Latest / The Acquisition Talk with Fexingo: Mergers, Buyouts, and Business Sales for Operators / How Customer Churn Erodes M&A Valuations
Transcript
- Lucas: If these conversations have moved your work forward in some small way, consider supporting the show directly. It keeps the ad-free experience running and helps us dig deeper into cases like the one we are discussing today. Luna: Right, and if that resonates with you, the link is buy me a coffee dot com slash fexingo. It really does help sustain what we do here. Lucas: Thank you. Now, let’s get back to it. We have spent plenty of time talking about tax traps, earnouts, and working capital adjustments in previous episodes. But there is a silent killer of deals that rarely makes the headline: customer churn. Specifically, how sellers misrepresent the stability of their recurring revenue streams, only for buyers to discover the truth during due diligence. Luna: That feels like the perfect segue because churn is often treated as a vanity metric in marketing decks, but it is actually the heartbeat of any subscription-based valuation. Lucas: Exactly. And the problem is not just that customers leave. It is that sellers often conflate gross add-ons with net stability. I want to walk through a recent transaction involving a mid-market enterprise software provider. Let’s call them DataStream Solutions. They were selling for roughly eighty million dollars based on a multiple of their trailing twelve-month revenue. Luna: So they were selling on top-line growth rather than profitability? That is common in software, but it usually implies high reinvestment needs. Lucas: Precisely. On paper, DataStream looked fantastic. Their annualized recurring revenue had grown twenty-two percent year-over-year over the last three years. The pitch deck highlighted new logo acquisitions aggressively. But when the buyer pulled up the contract-level data, the story changed completely. Luna: I am guessing the new logos were coming at a steep discount or from a segment that was highly volatile? Lucas: It was worse. The new logos were mostly from small businesses with short contract terms and high cancellation rates. Meanwhile, their legacy enterprise clients, which made up sixty percent of their revenue, were quietly churning. The average tenure of those accounts had dropped from five years to two and a half years over the past eighteen months. Luna: That is a massive red flag. If your core base is leaving while you chase volume elsewhere, your unit economics are probably collapsing. Lucas: They were. The buyer’s team dug into the net revenue retention metric. In a healthy SaaS business, you want that number above one hundred ten percent. It means that even without adding a single new customer, your existing customers are spending more through upsells and cross-sells. DataStream’s net revenue retention was sitting at ninety-four percent. Luna: Ninety-four percent means the pie is shrinking every quarter regardless of new sales. That effectively destroys the compounding effect buyers pay premiums for. Lucas: It does. And here is where it gets interesting for operators. The seller argued that the churn was temporary, caused by a brief integration hiccup after a prior acquisition. But the data showed the attrition was concentrated in specific product modules that the buyer knew were becoming obsolete. This wasn’t noise; it was a structural decline. Luna: So the buyer didn’t just walk away? They used that leverage to reprice the deal? Lucas: They did. The final valuation was cut by fifteen percent. That is twelve million dollars vanishing from the table because of a metric that should have been visible in month one of diligence. The lesson here is that gross revenue growth can mask underlying rot. Buyers are increasingly looking at backward-looking churn trends, not just forward-looking forecasts. Luna: This highlights the importance of distinguishing between voluntary and involuntary churn too. Involuntary churn from payment failures is an operational fix, but voluntary churn is a product or market fit issue. Lucas: Spot on. In the DataStream case, about forty percent of the churn was voluntary. That part cannot be fixed by tweaking billing processes. It signals that the product was losing its competitive edge. For sellers, this means you cannot hide behind total revenue numbers. You need to be able to defend your net retention rate and explain the cohort behavior of your customer base. Luna: Do you think this trend of hyper-focused churn analysis is going to become standard across all asset classes, or is it mostly limited to software and subscriptions? Lucas: It is spreading rapidly. Even in service-based businesses, we are seeing buyers look at client renewal rates as a proxy for health. If you sell professional services, your ability to retain key accounts becomes your version of net revenue retention. The mechanics differ, but the principle is identical: stability drives multiples. Luna: So for a founder preparing to sell, auditing your own renewal pipeline six months before launch would be critical. Lucas: Absolutely. I would recommend running a cohort analysis on your last three years of customers. Identify where the drop-offs happen. Is it month six? Month twelve? If you see a cliff at the one-year mark, you need a narrative for why that exists and what you have done to address it. Silence on that front is a liability. Luna: And if the data shows a genuine problem, should sellers try to fix it pre-sale or disclose it upfront? Lucas: Fix it if you can. Show the buyer that the interventions are working. If you can demonstrate that churn has stabilized in the most recent quarters, that provides proof of concept. It shifts the conversation from historical failure to current trajectory. Buyers pay for momentum, not just past performance. Luna: That makes sense. Momentum is what you are ultimately selling. You are transferring the expectation of future cash flows. Lucas: Exactly. And when that expectation is clouded by uncertainty, the discount rate goes up, or the multiple comes down. It is a simple financial reality. We see this in private equity too. PE firms are now building internal models that stress-test churn scenarios much more rigorously than they did five years ago. Luna: They are treating churn like interest rate risk. A variable that can swing the entire return profile. Lucas: Yes, and that analogy holds up well. Just as a borrower needs to prove they can service debt in rising rate environments, a seller needs to prove they can retain revenue in shifting market conditions. It is about resilience. Luna: What about the role of customer concentration in this discussion? High churn combined with a few large accounts can be deadly. Lucas: It amplifies the risk exponentially. If your top three customers represent thirty percent of revenue and one of them churns, you lose a third of your baseline overnight. In the DataStream deal, the buyer found that two of the largest accounts had ambiguous renewal terms. They were technically on month to month contracts despite long histories. That lack of commitment was a major friction point. Luna: month to month contracts for legacy enterprise clients sounds like a governance failure on the seller's part. Lucas: It usually is. It suggests a lack of discipline in contract management or a fear of locking customers into longer terms because the product isn't sticky enough. Either way, it signals weakness. Smart sellers ensure their enterprise contracts have clear multi-year terms with defined exit clauses. It provides predictability. Luna: Predictability is currency. When you can predict cash flow, you can price the business higher. Lucas: Precisely. So, to wrap this up for our listeners: if you are an operator thinking about a sale, stop looking at your top line alone. Look at your net revenue retention. Look at your voluntary churn rate. Look at your contract lengths. These metrics will dictate whether you walk away with a premium or a haircut. Luna: And for buyers, never accept the aggregate number without drilling into the cohort details. The devil is always in the renewal data. Lucas: Agreed. It is easy to sell growth. It is much harder to sell stability. But stability is what sustains value over the long term. As we move further into this quarter, expect to see more deals priced on these fundamentals rather than pure revenue expansion. Luna: It seems like the market is finally maturing in how it assesses subscription assets beyond the initial hype cycle. Lucas: It is. And that maturity benefits everyone who takes the time to build a truly resilient business model. What do you think is the next metric that will come under scrutiny as we look toward the end of the year?