How best in class SaaS improve growth and profitability by focusing on retention
While many SaaS companies only track one or two retention rates, best in class companies (best in class companies maintain top quartile growth rates) track three retention KPIs: Net Revenue, Gross Dollar, and Customer Retention rates. These three KPIs give companies different information about their customer base, sales and productivity. In combination, the three retention metrics deliver a multi dimensional view on growth, customer health, and customer satisfaction. Viewed together, they provide a stronger foundation for revenue forecasting, growth opportunities, as well as delivering important information to diagnose weaknesses in a company’s sales and customer success.
Investors over the past couple of years have mostly focused on Net Revenue Retention (NRR) to the point where NRR became something of a vanity metric. Top investors, however, track all three retention KPIs in diligence and with their portfolio. After revenue/ARR growth rates, retention rates are the second most important metrics for valuations and defining a path to value creation.
We’ve written before about the dangers of over-indexing on NRR (Don’t Over-Index on SaaS Net Dollar Retention); let’s review how tracking and benchmarking all three SaaS retention KPIs drives growth and profitability.
NRR (or NDR if operating in dollars) Does Not Tell the Whole Story
NRR measures the percentage of recurring revenue retained over a specific period. NRR captures lost revenue due to customer attrition, reduced usage, or decreasing subscription levels, offset by increased revenue from existing customers through up-sells, cross-sells, price increases, or increased usage. The term “net” is used because lost revenue is “netted” against expansion revenue. NRR tracks the net recurring revenue renewed with existing customers.
For example, if $10 million worth of contracts were up for renewal with 100 customers but 20% of customers churned, and of the 80% of customers retained, the net value of their subscription contracts is $9.5M, then the NRR for this cohort is 95%. In this example, the customer retention rate is 80%. However, if only looking at NRR alone, management does not know that 20% of customers churned. Customer churn can also be interpreted as 20% of the customer acquisition investment has been lost and replaced by only 5% net increase in contract values.
Customer Retention Rates Give Important Market Segment and Sales Efficiency Information
Customer retention rates give a company important information about their overall sales ability and the market. To get a deeper understanding of the ideal customer profile from a retention perspective, customer cohort analysis is valuable. Who are these customers that churned? Is this the natural churn of the market? Customer cohort segments can be looked at by customer type, by geographies or sales territory, and by aging (did more customers churn in 2021 than in 2022?). Sales and Customer Success management needs this analysis and a comparison to relative benchmarks, to understand where to focus resources for higher productivity.
Because customer retention rates vary widely by business model, it is important to benchmark against similar types of customers in order to understand what is “normal” and what is poor performance. SMB customers in general are more likely to churn as it is a more volatile market with faster purchase decisions and just as fast churn decisions. 20% churn is not uncommon.
Enterprise sales companies with higher average contract values should have higher customer retention rates: less than 90% is bottom quartile, 95% is good, and 98% is best in class.
Early and growth stage SaaS companies also typically have higher churn as they improve their targeting of product market (customer) fit. We typically see at least a 10% improvement in Customer Retention as a SaaS vendor grows from $10M to $100M for growth SaaS.
And Don’t Forget Gross Revenue Retention (GRR or GDR if operating in dollars)
While NRR tends to get the most focus, followed by Customer Retention, Gross Dollar Retention adds important information. And GRR is relatively easy to calculate if you have reporting systems to calculate NRR. Gross revenue retention eliminates the impact of cross-selling, up-selling, price-increases, and organic customer growth within the installed customer base. It is an important indicator of how the company is really doing in retaining the original contract value from its customers over time. GRR is always equal to, or lower than, customer retention and cannot be greater than 100%.
The basic calculation is similar to that of net revenue retention, excluding any contract value increases. The ARR for each individual customer at the end of the current period cannot exceed the ARR for that customer from one year ago but may be less. This approach eliminates the impact of all the factors mentioned above.
GRR tells you if your customers are reducing their contract values (while maintaining a contract), and / or your sales organization is using discounting to retain customers. If the sales organization is commissioned or bonuses based on customer retention or NRR, without considering GRR, discounting may be more likely to be occurring – and management has no warning signals. NRR or customer retention rates alone would not tell you anything about contract reductions, or discounting, both of which impact forecasts and forecasting models.
5% Improvement of Retention Rates Impacts Profitability by 5-25%
SaaS customer acquisition costs are typically 3-4 times higher than customer retention costs and sometimes higher. Here’s an example of how a 5% improvement of retention rate translates to higher profitability, and more revenue (increasing the growth rate), driving up the Rule of 40.
Benchmarking Against Peer Companies with Similar Business Models Helps Set Appropriate Retention Targets and Diagnose Internal Weaknesses
Best in class growth and enterprise SaaS companies and investors track and benchmark all three retention KPIs. Comparing performance against peer companies with similar business models, as well as against top quartile performers, allows management teams to diagnose customer retention and upsell weaknesses in the organization. Benchmarking helps align teams on the diagnosis of retention issues, as well as on achievable targets.