How Net ARR Retention Contributes to Valuation
SEG Managing Partner, Allen Cinzori, recently joined SaaS Capital and ChurnZero to talk about the importance of retention for SaaS businesses. In the webinar, Allen presented an entirely new perspective on the interrelationship between valuation, ARR growth, and net retention all in one chart. For the full webinar, please watch here: How Do You Rank? Understand the Growth and Retention Metrics of SaaS Companies from Recent Surveys and M&A Activity.
The Rowboat Analogy:
There are two boats on a lake, Rowboat A and Rowboat B. Three people are in each boat, and the boats are floating at the same water line. If we were to consider the waterline to be a metaphor for ARR growth, both boats are growing at the same rate.
However, the boats are very different. Inside boat A are three people working feverishly to bail water from the boat, while the three people in boat B are comfortably sitting under an umbrella drinking Mai Tai’s.
Which boat do you want to be in? Which boat is more valuable? Clearly boat B.
The SEG Net Retention Wave:
There are several factors that contribute to a company’s valuation, including both qualitative and quantitative measures. However, few metrics have a more demonstrable impact on SaaS company valuation multiples than net dollar retention. A few months ago, we set out to better understand the how the correlation between ARR growth and net retention impacts a SaaS company’s valuation.
Upon analyzing and plotting data for SEG SaaS Client multiples over the past few years, primarily in the lower to middle market(1), we discovered wave-like patterns, and created the chart below. Click to Watch the Explanation of the SEG Net Retention Wave.
Let’s Look at an Example:
What attributes net ARR retention’s large role in determining valuation?
Net ARR retention looks at retention on a dollar basis. It is defined as the sum of customer expansion ARR, contraction ARR, and lost ARR, divided by the company’s beginning of year ARR (see previous blog on how to calculate churn).
Consider three companies with 40% ARR growth. Company A has 75% net retention and is in the 2x – 4X ARR range. Company B has 90% net retention and is in the 4x – 6x ARR range. Lastly, Company C has 100% net retention and is in the 6x+ ARR range.
Company A has a tremendous amount of “fill-in” required. Because net retention includes expansion, the burden is on the new account sales team (i.e., Hunters). This team needs to increase beginning of the year ARR by 65% for the company to reach 40% ARR growth.
Telling us a different story, Company C is starting at 100% net retention. From a new logo ARR perspective, the new account sales team needs to generate 40% growth to hit the ARR growth mark. Company C is a more efficient business. All else equal, Company C is also worth more than Company A.
Compounding Effects of Net ARR Retention:
Let’s take a closer look at Company C and see how the business can be improved. Click to Watch the Explanation of Compounding Effects of Net ARR Retention.
In the model below, Company C has $5M of revenue at the beginning of year one and $26.9M after year five. The Company is growing at 40%, gross churn is 20%, expansion is 20%, and net retention is 100%. This is the baseline case:
Imagine if Company C improves gross retention from 80% to 90%, all else equal. As a result, Company C will also see net retention improve from 100% to 110%.
Because the sales team has not changed its strategy and continues to drive 40% growth, ARR growth increases to 50%. As a result, and similar to compounding interest, the company drives $11.1M more in ARR over a five-year period.
If we are to assume a constant ARR multiple of 7x is applied to both the baseline case and improved retention scenario for the company C, the improved retention scenario has generated $78 million of additional value (EV) over a five year period!
The Reality Is…
The company’s size, retention metrics, and growth rate matter. The improvements in retention should drive a higher multiple than the base case. It’s not unreasonable to believe Company C’s improved metrics cause the ARR multiple to expand from 7.0x to 9.0x. In this case, Company C actually drives $154 million of additional value over five years!
Retention is within your control today. How much are you focusing on your existing customers? Continuously win over your EXISTING customers and they will reward the company with a much stronger valuation at capital raise or exit.
One of our favorite quotes from an SEG client is: “Having net retention over 100% is like earning compound interest on your customer base every year.” And that is exactly right.
The full webinar can be viewed here: How Do You Rank? Understand the Growth and Retention Metrics of SaaS Companies from Recent Surveys and M&A Activity.
For most SEG clients serving mid-market to enterprise customers, we see net ARR retention at or above 100%. Don’t hesitate to reach out if you’d like to discuss how retention may impact the valuation for your SaaS company.
(1) Please note that larger SaaS business should expect multiple expansion. The chart mostly represents SaaS sellers in the lower to middle market.