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Anna is out this week, so I’m back in the saddle for today. Here’s about 1,000 words on something that I’ve been chewing on for a few weeks! — Alex
Under pressure
Modern software companies grow in two key ways. They sell their products and services to new customers, and they sell more of the same to existing clients. The latter category is important as it helps with growth, and profitability.
It’s simple enough to understand: As SaaS companies sell their code on a subscription basis, they collect revenues over time. This means that sales costs are upfront and the revenue trails. The upside of having a subscription revenue stream over a one-time sale, even if the latter might be more convenient for cash flow purposes, is that it allows for strong revenue predictability. Everyone loves that.
However, spending to land new customers and collecting the sales value later means that SaaS companies can burn a lot of cash to build their customer base. Sounds tough, right? The magic of SaaS, however, is in the upsell. As most software products today charge on a recurring (subscription) or usage basis, they often see revenues from their existing customer base rise over time.
This is called net retention, net revenue retention (NRR) or net dollar retention (NDR). There’s not one perfect definition of this metric, so when you read an S-1 filing or similar from a software company, make sure to read how it defines net retention; otherwise you can wind up thinking that its business is better than it really is!
How does all that add up to profitability? Simple: Once a SaaS customer has paid back its acquisition costs (and related), its recurring revenues are largely a profit source. And, as customers tend to spend more over time, they also contribute to growth. It’s that combination of long-term profitability, growth and predictability that has made software revenues worth so much over time.
However, the net retention reality in the market is evolving in a manner that appears pretty tough for software companies, both large and small. NDR rates are slipping all over the software landscape, meaning that a lot of software companies are seeing their growth rates decline, not due to their inability to sell to new customers — or not merely that problem — but because their existing customers are not buying as much as they used to.
In a sense, this trend alone is a good reason for software shops to tidy up their expenses as some possibly expected growth simply won’t arrive — and that means less gross profit in the future to allay costs.
There has been a decline in SaaS net retention from Q1 2022 to Q1 2023, as this Blossom Street dataset details. OpenView has a good slide on this as well, which you can find on page 39 of this deck. But let’s lay out a few examples from recent earnings reports to lean on the most recent data:
- Amplitude Q2 2023: “NRR, on a trailing 12-month basis declined sequentially to 108%. In period NRR was 101%, down from 118% in Q2 2022. Gross retention this quarter was in the mid-80s.”
- Cloudflare Q2 2023: Net retention fell from 126% in Q2 2022 to 115% in Q2 2023..
- Snowflake April 30, 2023 quarter: Net retention fell from 174% to 151% compared to year-ago results.
- Datadog Q2 2023: “NRR was over 120% in Q2 as customers increased their usage and adopted more products. . . . If our growth trajectory continues at current levels, we expect our trailing 12-month NRR to decline to below 120 in Q3.”
You get the picture. And those are companies that I track because of their attractive market dynamics or simple business outperformance in recent years. Some companies with more measured growth rates are at times under even more pressure. DigitalOcean saw its net retention rate fall from 113% in the year-ago Q2 to just 104% in its most recent quarter, for example.
That’s 400 basis points above flat. Or, put another way, 500 basis points away from being negative.
Some of the decline in net retention is to be expected. Anyone looking at growth rates among public clouds has seen the numbers slip; optimization is the name of the game. But Amazon and Google and Microsoft can take IaaS and PaaS deceleration on the chin, as they are massive, multipart businesses. For tech shops with more targeted incomes, the issue can be steeper.
For startups, falling net retention rates, presuming that what is happening on the public markets is even partially affecting upstarts, must feel like a curse. A few years back, you could expect some level of net retention from already paid-for customers, boosting your gross profitability, limiting cash burn, and generally making your spend levels make sense on paper. If that tailwind slows to slack, growth is not only harder to accrete, but is also far more expensive. Certain costs may not make sense anymore; slower natural growth may be compounded by a need to curtails sales and marketing costs to limit near-term burn; a chief boon of the SaaS economy suddenly goes mute.
There is some reason to be optimistic that the current net retention trough will eventually recover its prior form. Amplitude has plans to get growth back on track. Twilio is also talking about reacceleration. And data from public clouds implies that the period of cost minimization (spend optimization, if you will) is slowing, indicating that there may be some reduced pressure from cloud customers looking to slash expenses.
On the other hand, it might take until early 2024 for net retention to recover.
Still, startups today are expected to grow fast. And not burn too much. And handle a global workforce, return-to-work pressures, more limited capital, a closed M&A market and a ghost town of an IPO window. And now, net retention is no longer helping like it once did. It’s a difficult mix of issues.
There was some chatter in startup circles recently about software companies and whether they are good businesses. My view remains that they are, and valuable ones, to boot. But I don’t think that the conversation sprung up simply because we’re seeing startups and larger software companies scramble to generate more cash to prove that they can. I think it’s because it’s harder than it has been in some time to sell software and keep that revenue line expanding. Something to think about.
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