Net Retention: The Most Important Metric For Ensuring Medium and Long-Term SaaS Business Health
In my last post, I talked about understanding the ‘behavior’ or characteristics of your SaaS company’s revenue and the importance of analyzing each element. Understanding and analyzing your revenue elements focuses on those elements that present the most opportunity and challenges and directs your efforts to those with the most significant impact on your top-line growth. In this post, I will focus on the metrics related to Revenue Retention because of the direct correlation between Revenue Retention and overall revenue growth.
Our friends and recognized SaaS experts, SaaS-Capital (www.saas-capital.com), have been conducting an annual survey of SaaS companies for many years. Their research has shown that “because of the compounding effect on growth, Revenue Retention is now established as the most important metric for ensuring medium to long-term business health.”
The following graph from SaaS-Capital’s blog post on “Growth and Revenue Retention in a SaaS Business” shows the direct correlation between Revenue Retention and revenue growth:
Evaluating Revenue Retention
Given the direct correlation between Revenue Retention and overall revenue growth, it makes sense that businesses looking to increase their valuation would be laser-focused on Revenue Retention metrics. The reason that well-run SaaS businesses command high revenue valuation multiples is their ability to deliver consistent year-over-year revenue growth. To do that, they must be good at three things:
- Acquiring new customers
- Increasing the revenue value of those customers over time
- Retaining those customers for a long, long time.
Revenue Retention is the measure of a company’s ability to deliver on the last two of those activities – continued revenue growth in its installed customer base and maintaining long-lasting customer relationships.
Distinguishing Between Gross Revenue Retention and Net Retention
When evaluating Revenue Retention, it is essential to distinguish between Gross Retention and Net Retention. Net Retention is the most comprehensive measure because it incorporates all the events that impact revenue from existing customers – expansion, contraction, and churn. Gross Retention is also an important metric because it specifically measures how much MRR is lost from customers not renewing or continuing their subscriptions. If Gross Retention is ignored in favor of looking just at Net Retention, robust MRR expansion in the base of retained customers can mask an underlying problem with Churn. However, because Net Retention is the most comprehensive metric, I will focus the rest of my post on that.
Evaluating Net Retention
Net Retention is the measure of the total change in recurring revenue from a group of customers over time. The following illustrates the calculation in its simplest form:
Current MRR from a group of customers/MRR from the same group of customers from a prior period (month, year, etc.)
Let’s look at a cohort of ten Customers to illustrate the calculation.
- MRR for each Customer one month ago was $450, totaling $4,500.
- One Customer failed to renew in the current month, resulting in $450 lost MRR.
- Current month MRR for each of the remaining nine customers is $550, totaling $4,950.
- Net Retention for the cohort of ten customers is Customer A is 110% ($4,950/$4,500)
The goal is a number in excess (hopefully well in excess) of 100% because this indicates you are retaining customers and increasing the revenue from them over time. If it’s less than 100%, that means the recurring revenue from your installed base is shrinking. If you have a healthy Net Retention opportunity in your product offering, that helps balance the effort needed to achieve revenue growth targets between new business and your installed base of customers. If you target 30% year-over-year ARR growth and rely on Net Retention to deliver a third of that, then that takes a lot of pressure off the new business sales effort. Correspondingly, if Net Retention is less than 100%, part of your new business sales effort is spent just getting back to breakeven on your revenue growth target curve.
In the example above, Net Retention is over 100%. So, all’s good, and we can move on, right? Not so quick. As with most things, the devil lives in the details, and understanding the details of your Net Retention calculation is critical because not all Net Retention numbers are created equal. Recall, Net Retention measures a company’s ability to retain customers over time and increase the revenue earned from those customers.
The Components of Net Retention
The components of the Net Retention are:
- MRR Expansion – Additional revenue earned through upselling, cross-selling, price increases, and organic growth
- MRR Contraction – The reduction in MRR due to price decreases and decreased customer usage (e.g., fewer subscribers, reduction in modules used, etc.)
- Churn – MRR lost due to customers not renewing their subscriptions
I will cover the above components in more detail in my next post. For now, let’s focus on what you can overlook if you don’t understand the parts of the Net Retention calculation. The following is an example of two different companies with the same net retention result of 110%.
|Company A:||Company B:|
|Beginning MRR for selected customers||$100,000||$100,000|
So, while Company A and Company B have the same Net Retention, achieving this same result is accomplished very differently. Company B’s higher Churn rate requires it to generate more Expansion MRR from its remaining customers to maintain 110% Net Retention. There are several questions Company B should consider, including the sustainability of 22.5% MRR Expansion and efforts to reduce Churn. Company A is performing well by limiting Churn and may want to evaluate options for increasing Expansion MRR.
The message here is to spend the time evaluating the elements of your revenue and understanding what they are telling you about your business. That’s what successful SaaS businesses do – focus relentlessly on results.
If you are a SaaS organization and need help with your metrics, we are here to help.
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