Net retention: Meaning, Criticisms & Real-World Uses

What Is Net Retention?

Net retention, often referred to as Net Revenue Retention (NRR) or Net Dollar Retention (NDR), is a key performance indicator (KPI) within the broader category of SaaS metrics and revenue analytics. It measures the percentage of revenue retained from a company's existing customers over a specific period, typically a month or a year, taking into account upgrades, downgrades, and churn. Net retention provides a comprehensive view of a business's health by illustrating not only how well it retains its current customer base but also its ability to grow revenue from those customers through upselling and cross-selling efforts. This metric is particularly crucial for subscription-based businesses like Software-as-a-Service (SaaS) companies, where recurring revenue is paramount.

History and Origin

The emphasis on net retention as a critical metric gained prominence with the rise of the subscription economy, particularly in the Software-as-a-Service (SaaS) sector. As businesses shifted from one-time software licenses to recurring subscription models, the ability to retain and grow revenue from existing customers became a primary driver of valuation and sustainable growth. Venture capital firms and investors, notably those focused on SaaS companies, began to scrutinize metrics beyond simple customer acquisition. For instance, in 2020, venture capitalist Martin Casado from Andreessen Horowitz highlighted "Net Dollar Retention" as a key indicator of a B2B company's economics, emphasizing that growth is increasingly driven by expansion within the existing customer base rather than solely new sales.²⁸ This marked a shift in focus from "growth at all costs" to "profitable growth," underscoring the importance of customer retention and expansion.²⁷

Key Takeaways

Net retention measures the percentage of revenue retained from existing customers over a period, accounting for expansions, contractions, and churn.
It is a crucial metric for subscription and SaaS businesses, indicating both customer retention and revenue growth from the existing base.
A net retention rate above 100% signifies that a company is growing revenue from its existing customers, even after accounting for churn and downgrades.
This metric is a strong predictor of future revenue growth and is closely watched by investors.
Improving net retention can lead to significant compounding revenue growth and enhanced company valuation.

Formula and Calculation

The formula for calculating net retention (or Net Revenue Retention, NRR) is as follows:

\text{NRR} = \frac{\text{(Starting Recurring Revenue + Expansion Revenue - Downgrades - Churn)}}{\text{Starting Recurring Revenue}} \times 100\%

Where:

Starting Recurring Revenue: The total recurring revenue from existing customers at the beginning of the period (e.g., Monthly Recurring Revenue (MRR) or Annual Recurring Revenue (ARR)).²⁶
Expansion Revenue: Additional revenue generated from existing customers through upsells, cross-sells, or increased usage of the product or service.²⁵
Downgrades: Revenue lost when existing customers reduce their subscription level or usage.
Churn: Revenue lost from customers who cancel their subscriptions or cease doing business with the company.²⁴

The calculation period is typically one year or one month.²³

Interpreting the Net Retention

Interpreting net retention involves understanding what different percentages indicate about a business's underlying performance in the realm of customer lifecycle management.

NRR > 100%: A net retention rate greater than 100% is highly desirable, especially for SaaS and subscription-based companies. It means that the revenue gained from existing customer expansions (upsells, cross-sells) outweighs the revenue lost from churn and downgrades.²² This indicates a strong product-market fit and effective customer success strategies that drive increased customer lifetime value.²¹ Companies with high NRR are often seen as having more predictable and stable revenue streams, which significantly influences company valuation.²⁰
NRR = 100%: A net retention rate of 100% means that the revenue from existing customers remained flat. While no revenue was lost, there was also no growth from the existing base. This could suggest that while churn is being managed, opportunities for expansion might be missed.
NRR < 100%: A net retention rate below 100% indicates that the revenue lost from churn and downgrades is greater than any expansion revenue. This is a red flag, signaling potential issues with customer satisfaction, product value, or the effectiveness of retention efforts.¹⁹ A consistent NRR below 100% implies that the business is shrinking its existing revenue base, requiring significant new customer acquisition just to maintain overall revenue levels.

Benchmarking net retention often depends on the Annual Contract Value (ACV) of the product. For instance, in 2023, the median net retention rate across all B2B SaaS companies was 102%, but for companies with higher ACVs (over $250,000), the median NRR was 110%.¹⁸

Hypothetical Example

Consider "CloudSolutions Inc.," a hypothetical SaaS company that provides project management software. On January 1st, CloudSolutions has a Starting Monthly Recurring Revenue (MRR) of $500,000 from its existing customer base.

During January:

Expansion Revenue: CloudSolutions' existing customers upgraded their plans or added more users, generating an additional $75,000 in MRR.
Downgrades: Some customers downgraded their subscriptions, leading to a loss of $20,000 in MRR.
Churn: Other customers canceled their subscriptions entirely, resulting in a loss of $30,000 in MRR.

Using the net retention formula:

\text{NRR} = \frac{\text{(\$500,000 + \$75,000 - \$20,000 - \$30,000)}}{\text{\$500,000}} \times 100\%

\text{NRR} = \frac{\text{\$525,000}}{\text{\$500,000}} \times 100\%

\text{NRR} = 1.05 \times 100\%

\text{NRR} = 105\%

CloudSolutions Inc. has a net retention rate of 105% for January. This indicates that the company successfully grew its revenue from its existing customer base by 5%, even after accounting for revenue lost to downgrades and churn. This positive net retention suggests a healthy and expanding customer base and effective strategies for maximizing customer value.

Practical Applications

Net retention is a cornerstone metric for financial analysis, particularly in the context of recurring revenue businesses and venture capital investments.

Investor Due Diligence: Investors heavily rely on net retention to assess the quality of a company's revenue and its long-term growth potential. A high net retention rate signals strong customer loyalty, effective product stickiness, and a business model that can compound growth over time without solely relying on new customer acquisition.¹⁷ This often leads to higher valuation multiples for companies demonstrating strong NRR.¹⁶ For instance, a 2023 survey of B2B SaaS companies revealed that the relationship between median net revenue retention and Annual Recurring Revenue (ARR) is positively correlated, indicating that NRR increases as companies scale.¹⁵
Strategic Planning: Companies use net retention to inform strategic decisions related to product development, pricing, and customer success initiatives. A declining NRR might prompt a review of the product roadmap or an increase in investment in customer support and engagement programs.
Performance Benchmarking: Net retention allows companies to benchmark their performance against competitors and industry averages. This helps in understanding market position and identifying areas for improvement. Data from surveys like those conducted by SaaS Capital provide valuable insights into median NRR rates across various annual contract values, enabling businesses to set realistic and competitive goals.¹⁴
Sales and Marketing Effectiveness: While often associated with customer success, net retention also reflects the effectiveness of sales in identifying ideal customer profiles and marketing in attracting customers who are likely to find long-term value in the product. It emphasizes the importance of ongoing engagement beyond the initial sale.
Forecasting Revenue: A strong NRR provides a more predictable foundation for future revenue forecasting, making financial planning more reliable.¹³

Limitations and Criticisms

While net retention is a powerful metric, it has certain limitations and can be subject to misinterpretation if not viewed alongside other key performance indicators.

One criticism is that a high net retention rate can sometimes mask underlying customer churn.¹² If a company loses a significant number of smaller customers but manages to heavily expand revenue from a few large customers, the NRR might remain high, suggesting overall health when there's actually a retention problem with a segment of the customer base. This can lead to a false sense of security regarding the actual rate of customer acquisition cost efficiency.¹¹

Another limitation is that net retention primarily focuses on existing customers and does not directly account for the influx of new customers. While strong NRR is desirable, a business still needs a robust pipeline of new customers to ensure sustained long-term growth and market expansion, especially in highly competitive industries.¹⁰ Relying solely on NRR might lead companies to neglect marketing strategies aimed at broadening their market reach.

Furthermore, net retention can be influenced by changes in pricing strategies. A significant price increase across the board, even without much added value, could temporarily inflate NRR. Conversely, strategic price reductions to gain market share might negatively impact NRR in the short term, even if they contribute to long-term customer base expansion. It's crucial to analyze the drivers behind NRR fluctuations to understand the true health of the business.

Finally, while benchmarks exist, what constitutes a "good" net retention rate can vary significantly depending on the industry, target market (e.g., small businesses vs. enterprises), and the maturity of the company. A rate that is excellent for one type of business might be average for another.

Net Retention vs. Gross Revenue Retention

Net retention (NRR) and gross revenue retention (GRR) are both critical metrics for subscription-based businesses, but they offer distinct perspectives on revenue stability and growth from existing customers. The primary difference lies in how they account for expansion revenue.

Net Revenue Retention (NRR), as discussed, provides a holistic view by considering all changes in recurring revenue from existing customers, including revenue from upsells and cross-sells (expansion), as well as revenue lost due to downgrades and churn. Because it includes expansion revenue, NRR can exceed 100%. A rate above 100% indicates that the revenue generated from growing existing accounts is more than offsetting any revenue lost from customers leaving or reducing their spend. This suggests strong customer loyalty and effective strategies for increasing customer lifetime value.⁹

Gross Revenue Retention (GRR), conversely, focuses solely on the revenue retained from existing customers without factoring in any expansion revenue. It only accounts for revenue lost from churn and downgrades. Therefore, GRR can never exceed 100%. A GRR of 90% means that 90% of the initial revenue from a cohort of customers was retained, with 10% lost to churn or downgrades. GRR is considered a more conservative metric as it highlights the absolute baseline of revenue retention, making it particularly useful for identifying core retention issues before expansion revenue might mask them.⁸ It can reveal how "sticky" a product is, irrespective of how much additional revenue can be generated from it.⁷

In essence, NRR tells you how much revenue you're growing or shrinking from your existing customer base, while GRR tells you how much revenue you're losing from your existing customer base. Both metrics are valuable; NRR provides a picture of overall revenue momentum, whereas GRR offers a clear view of customer attrition and the fundamental health of customer retention.

FAQs

Why is net retention important for investors?

Net retention is highly important for investors because it signifies a company's ability to generate compounding revenue growth from its existing customer base, which is often more cost-effective than acquiring new customers.⁶ A high net retention rate indicates strong customer satisfaction, product stickiness, and predictable future revenue streams, making a company a more attractive and less risky investment.⁵

What is a good net retention rate?

A good net retention rate generally exceeds 100%, particularly for SaaS companies.⁴ A rate of 100-120% is often considered good, while 120% and above is considered excellent, demonstrating significant growth from the existing customer base even after accounting for churn and downgrades.³ However, "good" can vary by industry, product type, and annual contract value (ACV). For instance, products with higher ACVs tend to have higher net retention rates.²

How can a company improve its net retention?

To improve net retention, a company can focus on several key areas: enhancing customer success and support to boost customer satisfaction and loyalty, actively identifying and pursuing upsell and cross-sell opportunities, continuously improving the product or service to increase its value, implementing proactive churn prevention strategies using data analytics to identify at-risk customers, and offering flexible subscription models.¹