Let's start with the basics of what makes a SaaS model valuable. SaaS subscription businesses are far more predictable than the wild ride of starting each quarter from zero as in traditional, perpetual license software. SaaS metrics like last quarter's or last year’s revenues, new customer acquisition, renewals, and customer expansions together with churn rates are both lagging and leading indicators. There isn’t a single metric that can predict the future, but when the right subscription KPIs are tracked properly and added together, SaaS forecasts are highly predictable and take some of the risk out of investments.
So, for investors in a growth investment environment over the past couple of years, Net Dollar Retention (NDR), a measure of net subscription revenue, was a straightforward KPI to index a company’s valuation and determine valuation multiples. And NDR became something of a vanity metric in the industry with comparisons to Snowflake’s 180+% NDR as a benchmark, whether it was an appropriate benchmark for every subscription model or not. Loads of blogs exhorted the importance of NDR as the most important KPI to track and to build the value of your company.
So what’s wrong with over-indexing on Net Dollar Retention (NDR)?
So what’s wrong with over-indexing on Net Dollar Retention (NDR)? By over-indexing, I mean giving one attribute too much focus to the exclusion of other attributes and thereby causing changes to or worsening of that attribute. Don’t get me wrong, NDR is a key retention metric to track and benchmark against peer companies. But focusing on NDR alone is dangerous to the health of your growth and profitability as a SaaS company and here’s why.
NDR doesn’t tell you how many customers renewed, or how much contraction any portion of those contracts underwent. It is just a net total of your renewal contracts for a cohort or all your customers from one time period to the next. Let’s say your company falls into the 80/20 rule where 20% of your customers provide 80% of the revenue. If a significant portion of your customers aren’t renewing or expanding, then you need to make sure that your unit economics for those customers make it worth spending any sales, marketing or customer success resources on them at all — probably not.
Here are the other key factors to assess:
- What is your customer retention rate? SMB customer retention rates are in the range of 80-85%, while enterprise customer retention rates are typically above 90% — the larger the average contract, the higher the customer retention rate should be. Which customer cohorts are unprofitable or have unacceptable churn? Are the resources supporting those customer segments worth the return?
- Cohort CAC Analysis: What’s your CAC for churning customer segments? Do you have the ability to benchmark CAC for specific cohorts which might be quite different from your overall company CAC benchmarks?
- Are you marketing to unprofitable customers and spending too much on lead generation for churning customer segments? How do you compare on MQL-to-close rates for comparable companies? If you are below the benchmark, one inefficiency in your Lead Gen might be that you are developing leads for churning customer segments.
- What is the customer-to-customer success headcount ratio for unprofitable customer segments? What is the benchmark for comparable companies in terms of CS headcount-to-customer ratios?
Don’t Forget Gross Dollar Retention Rates
Gross Dollar Retention (GDR) rate is the measure of subscription contract renewal values, excluding expansion and upselling. For example, if you had 100 customers last year, with contracts worth $100M, and by the end of this year, 85 customers had renewed but the value of their contracts (without adding in any expansion or upsells) was now $70M, your GDR rate would be 70%. You need to understand exactly why your GDR isn’t 85%.
A few questions would be:
- Did your sales force, focused on customer retention, discount contracts to get the customer to renew, but reduce the value of the contract (that your LTV/CAC ratio analysis was based on)?
- Or did some portion of your customers in an uncertain market reduce their contracts because their businesses are contracting?
- Or some combination of the above?
Net Dollar Retention rate won’t give you any of the above information. And at the end of the day, not all customers will keep growing their contracts, year over year, by significant amounts. Targeting those customers, as well as making sure that acquiring and retaining the rest of your customer base is profitable, requires analyzing more than just NDR.
If you want to move your company from the “growth at all costs” mentality of the last couple of years to an efficient growth framework, don’t over-index on Net Dollar Retention. Use it in conjunction with Customer Retention and Gross Dollar Retention — and compare each of these retention rates against the relevant benchmarks for your business model. Investors are focused on efficient growth in 2023 and are also evaluating companies on more than just NDR.