Understanding how net ARR retention contributes to valuation is important for SaaS founders looking forward to an investment or exit. After all, when given the proper focus and resources, retention becomes the gift that keeps on giving (in valuation dollars, at least).
To help SaaS businesses understand the importance of net retention, SEG Managing Partner Allen Cinzori teamed up with SaaS Capital and ChurnZero in a joint webinar to present an entirely new perspective on the interrelationship between valuation, ARR growth, and net retention — all in one chart.
In this blog, we break down the key takeaways of SEG’s net ARR retention wave from the webinar to help founders understand how net ARR retention affects valuation.
The SEG Net ARR Retention Wave
Various factors 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 (more on this later).
That’s why, in order to better understand how the correlation between ARR growth and net retention impacts a SaaS company’s valuation, we decided to analyze and plot data for SEG SaaS Client multiples (primarily in the lower to middle markets) over the past few years. We discovered wave-like patterns correlating with valuation for every improved net retention score. Check out the chart below.
Chart Note: Larger SaaS businesses should expect multiple expansion. This chart mostly represents SaaS sellers in the lower to middle markets.
How Net ARR Retention Affects Valuation: A Rowboat Analogy
In order to better understand the net ARR retention wave, let’s start things off simple with an example. Picture two boats on a lake. Let’s call them Rowboat A and Rowboat B. Three people are in each boat, and the boats are floating at the same waterline. If the waterline is a metaphor for ARR growth, both boats appear to be “growing” at the same rate.
However, if we look a bit closer, it turns out the boats are in very different situations. Inside Rowboat A, the three people are working feverishly to bail water from the boat. Meanwhile, the three people in Rowboat B are comfortably sitting under an umbrella drinking Mai Tais.
If the activity going on in the boat represents the internal sales and retention flow of the business, Rowboat A clearly has to do more work than Rowboat B when it comes to staying at the same waterline (ARR). So, which boat do you want to be in long-term? Which boat is more valuable? Clearly, Rowboat B.
An Example of Calculating Net ARR Retention
Taking this back to the real world, let’s answer this fundamental question: Why does net ARR retention play such a large role in determining valuation? We’re glad you asked.
Net ARR retention looks at retention on a dollar basis. It’s defined as the sum of customer expansion ARR, contraction ARR, and lost ARR, divided by the company’s beginning of year ARR (learn more about calculating churn here).
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.
Telling us a different story, Company C is starting at 100% net retention. From a new logo ARR perspective, the new account sales team only needs to generate 40% growth to hit the ARR growth mark. Company C is a more efficient business.
All else equal, Company C is worth more than Company A because it doesn’t require the same effort as Company A to maintain new ARR growth over time.
The Compounding Effects of Net ARR Retention
Let’s take an even closer look at Company C to see how the business can be improved. In the model below, Company C has $5M of revenue at the beginning of Year 1 and $26.9M after Year 5. The company is growing at 40%, gross churn is 20%, expansion is 20%, and net retention is 100%. This is the baseline case:
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 Company C, the improved retention scenario has generated $78 million of additional value (EV) over a five year period!
The Reality of Net ARR Retention
When it comes to valuation and net retention, the company’s size, retention metrics, and growth rate matter. However, the improvements in retention should drive a higher multiple than the base case.
In the example above, it’s not unreasonable to believe Company C’s improved metrics could cause the ARR multiple to expand from 7.0x to 9.0x. In this case, Company C would actually drive $154 million of additional value over five years due to improved net retention!
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 SEG clients got it exactly right when they said:
“Having net retention over 100% is like earning compound interest on your customer base every year.”
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 can impact the valuation for your SaaS company.
Don’t forget to view the full webinar here: How Do You Rank? Understand the Growth and Retention Metrics of SaaS Companies from Recent Surveys and M&A Activity.