Customer retention is a critical performance metric for all SaaS companies. It is one of the best measures of long-term value creation. A large, retained customer base provides predictable ongoing future cash flows.
Yet just as the software-as-a-service model was a major business model innovation, so too are customer retention metrics a recent change in financial reporting. Publicly traded companies are not required to provide detailed information about their customer retention performance to investors.
Among the older SaaS companies who share this information, there is little uniformity in how the information is shared. Salesforce ($CRM) shares a customer attrition rate, which measures how many customers choose not to renew. LogMeIn ($LOGM) provides a gross dollar renewal rate that provides insight into how much contract revenue is renewed from year-to-year. But this fails to speak to revenue growth among existing customers due to cross-sells, upsells, and contract expansion.
The emerging gold standard reporting metric for customer retention is net dollar retention. When looking into SaaS companies that have gone public since 2011, I found 16 out of 18 shared a net dollar retention metric in their filings. And one of those 16 companies, CornerStone on Demand, actually changed their reporting to net dollar retention after reporting gross dollar retention for a couple years.
I’m a big fan of net dollar retention because it summarizes how well a company is monetizing existing customers. A net dollar retention over 100% indicates a company is doing a good job securing contract renewals and winning new revenue from those same customers.
Now that there is some consistency in how SaaS companies report on retention & churn, we can dig into the data and identify how retention affects other business performance metrics. This article will explore how customer retention predicts near-term future performance for SaaS companies.
Going Public Requires Higher Net Dollar Retention
As the SaaS (software-as-a-service) business model has become more common, there are signs that the public market investors are beginning to appreciate the importance of strong retention performance. There’s now evidence suggesting that high retention rate is a prerequisite for taking a SaaS company public.
Included below is a table detailing the IPO year and net dollar retention rate for several SaaS companies that went public between 2012 and 2016.
There is a clear trend towards increasing net dollar retention at the time of going public. Prior to 2015, companies would go public with net dollar retention well below 100%. Yet now the bar is considerably higher, with 110% net dollar retention appearing to be the new floor.
This shift indicates that renewals alone are no longer sufficient. Successful upsell and expansion revenue from existing customers are required to deliver net dollar retention in excess of 100%.
One recent exception to this rule is Dropbox ($DBX), which reported ~90% net dollar retention in its S-1 filing earlier this year. Yet they are the exception that proves the rule, as the company had a few unique circumstances (over $1 billion in annual revenue, massive amounts of capital raised, long-delayed IPO) surrounding their public offering.
Higher Net Dollar Retention = Faster Growth
Companies with high net dollar retention outgrew their peers. In their IPO year, companies with net dollar retention greater than 100% generated an extra 15% of topline growth on average versus their peers. This growth gap shrunk to 7% during the first year post-IPO, but it still persisted.
High Net Dollar Retention = Efficient Growth
One assertion that is frequently repeated by VCs and entrepreneurs alike is that “a dollar retained is worth more than a dollar sold.”
The basis of this argument is simple. It costs a lot of money to win new customers. It is considerably easier to make current customers stick around and win a renewal. And once you’ve established a good relationship, it is easier to sell additional services to an existing customer.
Assessing the truth of this assertion is tricky, since most companies don’t break out their costs associated with new sales, renewals, and upsells. Instead, the impact must be measured indirectly. The best way to do so is to compare the relative efficiency of revenue growth.
Why revenue growth efficiency? Companies with strong net dollar retention numbers should be able to generate more topline growth for their sales and marketing spend. That’s because these businesses don’t struggle from the leaky bucket problem (i.e., using new sales to fill the holes left by customers who have churned). For these companies, new customers should translate to topline growth.
To measure revenue growth efficiency, I divided the revenue growth % of each company during its IPO year by its sales & marketing expense as a percentage of revenue during the IPO year:
An RGSM Efficiency score of 0.5 would mean that it costs 2% of revenue to generate 1% of revenue growth.
The results of the analysis are included below:
Companies with high net dollar retention once again outperformed their peers. These companies were ~75% more efficient in generating revenue growth for each percentage of revenue “spent.”
High-flyers Veeva & Twilio both managed to generate an efficiency greater than 2.5, significantly higher efficiencies than those experienced by any other companies. Unsurprisingly, these two companies also had the two highest net dollar retentions measured, with both exceeding 160%.
Strong customer retention performance is increasingly a must-have for SaaS businesses looking to go public. The net dollar retention performance of companies that go public has increased over recent years, suggesting a new threshold for IPO-readiness.
But the prize for high retention is quite clear: fast, efficient growth.