The Cost of Bad Fit Customers: The $1.2M Churn and Burn to Learn Mistake
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.
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.
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.
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.
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.
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.”
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.
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?
The moral of this tale is simple: you don’t have to churn and burn to LEARN THINGS YOU (SHOULD) ALREADY KNOW!