A company that sells a program on a disc is paid once. A company that sells the same program as a subscription is paid every month, for as long as the customer stays. That single change, from a sale to a relationship, explains why software-as-a-service businesses talk about churn, retention and lifetime value so much more than about units sold.
What the key terms mean
Stripe, whose payment tools underpin many subscription businesses, publishes plain definitions that most investors and operators share.
- MRR, monthly recurring revenue, is the predictable revenue expected each month from active subscriptions, excluding one-time payments and professional services.
- ARR, annual recurring revenue, is the usual shorthand for MRR multiplied by 12.
- Churn comes in two forms. Customer churn is the percentage of users who cancel. Revenue churn is the percentage of recurring revenue lost to cancellations.
- Net revenue retention compares revenue today from the customers you had at the start of a period, after cancellations, downgrades and upgrades. Above 100 percent means existing customers are spending more in total, even after some leave.
- CAC, customer acquisition cost, is the total sales and marketing cost of winning customers in a period divided by the number won.
- LTV, lifetime value, is what a customer is worth over the whole relationship, built from revenue per customer, how long they stay and the margin earned.
Companies define some of these slightly differently, and Stripe’s own guides give more than one version of LTV, so comparisons between businesses need care.
A worked example
The numbers below are invented to show the arithmetic. Imagine a plan priced at 50 dollars a month, with 5 percent of customers cancelling each month.
- If 5 percent leave each month, the average customer stays about 20 months, since lifetime is roughly 1 divided by 0.05.
- Over those 20 months, a customer pays 1,000 dollars.
- If serving the customer costs 20 percent of revenue, gross profit is about 800 dollars.
- If winning each customer costs 300 dollars in sales and marketing, the ratio of gross-profit LTV to CAC is about 2.7.
- Monthly gross profit per customer is 40 dollars, so the 300 dollars is earned back in about 7.5 months.
Stripe offers rules of thumb for judging such numbers: an LTV-to-CAC ratio of 3 or more suggests growth is probably sustainable, and CAC payback of 12 to 18 months is typical for healthy SaaS companies. It also cautions that its payback formula uses revenue, while many analysts use gross profit, which gives a longer and more conservative figure. Here the example comes in just below the 3 mark, and nothing in a rule of thumb replaces looking at the real business.
Why churn dominates the math
Churn works like a leak in a bucket: new customers must first replace the ones who left before they add any growth. Even modest-sounding monthly rates compound. At 5 percent a month, roughly 46 percent of a group of customers is gone within a year. That is why improving onboarding, support and the product’s value to existing users often does more for growth than spending the same money on marketing.
Net revenue retention captures the other half of the story. A company whose existing customers expand their plans faster than others cancel can grow even if it adds nobody new, which is why Stripe notes that leaders often exceed 120 percent.
Where the model goes wrong
A few patterns recur in struggling subscription businesses:
- Acquisition that costs more than the customer will ever return.
- Healthy-looking revenue that hides a falling customer count, because a few large accounts are growing.
- Heavy discounting that attracts customers who leave when the price normalizes.
- Weak onboarding, so that customers never reach the moment when the product pays off and cancel early.
Investors scrutinize exactly these ratios when deciding whether to back a company, as described in our guide to startup funding rounds. The same measures matter to tiny companies, including solo founders running a single product, since a small business with a leaky bucket never gets bigger.
This is general information, not financial, investment, tax or legal advice.
