Net revenue retention and the 3 things every venture capitalist looks for
When considering an investment in a software as a service (SaaS) business, potential investors want to ensure the business has a stable or growing customer base. This consideration makes perfect sense.
Because SaaS businesses follow a recurring revenue model, a business can have a solid product, great management team and steady history of growth, but its net revenue retention (NRR) is average or below average, obtaining funding could be challenging.
Why? Investors consider NRR a key performance indicator (KPI) for a SaaS start-up.
Any start-up looking for investment should understand the importance of analysing and optimising NRR internally before a funding round. The start-up should do so especially if its KPI metric is average or below average.
To understand all this information broadly and specifically, we’ll go over what NRR is, why it’s important and how a related KPI (e.g. gross revenue retention, or GRR) allows investors to determine whether a business is retaining its existing customers.
What is NRR?
NRR is the percentage of recurring revenue retained from existing customers over a month or a year. NRR also includes revenue from customer upgrades, cross-sales, downgrades and cancellations.
According to industry data, the valuation of a SaaS business with high revenue retention can be double that of a business with average rates.
In this space, potential investors will focus their analyses on the business’s customer base and growth potential.
NRR and GRR do not directly indicate to management or an investor that the business is losing customers. These KPIs tell investors how well the business is generating and retaining revenue from customers over a certain period — again, usually a month or a year.
Overall, NRR helps businesses determine their “churn” rate.
A churn rate is the percentage of current customers cancelling subscriptions. A deep understanding of a business’s NRR and churn rate will guide management towards ways of optimising their NRR to attract investors.
[Related: How to calculate burn rate (the right way!)]
Why is NRR important?
NRR helps a SaaS venture understand how its churn rate influences its overall revenue and whether it might be losing low-value or high-value customers. Think of NRR as a proxy for customer satisfaction and success. It’s a primary consideration for an investor.
A business that retains NRR signifies that its sales and customer teams are gaining repeat sales or even expanding sales to existing customers.
Enthusiastic customers are more likely to praise the business’s virtues and product(s) to other potential customers. Or in other words, they’ll say good things about the business, which will likely lead to more sales and thus more growth.
Understanding NRR is critical because the average cost to acquire new customers in the SaaS industry is only USD205. In essence, compared to other industries, the SaaS sales environment is highly competitive.
An NRR over 100% indicates a business is retaining existing customers and growing sales quite well. Moreover, an NRR at 100% means the business can continue to grow even if it doesn’t gain another customer.
How to calculate NRR
To calculate NRR, you need four specific data points:
Last month’s recurring revenue
Churn rate (percentage of current customers cancelling their subscriptions)
Revenue ‘expansion’, meaning revenue from upgrades, cross-sales and increased prices
Revenue from any downgrades or cancellations
Once you know this information, the formula to calculate NRR looks like this:
NRR = [(total revenue + expansion revenue) – churn] / total revenue
Example of an NRR calculation
Assume the SaaS business has 100 customers paying USD2,000 per year to subscribe to its software. During the relevant period, 10 customers cancel, 80 renew their subscriptions and 10 upgrade to a USD4000 per year subscription package.
With this information, the business’s NRR is as follows:
[(USD200,000 + USD40,000) – USD20,000] / USD200,000 = 110%
In this example, the business and potential investors can see that although the business has lost some customers over the period, the average revenue that each remaining customer has generated has increased.
So, from an investor’s perspective, this business’s NRR suggests a stable customer base as well as future revenue growth.
GRR and NRR: What’s the difference?
GRR also measures revenue lost from the customer base, but the calculation doesn’t include expansion income from cross-sales, upgrades and price increases.
In this way, GRR provides a clearer picture of existing customer retention because increasing expansion income can’t obscure customer cancellations. That’s why many investors prefer to analyse GRR rather than NRR.
GRR will always be equal to or lower than NRR, and GRR will never be greater than 100%.
GRR = (total revenue – churn) / total revenue
In the example above, GRR would equal 90%. GRR shows investors that while the business may be doing a great job at upselling some existing customers, if it’s losing customers on an absolute basis, growth could eventually stall or decrease. That’s if a critical large customer cancels their subscription.
In other words, NRR may be above 100%, but if GRR is low, potential investors will be very cautious and will likely ask for further analytics or decline an investment opportunity altogether.
[Related: How to calculate opportunity cost]
The 3 things venture capitalists look for in NRR and GRR
An NRR at or above 100% suggests a business is excelling at upselling and servicing remaining customers (despite any customer losses).
It’s unsurprising that potential investors in a SaaS business want to see an NRR at or above 100%.
High GRR indicates a sustainable revenue stream and future growth. Generally, in the SaaS investing ecosystem, many venture capitalists look for a GRR between 75% and 90%.
Some venture capitalists prefer NRR to provide an insight into product acceptance and customer satisfaction because it focuses on revenue generation from all sources — including upgrading happy customers.
To a potential investor, a high NRR and a lower GRR might simply mean the business is focusing its sales and marketing efforts on high-value customers and shedding low-value ones.
Lastly, potential investors in a SaaS business want to see a low churn rate. NRR and GRR help that analysis. A low churn rate means the business is excelling at retaining customers in an absolute sense but doesn’t account for revenue expansion.
In short, a business with a high NRR and a high GRR will likely attract venture capitalists’ interest. And a business with a high NRR and low GRR might raise questions concerning growth sustainability.
A business with a low NRR has work to do if it seeks investment.
How to optimise your NRR
A high churn rate or low NRR could indicate deficiencies in customer or technical support and technical issues. Or it could mean that sales teams are trying to upgrade new customers too aggressively (or too quickly), and these customers are leaving at the first opportunity.
In any case, what can a SaaS business do to increase NRR?
Customer segmentation is a valuable analytic exercise.
Separating high-value and low-value customers will inform strategies to increase expansion revenue in high-value customers.
For high-value customers, a high-touch model with substantial personal coaching and training might be the answer. The business might interact with low-value customers with more of a tech-touch model.
Another way to increase NRR is to closely monitor customer behavioural data and other adoption trends.
Quantitative and qualitative data on service utilisation, product usage, engagement and customer support and satisfaction should provide a ‘customer health’ score. For example, analysing such data might provide insight on the right time to try to cross-sell or upgrade because of a high customer health metric.
Relentlessly focusing on customer success can also benefit NRR.
Customer success directly correlates to the value a customer realises in doing business with your business. If the business doesn’t have a dedicated customer success team, then you should create one.
If your business has a client success team but is losing customers at an unacceptable rate, the business could attempt to link all or part of the success team’s compensation to customer renewals and expansion revenue.
The goal of any effort to increase NRR is to increase customer success.
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