Pricing StrategyApr 28, 2022
Todd Gardner founded SaaS Capital, a leading venture debt firm, and has deep domain knowledge in SaaS. In this guest blog, he explains why Net Revenue Retention (NRR) has such a profound impact on a SaaS company’s valuation, and provides some basic tools to quantify the valuation impact.
This brief article will explain why Net Revenue Retention (NRR) has a profound impact on a SaaS company’s valuation. We will also provide essential tools to quantify the effect. In the companion article, Usage-Based Pricing is the Best Way to Drive NRR; we discuss the different ways to increase NRR. This article is intended to demonstrate the “size of the prize” of driving higher NRR; it is not a guide for implementation.
All company valuations are grounded in a discounted cash-flow model -- How much cash will a business throw off, when will it generate that cash, and what are the odds it will happen? Valuation multiples (of EBITDA or revenue) are a simplified expression of a discounted cash-flow model analysis. Instead of projecting out all the future cash flows of a business and then discounting those back to today based on a risk-adjusted discount rate, a valuation multiple is applied to the current business performance.
Embedded in the valuation multiple are assumptions regarding both the size of the future cash flows (relative to where they are today) and the risk they will or will not occur. SaaS businesses are typically valued using a multiple of revenue because many are not yet generating any meaningful cash (EBITDA). Specifically, Annual Recurring Revenue (ARR) is generally used as the basis of a valuation because it is the most accurate current snapshot of the business’s capacity to generate cash.
ARR * Valuation Multiple = Equity Value
Net Revenue Retention, also known as Net Dollar Retention (NDR), is frequently defined as the monthly recurring revenue (MRR) generated in the current month by the cohort of customers the company had one year ago, divided by the MRR the cohort generated one year ago. An example is below – it’s not as confusing as it sounds.
In the chart above, the company had five customers one year ago who collectively generated $130,000 in MRR. Since then, one of them churned, and the other four grew their MRR slightly. Revenue growth at the individual customer level (organic growth) more than offset revenue lost by the churned customer. Therefore, the company’s net revenue retention was 102% (when NRR exceeds 100%, it’s called “negative churn”).
NRR can be measured over periods other than one year, but remember to annualize the results. For example, if you calculated it over one month, take the result to the 12th power. If you calculate it over one quarter, take the result to the 4th power.
The above example is generally referred to as the cohort method and is the most accurate measure of retention. It’s possible to use a formula too: (churn+contraction-expansion) /(beginning MRR). The drawback of the formula method is that some of the churn during the period might not be related to customers included in the beginning MRR. If out-of-period churn occurs, the calculation will be incorrect.
Net Revenue Retention is an excellent metric because it concisely describes the company's trajectory if there were no new customers.
Net Revenue Retention is so powerful as a valuation driver because: (1) it meaningfully increases ARR over time due to compounding, and (2) it increases the company’s growth rate, which increases its valuation multiple. Said differently, NRR meaningfully impacts both factors in the SaaS valuation equation, and when both elements of a multiplication equation increase, the result increases exponentially. In addition, there is a distinct NRR valuation premium independent of growth rate when NRR is driven through Usage-Based Pricing.
In terms of ARR, the chart below graphically represents the cumulative effect of different retention rates on ARR. It’s crucial to graph these results over time to demonstrate the cumulative impact of a change in NRR, which can sometimes be lost in an annual budgeting cycle where a few percentage point difference does not seem that significant. In the chart below, High Retention Inc. has a Net Revenue Retention rate of 105%, and Low Retention Inc. has a Net Revenue Retention Rate of 85%. In this example, both companies are booking new business at precisely the same level.
As mentioned earlier, the revenue difference after just one year is not that significant and tends to be overshadowed in the short term by the amount of new bookings. Zooming out, and looking at the impact over five years, however, reveals that better revenue retention results in annual revenue that is 2.3 times higher. It would take herculean new sales efforts to achieve the same results via new bookings.
In addition, the growth rate for High Retention Inc. is much higher -- three times higher in fact -- 30% compared to 10%. It is also a more sustainable growth rate because it’s driven by an ever-expanding base of existing customers and is less dependent on volatile new bookings.
So, all other things being equal, and not even considering the valuation multiple, the higher NRR in the example above would lead to a 230% increase in valuation simply based on the higher ARR.
As shown in the graph of public SaaS companies below, there is a high correlation between a SaaS company’s growth rate and its valuation multiple.
The data in the graph are from the Bessemer Cloud Index in April 2022, but this relationship has held relatively constant over many years. Revenue growth is the dominant factor in determining a valuation multiple. Investors focus on how big the future cash flows of a business will be, and the single best indicator of future growth is current growth.
Looking at the slope of the trend line in the graph above, each one percentage point increase in growth rate yields a valuation multiple increase of .25. (Caution: this is a rule of thumb approximation. The correlation is not one, as is demonstrated by the fact that not all the dots are on the trend line. There are many other factors influencing valuation; it’s just that growth is the most important.) The slope of this line in mid-2021 showed the relationship between growth and value was even higher, with each percentage point of growth delivering a .5 increase in the multiple.
Using the valuation multiples above and applying a relatively standard 30% discount for private company valuations, Low Retention Co. would be worth about $5.6 million after five years. ($1.6 million in ARR times a valuation multiple of 5.0, less 30%). With the same new bookings over five years but with better net retention and thus better growth, High Retention Inc would be worth about $26 million. ($3.7 million in ARR times a valuation multiple of 10, less 30%).
So, each one percentage point increase in net revenue retention increased the company’s valuation by 18% over five years. (364% valuation increase divided by a 20-point difference in net revenue retention.)
This is a very dramatic difference, and although it’s based on actual valuation multiples and simple arithmetic, if there is some skepticism, take the result and cut it in half – it’s still shockingly powerful.
If your business has driven its strong NRR performance through usage-based pricing (UBP), you may be entitled to an additional valuation multiple bump. A premium makes sense because growth through UBP typically requires little sales or customer success expenditure and is, therefore, more profitable per dollar of revenue. Done properly, NRR growth through increased customer usage is frictionless.
Supporting evidence of a UBP premium comes from Openview Partners, who benchmarked public SaaS companies using usage-based pricing versus those who do not. In 2020, SaaS businesses with usage-based pricing were growing 38% faster than their peers; however, they boasted valuation multiples 50% higher than SaaS businesses with traditional pricing models. The overall relationship between growth and valuation multiples would have delivered a 34% premium based on the higher growth, so the 50% valuation increase seems to support a usage-based pricing premium of 16% or so. (Caution again – this is an approximation.)
If you own equity in a SaaS business, there is no more powerful way to increase its value over time than increasing its NRR. Applying simple valuation models demonstrates that each percentage point increase in NRR is worth an 18% increase in SaaS company valuation over five years. Some approaches to driving NRR are better than others, and applying UBP appears to have its distinct advantages. Please refer to “Usage-Based Pricing is the Best Way to Drive NRR” for more details.
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