Introduction to B2B SaaS Net Revenue Retention

In this post, we provide an overview on net revenue retention including an explanation of why various types of retention are important, how to calculate gross and net revenue retention, and suggestions on how to improve net retention.

Table of contents:

Intro to net revenue retention | Definition of terms | How is net retention calculated? | Net retention benchmarks | Business impact | Challenges of net retention | How to improve net retention | How to analyze net retention | Takeaways |

Introduction to net revenue retention

What is net revenue retention?

Net revenue retention (NRR) is a metric that tells the revenue story of a cohort of customers during a specific period of time, generally a year. However, most organizations calculate this metric on a quarterly basis and share the results with their board of directors. It has become a key metric for SaaS businesses to track, as it tells the full revenue contraction and expansion story of your existing customer base. It also provides a starting point for deeper analysis of how acquisition and retention strategies are performing. The equation takes into account expansion through upsells and organic growth, as well as contraction through churn or downgrades.

NRR = (prior period revenue + revenue expansion - revenue contraction) ---------------------------------------------------------------------------------- prior period revenue 

Net revenue retention may also be referenced as net dollar retention (NDR) or dollar retention rate (DRR).


Why does net revenue retention matter?

Net retention is important because it demonstrates to investors that a SaaS company is growing in a healthy and sustainable manner. Companies with high net retention rates are helping clients get value from their service and these clients are continuing to invest in the partnership (thus creating organic growth).

Net revenue retention is exponentially valuable to long-term business growth by summarizing the impacts of both gross retention and expansion. It is particularly important to companies reliant on recurring revenue and subscription, such as software as a service. It’s either a dividend or a tax that you pay on every group of customers that you acquire, and the more customers you acquire over time, the more this adds up.

Finally, companies with high net retention can wield this as a competitive advantage. One important decision that companies face is how much to invest in sales and marketing expenses. Net retention plays an important role, because companies with higher net retention have higher customer lifetime value, which allows them to justify a greater investment in upfront customer acquisition.

Definition of terms

Attrition, churn, turnover: The loss or non-renewal of a customer.

Expansion revenue: Growth through the purchase of additional products or services.

Gross churn: The loss of existing customers and their associated recurring revenue for contracted products or services during a particular time period (such as a month or a year).

Leaky bucket metaphor: This metaphor explains the acquisition and retention cycle that SaaS companies experience. The larger the holes in your bucket from churn or downgrades, the more water must constantly be added (e.g. acquiring new customers, upsell, cross sell, organic growth) to keep the total customer base (waterline) moving up.


Negative churn: Growth from your install base that offsets any losses.

Net churn: The amount of revenue lost after taking into consideration new, upsell, or expansion revenue for the same cohort and time period.

Retention: The ability to renew and keep a customer over time.

SaaS quick ratio: This is the “back of the envelope” version of net revenue retention, in that it captures a company’s new + expansion MRR  / churned + contraction MRR x 100. Achieving a SasS Quick Ratio of 4 is a good benchmark for young, high-growth companies, but the equation changes as those companies reach scale.

How is net revenue retention different from gross revenue retention? Gross revenue retention only looks at the loss of recurring revenue (i.e. holes in the bucket) for a specific cohort of customers during a set time period. This number cannot be greater than 100%. This metric measures revenue decreases such as price (e.g. write downs due to RFP), downgrades, and customer losses.

Net revenue retention includes all the revenue decreases listed above and factors in cross-sells, up-sells, organic growth within a customer account, and price increases. If this number is above 100%, congratulations! Your customer base is growing.

How to calculate net revenue retention

The equation for calculating net revenue retention is NRR = (prior period revenue + revenue expansion - revenue contraction) / prior period revenue 

Here’s a fictitious example from ACME Corp.

In year 2, Acme retained 220 of their 250 initial customers. Year 1 revenue = $5,000,000

Year 2 revenue expansion = $640,000 Year 2 revenue contraction = $450,000 NRR = ($5,000,000 + $640,000 - $450,000) / $5,000,000 Acme’s net revenue retention for Year 2 is 104%


Why don’t more companies use net retention as a standard metric? While net revenue retention offers insight into a company’s performance, accessing the metric can be challenging at some organizations.


Net retention is not defined by Generally Accepted Accounting Principles (GAAP) standards, but is used by SaaS companies and venture capitalists in determining how a management team is growing the business. Because it assesses a specific cohort of recurring revenue, net revenue retention is a hard to derive metric and is calculated by finance teams. Your team may look at net retention by month, quarter, or annually, and may have different definitions for each of the elements in the equation.

Some companies which sell products and services may only report on recurring revenue from product or software sales. Churn is most often defined by the date the subscription ends and a renewal doesn’t happen, but some teams may look at churn based on the date of the cancellation and final payment. Get a clear understanding of how your finance team is pulling data as you consider this metric.

Benchmarking net retention rates

What are good or bad net revenue retention rates?

Saas Capital issues an annual report that reflects benchmarks for SaaS companies. They report that “for established SaaS companies, net revenue retention typically ranges from 60% (really bad) to 150% (really good), while earlier stage companies can see even higher numbers. Across all SaaS companies, the 2020 median net retention is 100%, and median gross retention is 90%, consistent with prior years’ data.” They recommend benchmarking your company based on your average contract value (ACV), as sales and implementation cycles are often similar for companies with similar ACVs.

Source: SaaS Capital 2020 Benchmark Report


What are some examples of net retention rates of publicly traded SaaS companies?

Crunchbase analyzed publicly traded SaaS companies at their IPO and compared it to their net dollar retention in this November 2018 chart.

We already track our monthly churn rate and the number of customers who churn- isn’t that enough? Monthly churn by revenue and by number of customers are a good point in time metrics. So is logo churn (the loss of a customer’s logo from your lineup).


How does customer lifetime value fit into this?

Average customer lifetime value is the amount of revenue the average customer generates before churning. Retaining a customer over time increases their lifetime value.

The business impact of high net retention

New logos and new annual recurring revenue only tells part of the story of the health of your business and how well your product is being adopted. Typically the higher the net retention, the faster the overall company growth rate and therefore company valuation. Customer acquisition cost, net new ARR growth, and gross margin are other important variables that determine company valuation.


Profitability and unit economics

If your customer never churns, their lifetime value (LTV) is infinite. Of course, customers do churn, which makes the sunk cost of acquisition, implementation, and ongoing support for new customers important to consider. From a customer acquisition cost perspective, it often takes SaaS companies six to twenty four months to recoup their investment. If the customer churns within that window, the cost of acquiring the customer could potentially be greater than the revenue generated during the term of the relationship. This would represent a net loss to the firm and explains why both net retention and customer acquisition cost are critical metrics for the management team to manage. A commonly cited statistic is that it costs 6 to 7 times more to acquire a new customer than retain an existing one.


Acquisition

In some cases, the net revenue can be used to justify increased spend on customer acquisition — if a business consistently has annualized net dollar retention of over 140+% each quarter, it could be a good idea to spend more on customer acquisition, even if the paybacks are ~18+ months. If a business has low net dollar retention (<75%) they should probably spend less on acquiring new customers and assess why their current customers are churning and/or spending less. Atlassian was able to show in their S-1 that $1 of spend in year 1 would become $7 of spend by year 5, on an indexed cumulative basis.


Source: @AlexFClayton


Valuation Saas Capital states that “for every 1% increase in revenue retention, a SaaS company’s value increases by 12% after five years. Net new revenue from the right customers, lower cost acquisition, plus ongoing customer retention and expansion translates to long term business growth.



Analyzing and improving upon net retention


How to analyze net retention issues

Net revenue retention is a diagnostic metric that highlights the levers impacting the growth of the install base. Actions that “keep the water running” include acquiring net new customers and expanding MRR from existing customers via organic growth and add-on product bookings. Actions that help retain MRR include ensuring a strong product-market fit that results in organizational alignment, a high value exchange, and product/ feature usage. Customers churn for a variety of reasons, but some of the most common include:

  • Low product adoption

  • Sponsor or champion leaves

  • No return on investment / low value

  • Stalled or incomplete implementation / lack of training

  • Gaps in product or customer’s expectation of the product

  • Performance issues

  • Poor customer service

By assessing each step in the prospect to customer to renewed customer journey, go to market teams can make incremental improvements to their net revenue retention.


How to improve net retention

A company with poor gross retention, but strong expansion revenue could have the same net revenue retention ratio as a company with decent retention, but little organic growth or upsell opportunities. That’s where macro and micro analysis of your net revenue data points comes in.


As a general rule of thumb, if your SaaS company does not have add-on or expansion products to sell, it will be more difficult to have net retention rates above 120%. However, some SaaS companies may be able to achieve greater than 120% net retention rates if they have a component of their licensing model that is based on usage. In this scenario, increase in revenue would be driven by organic growth.


Improve net retention as a company

  • Everyone at the company is responsible for net retention, however, most people don’t understand the metric and how their actions contribute,

  • Explain net retention during an All Hands, share the annual target internally, and explain actions that will be taken to improve retention and growth,

  • Assign an executive leader with accountability for a cross-functional net retention goal.


Improve net retention as a go-to-market team

  • Focus on your best customers (which will hopefully align with your ideal customer profile),

  • Convene a cross-functional team from marketing, sales, product, and CS to align on how you’ll address net retention. A few (of the many) diagnostic topics to cover:

  • Which ICPs have the highest LTV?

  • Which high value features are driving the value exchange with your customers?

  • How long is the onboarding process? Time to first value?

  • What is your customer health by vertical?

  • Set clear NPS or CSAT goals. Ask for NPS or CSAT feedback at key points in the prospect to customer journey, and act on areas of improvement.

  • Continually talk face to face with customers. Record your conversations, share a summary with your GTM team.

  • Identify what “first value” is for your customer, and how long it takes for them to get there. Be maniacal about improving that metric.

Resources


Benchmarking

Many of the top venture firms offer annual benchmarking data:

Insights

Some of our favorite articles about net retention include:



Takeaways


Enduring companies must generate predictable and repeatable earnings. Having a clear understanding of your ideal customer and focusing on exceeding their expectations is an investment in your long term growth. A one point increase in your net retention number can have a dramatic impact on your company valuation. Focusing on net revenue retention can save your company money, while increasing revenue and customers’ lifetime value.


While most SaaS leaders know the importance of net retention, they may not have a strategy for improvement. Need help in assessing and optimizing your retention strategy? We can help! Contact us for a free initial consultation