should tailor messaging to.
- Train your sales team to recognize good-fit and bad-fit customers. You can even incentivize good-fit acquisition by offering bonuses to customers that stay signed up for a certain length of time.
- Interview churned customers, lost prospects, and satisfied customers to inform your ICP. Who benefits the most from your offering? The least?
- Calculate your prospects’ success potential. This means looking at their technical fit, functional fit, resource fit, competence fit, experience fit, and cultural fit. Use data to recalibrate these fit metrics as needed.
- Focus on great leadership. It’s easy to blame sales representatives for an abundance of bad-fit customers, but the reality is that it falls to leadership to outline who is a good fit, who is a bad fit, and how to identify the difference to avoid signing bad-fit customers.
Finally, watch for trends in your sales. You want a sales cycle that consistently closes deals or sends people on their way in a reasonable time. Sales shouldn’t drag on trying to convince prospects that your offering is a perfect match if it isn’t.
Draw data from your tech stack to avoid bad-fit customers and increase recurring revenue
Software such as Fusebill’s subscription billing platform provides subscription businesses with insights into who their best customers are.
Inform the creation of your ICP by seeing which customers generate recurring revenue in large amounts or sign up for additional features and functionality. Generate reports that reveal customers providing the smallest amounts of average revenue and may be likely to churn.
These reports can help define customer cohorts, digging into details like the sizes and industry types of your top customers. In the right hands, this data leads to more informed sales decisions, better-fit customers, and more predictable revenue for your business.