Why retention is the most important metric we look at

This is a guest blog post by Jeff Galowich, CEO of Blue Horizon Software.

In a world seemingly obsessed with hyper-growth, this may sound like heresy, but when evaluating a B2B software-as-a-service (SaaS) company, the most important metric we look at is retention. This is the key component of what we call the “quality of revenue,” which focuses on the stability and predictability of a company’s underlying business fundamentals.

The different types of retention metrics

While the concept of retention seems simple, there are actually a number of different retention metrics. Three of the most talked-about metrics are logo retention (also called customer churn), gross revenue retention (also called gross dollar retention), and net revenue retention (or net dollar retention).

Logo retention is the simplest and represents how many customers you retained over a set period. For example, how many of the customers you had one year ago are still customers today?

Gross revenue retention takes logo retention a bit further and compares the aggregate annual recurring revenue (ARR) today from that same pool of customers relative to a year ago, but eliminates revenue from expansions (e.g., cross-selling, upselling, etc.) and price increases (depending upon the nature of the business, some people use monthly recurring revenue instead of ARR to assess revenue retention). In other words, gross revenue retention measures the impact of downgrades and cancellations on the recurring revenue stream, so gross revenue retention can never be more than 100%.

Net revenue retention still looks at the same pool of customers over a set period but allows for all revenue changes. In other words, it includes expansion revenue as well as downgrades and cancels.

For the purposes of this discussion, I am going to focus on net revenue retention. Also, it’s worth touching on the distinction between retention and churn. At the highest level, retention refers to the customer and revenue you retain, while churn represents the customers and revenue you lose. They are the opposite sides of the same coin. High retention is good, while high churn is bad. For more details about these distinctions and other key metrics, check out this resource from ChurnZero.

The impact of retention on a SaaS business

Strong net revenue retention enables efficient revenue growth in a SaaS business and can be thought of as analogous to a sales flywheel. A flywheel is an ancient concept that is still used today to smooth out the delivery of power and efficiently store power. The idea is that it takes an initial effort to get it spinning, but once in motion, it provides stability to a system, and incremental effort can build even greater momentum.  SaaS businesses with high net revenue retention are able to leverage existing customer relationships to not only cross-sell and upsell their products and services but also to accelerate new logo sales through referrals.

Businesses that implement great customer success programs will generally have higher retention rates and customer loyalty than businesses that do not.  To illustrate this point, I looked at a cross-section of survey data from SaaS Capital. The survey asked respondents, among other things, what customer success platforms their company used. In particular, I looked at companies with an annual contract value of at least $25,000 and at least 100 customers as they seemed a natural fit. Surprisingly, only 44% of respondents indicated that they used a customer success platform. However, those that did reported median net retention of 104% vs. 98% for those that did not use a platform.

Well-run customer success programs help SaaS businesses build a firewall against competition by addressing two key factors often cited as important determinants to retention.  The first factor is providing a product that fills the customer’s need and delivers value better than others. The very essence of customer success is to assure that, at a minimum, the customer realizes the value/outcomes they desired when they purchased the product.  This translates into high customer satisfaction, which generally results in high retention.

The second factor involves complexity. Complexity results in higher switching costs. Switching costs are the costs that a customer would incur in order to replace a product (costs can be psychological and effort-based as well as monetary).  In addition to the financial cost of implementing a new product, users of a product in a complex environment are reticent to change because of the time investment necessary to implement and learn a new product and transition to a new vendor.  Strong customer success processes foster psychological and perceived effort barriers to switching products by assuring customer satisfaction with the existing solution.

Consistent with the sales flywheel analogy mentioned above, an effective customer success program should not only improve retention results but also improve overall revenue growth.  In the SaaS Capital survey, the companies mentioned above that used a customer success platform showed median growth of 32%, compared to 24% for the companies not using a platform. In other words, those companies that were using a customer success platform showed 33% higher growth. While this is admittedly a smaller subset of the overall responses, it demonstrates how companies not using a platform might benefit from formalizing their customer success practices. There is also another point to consider regarding retention metrics – the relationship to a company’s valuation.

Quantifying net retention’s impact on growth and valuation

Private SaaS businesses are valued based on a multiple of the company’s ARR. Businesses with high retention rates reduce investment risk, facilitate more efficient revenue growth, and are positioned to achieve higher profitability margins.  As a result, retention metrics are a key factor in determining the revenue multiple applied to a business for valuation purposes.

Tomasz Tunguz, Venture Capitalist at Redpoint, took a look at the impact of net revenue retention. He pointed out that, assuming all else is equal, a company with 160% net revenue retention would be 4.2x bigger than a company with 120% net revenue retention after 5 years. In other words, net retention has a meaningful impact on growth.

Supporting this is another study on private SaaS companies that found for every 1 percentage point increase in revenue retention, a SaaS company’s value increases by 12% after five years. To provide some context, the 6 additional points of net revenue retention described above for businesses using a customer success platform would result in those businesses achieving a 72% improvement in their valuation five years later.  So, even incremental increases offer a long-term benefit on valuation.

Retention drives long-term growth

Retention is core to the long-term stability, growth prospects, and ultimately profitability of a SaaS company. However, many companies focus value creation largely on new customer growth and overlook the importance of customer and revenue retention metrics. Creating a robust customer success team with dedicated resources can improve retention which spurs growth, and ultimately, a higher valuation for the business.

About the Author:
Jeff Galowich, CEO of Blue Horizon Software
Blue Horizon acquires and invests in profitable software businesses with stable recurring revenue streams. The Blue Horizon platform combines long-term capital and industry expertise with an operating model that enables businesses and their leaders to focus on growth and profitability. Learn more about us here.