In recurring revenue businesses, there are various measures of churn or revenue retention worth paying attention to. Today, I’ll focus on net revenue retention (NRR). While many hear this term and know investors ask about it, there are quite significant math implications to NRR that most people massively under-appreciate.
Let’s start with the basics and then build up to the insightful.
First, gross revenue retention refers to your ability to keep existing customers without them canceling their subscriptions.
If you have 100 existing customers on the first of the month paying you $1 each, and 100% of those customers are still there on the last day of the month paying you $1/month, then your gross revenue retention is 100%. (Or the same idea stated in other terminology: your gross revenue churn rate is 0%.)
Note: Gross Revenue Retention % + Gross Churn Rate % = 100%
Gross revenue retention specifically excludes upsells in the month. It only counts what existing customers were contracted for on the first of the month and whether they are still there at the end of the month.
Net revenue retention measures how good you are at two things:
1) Gross Revenue Retention
In this next example, let’s say you have 100 existing customers on the first of the month paying you $1 each. At the end of the month, all 100 customers are still there. They’ve all maintained their existing contract, thus the gross revenue retention is 100%.
However, let’s say 10% of your customers were upsold into a higher plan. They now pay $2 a month instead of $1. So from this group of customers, you started the month at $100/month. Going into next month, they are now all contracted to pay an aggregate of $110 ($100 base + $10 in upsells).
In this scenario, your net revenue retention is 110% (and your net revenue churn rate is actually a negative 10%).
Remember: Net Revenue Retention % + Net Revenue Churn % = 100%
110% NRR + (-10%) Net Revenue Churn = 100%
Okay, now that we have that out of the way, let’s get to the more interesting stuff.
Other than the fact that you get to keep more revenue, what is the big deal about net revenue churn anyway?
Generally, the higher the net revenue retention, the better. But, there’s an enormous inflection point when NRR exceeds 100%.
This is enormously important to grasp, especially if you have a SaaS business that is at or able to get to NRR over 100%.
To understand why this is such a huge deal, we have to step back for a moment to look at the math of recurring revenue businesses.
Net Revenue Retention < 100% Creates Recurring Revenue Ceilings
Recurring revenue businesses are great. You get 90%+ of your revenue every month on the first day of the month.
However, there’s a problem with recurring revenue businesses at scale. Eventually, the business gets so big that the churn dollars get enormous.
At this mathematical ceiling on the business, your monthly new bookings dollars = monthly churn dollars.
This is because, in most recurring revenue businesses, there is some revenue loss each year. If there is any revenue loss, that means that without new bookings, the revenue base shrinks over time.
Net Revenue Retention over 100% Massively Impacts ARR
However, when net revenue retention is over 100%, there is no loss. Every initial sale not only retains but expands as well.
When you do the math, there is no revenue ceiling on the business.
This means that if you can sustain net revenue retention over 100% and you have any new bookings each month, your business will theoretically and mathematically become a billion-dollar ARR business… eventually (even if it takes 100 years).
The theoretical mathematical maximum revenue at maturity for a SaaS business with NRR over 100% is…. wait for it… infinite.
Here’s why this matters.
When company valuations are determined, they are determined in one of two ways (and often both ways). The first is to look at what comparable companies are selling for. The other is to build a model forecasting the company’s lifetime revenues and net income.
Intuitively, it makes sense that a business whose current trajectory never hits a ceiling is worth more than a company whose current mathematical trajectory tops out at $10 million ARR. They have wildly different economic values and thus wildly different company valuations too.
Conceptually, NRR over 100% is extremely exciting. But to really grasp why investors value this metric (especially when combined with over 100% annual growth in new ACV and high margins), you have to do the math.
Here’s a simple example.
Take a fast-growing company with a $10M ARR that’s growing new customer ARR at 100% per year with 120% NRR (from existing and new customers). If the company can keep this up for, say, five years, what do you think ARR will be in year five?
Take a guess…
Here’s some simplified math (ignore the simplifications and focus on the big picture here):
Year 0: $10M ARR
Year 1: $10M ARR + $10M New Customer ARR + $4M from Existing and New Customer Net Revenue Retention = $24M Total ARR
Year 2: $24M ARR + $24M New Customer ARR + $9.6M from Existing and New Customer NRR = $57.6M Total ARR
Year 3: $57.6M ARR + $57.6M New Customer ARR + $23M from Existing and New Customer NRR = $138.2M Total ARR
Year 4: $138.2M ARR + $138.2M New Customer ARR + $55.3M from Existing and New Customer NRR = $331.7M Total ARR
Year 5: $331.7M ARR + $331.7M New Customer ARR + $132.7M from Existing and New Customer NRR = $796.1M Total ARR
Over $796M in ARR
Now let’s repeat the math, this time assuming that the NRR is 70% (also known as 30% net revenue churn).
Year 0: $10M ARR
Year 1: $10M ARR + $10M New Customer ARR – $6M from Existing and New Customer Net Revenue Churn = $14M Total ARR
Year 2: $14M ARR + $14M New Customer ARR – $8.4M from Existing and New Customer NR Churn = $19.6M Total ARR
Year 3: $19.6M ARR + $19.6M New Customer ARR – $11.8M from Existing and New Customer NR Churn = $27.4M Total ARR
Year 4: $27.4M ARR + $27.4M New Customer ARR – $16.4M from Existing and New Customer NR Churn = $38.4M Total ARR
Year 5: $38.4M ARR + $38.4M New Customer ARR – $23M from Existing and New Customer NR Churn = $53.8M Total ARR
Notice that, in both cases, the sales team delivered new ARR bookings equal to last year’s total ARR.
The difference is that when there’s churn, a huge part of the new ARR goes to backfill customers who churned out. If you look at year five, the sales team generates $38.4M in new customer ARR which is offset by $23M in existing and new customer churn.
It’s as if the sales team devotes the first two quarters of the year just to prevent a decline in ARR and only gets the last two quarters of the year to grow the top line.
If you compare the two examples, the company in example A outperforms the company in example B by over $740M in ARR in year five.
In recurring revenue businesses, ARR is extremely sensitive to net revenue retention.
If you look at things from a valuation standpoint, a valuation multiple of $796M is going to be a much bigger number than the same multiple applied to $53.8M.
But wait… there’s more! 🙂
There’s a third-order implication to net revenue retention too… It has to do with the ratio of lifetime value to customer acquisition cost (LTV/CAC).
The LTV/CAC ratio helps evaluate a go-to-market team’s ability to cost-effectively acquire customers. Typically, an LTV/CAC ratio of 3.0 or higher is good.
Here’s the plot twist.
You can only really calculate the lifetime value of a customer when they leave. What happens if customers never leave and, in fact, stay and spend more?
In theory, the LTV is infinite or can’t yet be determined.
So, what’s the implication for this?
Let me spell it out for you:
- The company that has the highest LTV can afford to spend the most to acquire a customer.
- A company with a strong sales process that can outspend competitors to acquire customers (and still be very profitable) has an enormous advantage.
So, many companies try to get their customer acquisition cost down. This is totally wrong thinking. (Okay, it’s not “wrong” per se, but it is limited.)
Instead, you want to get your LTV up so high that you can tap lead-generation sources and customer-acquisition channels that your competitors cannot economically afford to pursue.
In every market, there are low-cost lead-generation channels and high-cost ones.
If your LTV is high enough, you can afford to acquire new customers through all channels, including the more expensive ones.
All of your competitors with lower LTV can only afford to compete in the low-cost lead-generation and sales channels.
Let me give you some simple examples.
For many SaaS companies, referrals from existing customers are the lowest-cost way to acquire new customers… because there’s virtually no cost.
If your competitor has a very low customer-lifetime value, then they really can’t afford higher-cost customer-acquisition channels like paid ads, sponsorships, content marketing, outbound telemarketing, or live events.
If you have a very high LTV (fueled in large part by high net revenue retention), then you can go acquire new customers via paid ads, sponsorships, content marketing, outbound telemarketing, and live events… while they can’t.
Eventually, a company that can compete on all fronts generates enough critical mass to become the de facto standard in that market. You become the “safe choice” because everyone else is already using you. This then starts a virtuous cycle upward. Lifetime value goes up, while customer acquisition costs go down. When the LTV/CAC ratio goes up, you can afford to spend more to acquire even more customers.
Key performance metrics like net revenue retention are not just numbers you’re supposed to manage just because investors and debt lenders care about them. Metrics like NRR have relationships with other key metrics that, in turn, have enormous implications for winning in the marketplace. To be an effective SaaS CEO, you must understand these relationships and the implications they have on the outcome of your business.
This is the strategic part of being a CEO. It’s playing “chess” and seeing five moves ahead when everyone else can only see one move ahead.
NRR drives an advantaged LTV/CAC ratio… a superior LTV/CAC ratio exploited properly gives you access to corners of the market that your competitors can’t reach. In other words, when you have an LTV/CAC advantage, your TAM (total addressable market) is significantly bigger than your competitor’s.
If your competitor can only contact those prospects that their existing customers know while you can afford to contact the entire market, you will win.