Source: Hunter Witherington, SSM Partners
As SaaS investors, we are often asked by entrepreneurs and others what we think the most important metric is for a SaaS business and what we focus on the most when we evaluate a SaaS company as an investment opportunity. While there is no one single metric that provides a perfect picture of the success of a SaaS company, our experience has taught us that retention, or its opposite – churn – which is calculated as one (1) minus retention rate, is the most telling metric of the health of a SaaS company. In this short write-up, we will focus on why retention is so critical to a company’s success and what it can tell you about your business.
One of the attractive characteristics of a SaaS business is the recurring, subscription revenue model. In its most simplistic form, each year’s revenue consists of two factors: (1) revenue from existing customers and (2) revenue from new customers. If a SaaS company can maintain, or even grow, its existing customer revenue from year-to-year, then each dollar of revenue that a company adds from new customers drives revenue growth. So, revenue retention from existing customers is critical to growth, and therefore value, in a SaaS company.
While I do not intend to delve too deep into the details of retention/churn calculations, I do need to establish some baseline for what I mean by retention. There are several different ways to evaluate retention. Here are the most commonly used metrics and a brief description of each:
- Customer retention – defined as how many customers you retain from one period to the next; for example, you had 100 customers in Year 1 and of those 100 customers, 80 of them were still customers in Year 2, giving you an 80% customer retention rate (or 20% churn rate)
- Gross revenue retention – defined as the percentage of dollars of revenue in one period that renew in the following period; for example, your 100 customers produced $10 million of revenue in Year 1; of that $10 million of revenue, $9 million of it renewed in the following year, or a 90% gross revenue retention rate (10% gross revenue churn); the gross revenue retention metric does not give you credit for revenue growth / upsells from your existing customers
- Net revenue retention – defined as the dollars of revenue generated from customers in the second period relative to the dollars of revenue generated from those same customers in the first period; for example, 100 customers generated $10 million of revenue in Year 1 and those same 100 customers generated $11 million of revenue in Year 2 (even though you lost 20 of your customers following the example above, your remaining 80 customers produce $11 million of revenue in Year 2); in this example, the net revenue retention number is 110% (or -10% net revenue churn); the net revenue retention number factors in the revenue growth / upsells of your existing customer base
Each of these retention metrics is important on its own but looking at all three of them together can shine a light on key business questions and inform important strategic decisions. Using the illustration above, you might start with the premise that 80% customer retention is too low because it means that 20% of your customers aren’t getting enough value out of your solution to renew (or they go out of business, etc.). Then you look at your gross revenue retention rate and realize that you retained 90% of your revenue from one year to the next, even though you only retained 80% of the customers. So on average, you are losing customers who contribute lower revenue to your business compared to the customers you retain. Lastly, you look at the net revenue retention rate and realize that those 80 customers that you retained from last year that did $9 million of revenue grew to generate $11 million of revenue in the following year when you include the upsells and expansions within those 80 remaining existing customers. Some subset of your customer base is consuming more of your product/solution than they were in the prior year and therefore is presumably pleased with the value proposition and ROI that you are providing them.
There is another important observation about evaluating revenue retention/churn that is particularly relevant for companies that have a higher churn rate (above 10%), which typically includes companies that sell to SMBs. Don’t just look at churn as a percentage but also look at it as the actual dollars that you are losing during a period. While a company with a high churn rate may be able to grow at rapid rates when it is smaller because of its ability to add new revenue that is sizeable in proportion to its small revenue base, as the company becomes larger, this high churn rate means that the company must replace a larger portion of dollar revenue each year before it is able to grow. For example, having a 25% churn rate on a $10 million revenue business may be ok if the company is growing at a 100% rate (before churn). In this scenario, losing $2.5 million of revenue to churn (25% of $10 million) but then adding $10 million of revenue from new customers (100% growth on $10 million) results in a SaaS company growing 75%. However, when that same company is $30 million of revenue, it is now losing $7.5mm of revenue (25% of $30 million) to churn, so if it is still adding $10 million of revenue from new customers, the resulting revenue growth is 8% ($32.5 million over $30 million). That’s not so hot.
SSM doesn’t apply a cookie-cutter approach to retention/churn. We do recognize that there are a variety of factors that impact retention/churn and that the most important retention metric for one company might not be the most important for another. In fact, there are many other variations of retention that you can run by segmenting customers by size (SMB vs. Enterprise), industry (retail vs. healthcare), when they became a customer (2014 vs. 2015), etc.
This gets to the main point that I want to emphasize. Retention is not simply a financial metric. In addition to the pure financial benefits of having strong customer/revenue retention which drives revenue growth, retention metrics and the underlying data needed to calculate them can inform critical business decisions and drive business strategy. While each company is unique and therefore you can’t necessarily apply the same learning from company to company, below are several different questions that we’ve been able to glean insights into based on studying a company’s retention metrics:
- How strong is your value proposition and ROI to customers?
- How sticky is your solution / how difficult is it for a customer to leave you?
- How should you segment your customers and who should your target customer be?
- What industry verticals find your product/solution the most valuable?
- How competitive is your market and what effect is competition having on your company?
- How much pricing power do you have with your product/solution (or pricing weakness)?
- How good is your account management and/or sales organization at upselling your customers?
- How happy are your customers with your service and support functions?
So, I would encourage you to focus on retention, not simply to improve a financial metric, but to dig deep into the heart of your customer/revenue base to figure out what you can learn about your company from the data. You might be surprised by how much you can learn!
About SSM Partners. SSM has partnered with talented entrepreneurs for more than 25 years. The growth equity firm invests in rapidly growing companies that have proven and differentiated software, technology, or healthcare business models. Starting with a relationship built on trust, SSM offers its entrepreneur-partners a thorough understanding of the growth company lifecycle and a collaborative approach to building great businesses. Learn more at www.ssmpartners.com.
About Scale Finance
Scale Finance LLC (www.scalefinance.com) provides contract CFO services, Controller solutions, and support in raising capital, or executing M&A transactions, to entrepreneurial companies. The firm specializes in cost-effective financial reporting, budgeting & forecasting, implementing controls, complex modeling, business valuations, and other financial management, and provides strategic help for companies raising growth capital or considering M&A/recapitalization opportunities. Most of the firm’s clients are growing technology, healthcare, business services, consumer, and industrial companies at various stages of development from start-up to tens of millions in annual revenue. Scale Finance has multiple offices in the Carolinas including Charlotte, Raleigh/Durham, Greensboro, and Wilmington with a team of more than 45 professionals serving more than 130 companies throughout the region.