Dynamics of SaaS Investing — Growth, Retention, and Profitability
Unlike traditional software businesses, SaaS businesses are built upon a single and shared infrastructure that facilitates competitive advantage to achieve widespread distribution and economies of scale — the internet. Throughout a company’s lifecycle, there are considerable shifts from growth to retention to profitability. The way companies optimize for each of the three during the journey is worth understanding.
This analysis will focus on growth-stage companies, where execution risk prevails over venture risk. Rather than helping companies get off the ground like in earlier stages, growth investors are looking to maximize the potential of fast-growing software businesses through scale. Investing at this stage is a rewarding experience to build large-scale companies that can triple or quadruple in sheer magnitude during the term of the partnership while also building better and stable businesses that serve multiple end markets. To do so, getting a firm grasp on the drivers and outcomes of growth, churn, retention, and profitability are critical.
What makes software exciting?
There are several reasons why software investing has been increasingly gaining attention over the past several years. Here are to name a few:
- a considerable degree of predictability as a result of recurring revenue
- high gross profits due to the absence of a fixed physical asset
- marginal costs to produce a piece of software to an additional customer is zero because software is packaged lines of code
- long product cycles in B2B
- high retention
- low capex with most of it being on IT spending
- opportunistic exit environments
Successful high-growth software companies can generate significant free cash flow that can deliver a great deal of shareholder value.
Power of Retention
Revenue retention is the company’s ability to maintain and grow its revenues from its existing customers, and the way it’s measured shares different dynamics that tell two different stories.
Net Revenue Retention (NRR)
NRR measures the change in recurring revenue from a group of customers, or cohort, over time by taking into account both the negative consequences of churned customers along with the positive effects of upsells, price increases, and cross-sells.
We calculate this metric by comparing the MRR (Monthly Recurring Revenue) of the same cohort at different intervals to determine how much revenue was retained, hence termed ‘Net Revenue Retention’.
Let’s take a look at a simple example of 3 different cohorts in a SaaS business on an annual basis:
Cohort 1 — a group of 5 accounts that joined in January — consisted of a mix of churn (Customer 3), contraction (Customer 5), and expansion (Customer 1). The SaaS business earned $30,500 solely from Cohort 1 in the past year and a year later earned $24,000, resulting in an NRR of 79%.
Cohort 2 — a group of 5 accounts that joined in February — consisted of a mix of expansion (Customer 7) and churn (Customers 9 & 10). The SaaS business originally earned $34,000 to $25,500, leading to an NRR of 75%.
Finally, Cohort 3 — a group of 5 accounts that joined in March — consisted of expansion (Customer 12) while the rest had consistent revenue streams. This cohort generated 107% NRR since the current MRR > past MRR.
You may start to realize that an NRR > 100% indicates growth in MRR. If a company generates 100%+ NRR, booking a new customer isn’t necessary since you can still grow as this has a significant compounding effect on revenue. Think about it as earning compound interest on your customers every year. Here’s a benchmarking tip:
- <90% NRR → not as strong
- 100% NRR → benchmark
- >110% NRR → very strong
The Devil is in the Details
It is important to not take NRR at face value without performing some diligence. A business with 90% NRR may be different than another business that also has 90% NRR.
Remember, NRR accounts for both the positive (expansion revenue) and negative (churn, contraction revenue, and cancellation) impacts of a SaaS business. Company X has an absurdly high churn rate balanced with expansion revenue, whereas Company Y can successfully retain 90% (10% churn and cancellation) of its customers and isn’t relying on expansion revenue to have the same NRR. This is why investors don’t only look at Net Revenue Retention, but also Gross Revenue Retention.
Here’s a more intuitive example of Net Revenue Retention. Recall, a company can experience churn, cancellations, contractions, and expirations that would yield a lower NRR. However, the NRR can increase if the positive effects of expansion revenue offset the negative drawbacks of churn. An equal balance of both negatives and positives would result in 100% NRR.
Net Retention and Multiple Expansion
More often than not, net retention plays a significant role in exit multiples, and a high NRR ratio may ultimately warrant a higher multiple. The team at Software Equity Group discovered a strong correlation between exit multiples and net retention in the middle market, and the findings are worth highlighting.
Companies A, B, and C all share the same ARR growth rate (40%), yet they range in valuation multiples from 2.0x to 6.0x, and the reason is net retention. Company C values at a 6.0x EV/ARR multiple since it has a 100% NRR while Company A values at 2.0x-4.0x EV/ARR with an NRR of only 75%.
Let’s take Company B and increase gross retention from 80% (assuming) to 90% and then to 95% to highlight the effects of an NRR > 100%.
Taking a closer look at the change in ARR for Company B with 90% NRR to 105%, we can notice a $27M increase by the end of Year 5, resulting from diminishing net contraction and increasing net expansion.
In terms of valuation, let’s assume a 7.0x EV/ARR multiple:
By investing in customer success and increasing overall net retention to 105%, Company B’s valuation increased 73% to $448M. An additional point to note is when SaaS companies grow, the enlarged size warrants a multiple expansion. As a result, we can modify our valuations to reflect this principle as such:
Rather than the $64M ARR company being valued at a 7.0x multiple, we can safely assume a 9.0x multiple that would yield an enterprise valuation of $576M, an astonishing 122% increase.
Since growth would consist of increased costs for customer acquisition and hypothetically result in higher churn, retention is often more favorable. On the contrary, a company that focuses on retention doesn’t necessarily need to acquire another customer to scale but rather concentrate on retaining existing cohorts with the anticipation of expansion revenue.
Gross Revenue Retention (GRR)
Net Revenue Retention can hide a lot of information, so it’s critical to peel back the onion to get a real grasp of a business. Gross Revenue Retention, on the other hand, is a better metric to truly understand how a SaaS business is retaining its revenue from customers and dealing with churn. Unlike net retention, gross retention removes the positive impacts of upselling, cross-selling, price increases, and other sources of expansion revenue to solely measure and isolate the negative outcomes of churn and downgrades.
Keep in mind:
Gross Revenue Retention will never account for an increase in ARPU compared to the initial revenue earned, therefore never greater than 100%. A business with 100% GRR means that their customers that initially paid $x have either not churned or have not downgraded and are still paying the same or more.
Let’s take a look back at our cohort analysis and identify the Gross Revenue Retention for each.
Cohort 2 has experienced the most churn relative to the other groups by far, and this ‘penalty’ is evident by the lower gross revenue retention. Cohort 3 has successfully retained its revenue and although Customer 12 indicated revenue expansion, there was no impact on Gross Revenue Retention.
Gap Between Gross Revenue Retention and Net Revenue Retention
As described, understanding both the GRR and NRR are essential when performing due diligence on a company. But what’s more important is asking why and what information can be extrapolated from the difference between GRR and NRR.
Let’s examine 3 hypothetical companies:
Company X — the NRR < 100% indicates that the company is seeing more churn or contractions as compared to expansion. The relatively smaller gap between the NRR and GRR indicates a modest effort towards revenue expansion from existing customers.
Company Y — the NRR > 100% indicates a large amount of expansion revenue opportunity occurring but the very low GRR signifies a volatile membrane of customers entering and exiting the company. This results in less predictable growth with a reliance on upselling or cross-selling for larger revenues. The large gap between both metrics indicates a disproportional number of customers retaining and expanding.
Company Z — the NRR > 100% and the GRR close to 100% indicates a financially healthy and stable business that boasts high revenue retention and multiple opportunities for expansion revenue. The gap between both metrics conveys heavy investments towards expansion revenue.
It’s also important to note that the NRR and GRR at a particular point in time are not as relevant as understanding the trend between both data points over time. A company having 100% NRR at a particular point in time doesn’t allow us to draw justifiable conclusions, but if we know that the NRR has been slowly decreasing from 110% a year ago to 100% now tells a different story.
Retention vs. Growth
Software investors at different stages and different verticals all share distinct perspectives on what they put more importance to when it comes to identifying companies with higher retention or higher growth. This decision is influenced by their investment thesis on how they would want to add value for the company. Retention indicates the strength of the value proposition, while growth reflects the ability to attract customers at the onset without truly understanding how long the customers will stay.
Many growth investors are proponents of growth — not because of the associated nomenclature — but rather the market opportunity that comes with it and the potential to build a larger business through compounding. If we remember earlier, the size of a business is proportional to the valuation multiple, and achieving another level of magnitude can increase shareholder value recognized during liquidity. A company growing rapidly but with lower retention — say 75% — should have a large enough total addressable market (TAM) to continue attracting a large customer base. This constant flow between customers subscribing and churning represents a leaky bucket, where a business with churn will need to “fill” the leaky bucket to continue growing since the business is losing 25% of its customers annually. This is depicted as below:
Additionally, growth is expensive and requires extensive effort by the sales team to acquire, onboard, and establish implementation procedures for customers. If profitability is the top of mind, growth would more often than not steer you from attaining the goal in the short run.
Conversely, many other growth investors prefer companies with exceptional retention rates over growth rates, particularly in smaller markets where a large TAM isn’t possible but rather a strong and sticky group of customers. So a better way to distinguish the importance of both is largely dependent on time and industry. Early on, rapid growth is essential to build traction, but over time retention will slowly become a more important metric to consider. High retention leads to predictable recurring revenue, and when companies are ready to be owned by private equity firms, the recurring revenue would be a relevant proxy for debt investments because of the lower risk.
Path to Profitability
Growth Equity investors generally don’t find profitability necessary at the time of an investment but rather towards the latter of the holding period when steering for a liquidity event. And this makes sense — a mature SaaS business at the growth stage is most likely burning through cash to achieve profitability in the long term and to deliver exceptional returns for shareholders. This, ultimately, is an outcome for added value.
For a SaaS company to achieve profitability, the aggregated lifetime value for its customers combined must exceed the total costs of the SaaS business itself, including acquisition, operations, servicing, development, and so on.
Let’s first take a step back and understand why SaaS businesses have been more attractive than traditional on-premise software. For the customer, high upfront payments were no longer necessary, which led to a reduction in the total cost of owning the software as well as a lengthy integration and licensing process. However, the high total costs immediately shifted to the SaaS vendor with the intention of long-term and incremental recurring revenue streams that would soon surpass the costs to acquire the customer.
Understanding the drivers of time to profitability — growth and churn — are critical. A SaaS company rapidly growing suggests it is burning cash to acquire customers. And if the costs to acquire these new customers far outpaces the recurring revenue rate from existing customers, profitability is not even a question.
Chaotic Flow derived a formula using growth and churn to determine the time to profitability for a SaaS company as shown below:
A low acquisition growth rate (g) multiplied by a decreased time to break even with 0 churn (BE) has a higher chance of profitability when compared to a company with a higher acquisition growth rate and longer time to break even. Let’s take a look at a SaaS company that acquires 200 customers per year with a 20% logo churn compared to itself with no churn:
In this case, it’s simple to realize having no churn with a growth rate of 200 customers per year can lead to profitability shy of 3.5 years, while a more realistic 20% churn would delay profitability for 8 years. A churn rate of 25% means the churn rate is outpacing the total recurring revenue contributions, so profitability wouldn’t even come into the picture. This would create a horizontal asymptote approaching the CAC but never exceeding it, indicating an unprofitable business.
Well, we know one thing for sure — higher churn steers us away from profitability. We can also assume that growing to profitability isn’t possible if all else equal since the CAC would outpace total recurring revenue from the start. Here are some methods to consider to reach this threshold:
- Implement expansion revenue strategies (upsell, cross-sell, or price increases) to increase revenues without increasing costs
- Lower total costs of delivering service to the customer by the vendor through economies of scale and cost-efficient alternatives
Generally, an increase in revenue is associated with an increase in costs. But when increasing the revenue from existing customers, things may work in our favor as there are relatively small sales and marketing expenses to achieve this. An increase in the average revenue per customer (ARPU) can ultimately lead to profitability in the long run if the increase in recurring revenue can cover the cost of new customer acquisition.
It’s evident to notice that expansion revenue can help shorten the time to profitability, and in this case, although excessive, from 8 years to 4.5 years.
Lower costs throughout the value chain
At this point, it’s clear that a successful SaaS business would need to increase revenues from existing customers but also decrease as many costs as necessary throughout the entire value chain, including research and development, product operations, infrastructure maintenance, and sales and marketing. Many B2C and some smaller ticket B2B companies can be more cost-efficient in nature, especially since their sales processes are low-touch or self-service. Conversely, enterprise software companies have longer sales processes paired with high-touch sales strategies that certainly aren’t a dime a dozen.
In turn, there are several nuances when it comes to critical SaaS metrics, and to make a justifiable investment decision means to reverse engineer the data points to determine the ‘why’. Taking a step back to discern the trend allows for a more comprehensive analysis that would ultimately impact the fit between the investment thesis and the prospective investment opportunity.