One of the most striking commonalities among best-in-class SaaS companies is the stellar job they do in retaining and growing their customer bases. Customer retention affects nearly every other metric of a successful business, including how fast it grows, how stable its cash flows are, and ultimately how much value it creates.
This post explains why one way to calculate retention, known as Net Dollar Retention, is the most important metric you should be tracking for your SaaS company.
First, a definition of net dollar retention
There are many ways companies track retention. One of the most critical and informative retention metrics used, often reported by public SaaS companies, is known as "Net Dollar Retention."
A company's Net Dollar Retention (NDR) is simply the Annual Recurring Revenue (ARR) of customers today divided by the ARR of those same customers at a certain point of time in the past. We usually look at Trailing Twelve Month (TTM) Net Dollar Retention.
The calculation for TTM net dollar retention is simple:
- Sum the ARR of all customers today who were also customers 12 months ago
- Divide that figure from the ARR of all customers 12 months ago
If you had 10 customers 12 months ago paying you $10K each year, and now those same 10 customers pay you $11K each year, your company's net dollar retention would be 110%.
For more informative analyses, we can look at the net dollar retention of specific cohorts of customers, and observe how that retention rate is trending over time. We'll explore cohort net dollar retention in a future post.
Why Net Dollar Retention is so important
Simply put, net dollar retention is the most cost-efficient way of accelerating revenue growth and value creation.
To show the effect of changing net retention on revenue growth and valuation ("enterprise value"), we created a simple model in Excel. You can use this model to understand the impact of changing net dollar retention for your own company.
Take an example SaaS company currently at $10M ARR that added $7M ARR from new logos over the past 12 months. Assume this company expects the amount of ARR it generates from new logos to increase 10% per year for the next five years. Let's explore how changing this company's net dollar retention affects its ARR and valuation in five years.
With a 105% net dollar retention rate, the business will reach $64.2M ARR in five years.
With just a 5% increase in net dollar retention to 110%, the business will reach $72.5M ARR in 5 years. If we assume the business is valued at 6x ARR, this implies a $49.8M increase in value just by improving net retention by 5%.
The incremental ARR from net retention is of course not "free." It may require customer success or salespeople cross-selling or up-selling the existing customer base.
But what makes net retention so powerful is that for most companies, it's cheaper to sell to existing customers than to sell to new logos. This makes net retention the most cost efficient way to accelerate revenue growth.
Here's a sensitivity table showing how the enterprise value of a business with 110% net dollar retention changes based on a change in net retention. A 20% increase in NDR from 100% to 120% results in a ~62% increase in EV from $342M to $554M. And this is likely understating the impact of improving the net dollar retention of this business, as a high retention business will command a higher ARR multiple than low retention business.
What is "good"?
Best-in-class SaaS businesses typically have net dollar retention rates above 110%, and many of the top performing SaaS IPOs of the past few years have had net dollar retention rates above 130%.
For example, Twilio, Atlassian, Elastic, and PagerDuty all had net dollar retention well above 130%.
At Across, we're always eager to talk to companies about how they improve their net dollar retention rates. Please contact us at firstname.lastname@example.org if you'd like to get in touch!