Proxies for Cash Flow: Net Revenue Retention
A Series
I have previously written about the power of annual contract value (“ACV”) and how it can be used as a potent proxy for cash flow. One of the questions I received from a few dear readers was if I considered ACV to be the best proxy for cash flow. I definitely do not. Cash flow is too amorphous of a concept for it to be captured using just one metric. Truly understanding cash flow is a complex exercise that mixes science and craft into an ambiguous understanding of a Company’s health. In other words, it’s hard and imprecise.
For high-growth SaaS companies it can be particularly tricky to assess their cash flow situations because their business models are typically heavily dependent upon intangible investment cycles. Which is to say that SaaS growth is generated from harder-to-discern investments, such as hiring a bunch of new members of the sales team, increasing marketing spend to chase a new marketing strategy, or hiring a bunch of new engineers to focus on launching a new product. None of these investments are typically capitalized, thus it’s tough to pull them out of a cash flow statement or approximate their impact on a metric like EBITDA. If you look at a SaaS company’s operating profit trendline, it would be hard to tell if the SaaS business is unprofitable over the long term or if it is just heavily investing into intangible strategies that will accelerate growth. What’s more, it would be extremely difficult to know if the Company’s intangible investments were actually paying off.
There are a lot of folks who can better articulate the intangible investing conundrum than me - Michael Mauboussin is probably the guy who is writing the most about intangible investing over the past several years and he recently published a post about intangibles and their impact on earnings. He argues for finding ways to actually capitalize these intangible assets on balance sheets so as to have income statements more appropriately reflect cash flows. While that is very provocative, it would be very difficult to pull off in a real world environment across the board. However, the point still stands - it’s hard to sniff out intangible investments and their impacts on cash flow.
Again, this is where a variety of other proxies can help you get a better grasp for a company’s cash flow situation. You need to extract intangible “capital expenditures” to get a picture for how profitable the company actually is at any one point in time. There are a variety of unit economics metrics that can provide a decent snapshot, like CAC:LTV ratio, ACV, Churn, etc. These all will let you know how profitable an individual unit of SaaS will be (which is, in itself an intangible thing, as software is as intangible as it gets), but one thing they generally lack is any sense of velocity.
That’s where Net Revenue Retention (and Net Dollar Retention, which is slightly different), come in. Not only can they show you how a good signal for a SaaS product’s profitability, but they can also tease out the rate of growth and the rate of expected growth over the long term as well.
What is Net Revenue Retention? In simple terms, NRR is the percentage of revenue from existing customers that is retained from one period to the next. If you have 25 SaaS customers paying $100 per month for a subscription ($2,500 total monthly), and one of them churns the next month, reducing your total monthly revenue to $2,400 (24 customers x $100/month), then that would result in 96% Net Revenue Retention. In other words, the SaaS company has retained 96% of it’s revenues.
But the neat thing about good SaaS companies (and other kinds of companies as well, but this is particularly true in SaaS) is that revenue per customer is known to increase over time if the customer is enjoying their experience and finding value in the product. Customers might increase the number of seat licenses they have because they want more of their company using the product because of the strong ROI. Or they might purchase a higher tier of product because they want additional features and tools. Or they might add on additional products that the SaaS company offers. Regardless of how it happens, net revenue retention is not purely about the retention of existing customers paying the same price for a product. It can also show a company’s ability to upsell a product. This is a good signal that the products a company is selling are generating serious value and have significant lock-in.
Positive net revenue retention (above 100%) occurs when customer upsell occurs, and out earns any competing churn concerns. To illustrate, let’s use the same example above. A SaaS company acquires 25 customers all being charged $100 monthly for the product in the first month. Month two rolls around and one customer has churned, but 10 customers have increased their monthly payment to $150. So now the second month’s total revenue is $2,900 (14 customers x $100 + 10 customers x $150). This means that the NRR for this second month is 116%. That is pretty good for a single month. Importantly, you might be wondering how new customers being onboarded in the second month impacts NRR (i.e. the sale occurs in month two). It does not - this is a cohort analysis metric - you are only looking at a cohort of companies, and, in this example, that cohort is delineated by month.
As previously stated, positive NRR is important because it shows that the SaaS company is generating value for its customers, otherwise why would they increase what they are paying to the customer. It is also good because it shows that there is likely lock-in effects that prove that this product is sticky. If a customer doesn’t like a product, and wants to churn, they are unlikely to purchase additional features and increase their spend on the product.
Positive NRR is also a velocity signal for growth. If NRR is very high, then that is a good signal that growth is going to continue to accelerate. Why? To understand this concept, it is important to remember that SaaS is assumed to be very sticky - meaning that customers are less likely to churn than other kinds of products / business models (which is a decent assumption based on decades of historical data). Because of this lack of churn, when each new cohort of customers get brought on, it can be expected that as they stick around, they will continue to grow similarly to the prior cohorts. (Of course, cohorts are not created equal, so you need to make sure that you thoroughly test and examine your NRR drivers). As a result, the topline growth from one month might only represent a percentage of what that actual number of customers will bring in over their lifetime. So you might have added 25 customers this month for $2,500 topline growth, but there will be additional baked-in growth moving forward on top of that $2,500 monthly revenue assuming that cohort follows a similar trajectory as past cohorts which signal positive NRR.
Fundamentally, this is part of what makes SaaS so appealing. Not only is revenue predictable because it is contracted over a certain period of time - leading some to claim that it is more valuable than first-lien debt as a stream of income. But it’s growth can also be predictable as well - just look at historical NRR. And unless something hasn’t changed too drastically in the market or in the product, you can expect similar organic growth to keep on happening.
“Software contracts are better than first-lien debt. You realize a company will not pay the interest payment on their first lien until after they pay their software maintenance or subscription fee. We get paid our money first. Who has the better credit? He can’t run his business without our software.” - Robert Smith
While this predictable growth isn’t exactly a sign of strong cash flow, it is a sign that customer acquisition costs - one of the most common intangible investments on a modern SaaS company’s income statement - are being invested wisely. If NRR is high and CAC is being cleared in a short period of time, then that means that the SaaS company’s revenues will compound. It also shows that quality customers are being acquired and that a company is targeting the right segment of the market. So while you can’t tell what cash flow is using NRR alone, you can get a feel for whether or not a company is doing a good job investing in its growth. It’s P&L might appear unprofitable, but it is doing this in the name of capturing growing customer segments over the long term.
If you are looking for good NRR benchmarks in the private SaaS space, a good place to look is SaaS Capital’s 2022 report - found here. They generally do a good job with SaaS Benchmarking and this is no exception. The generally accepted NRR target for most private-SaaS’s is 110%, which shows that the company has positive velocity. However, for more high flying, younger SaaS company’s that have a new-to-market approach, you probably want something well above that figure. Best in class for public SaaS companies is typically 130%. So a startup with it’s hair on fire might do well to be above that number, especially at the start.
If you are looking for an NRR that will melt your face, look no further than public SaaS / Cloud darling Snowflake:
