Why Retention Margins Matter In Startups

Written by
Ross Andrewsarrow icon

Why Retention Margins Matter In Startups

Written by
Ross Andrews

Retention Margins are rarely discussed in many SaaS/Startup circles. MRR and CAC are widely discussed leading to everyone's favorite CAC Payback and LTV:CAC Ratios that founders and VCs alike typically use to benchmark startups that are trying to or have raised capital. The fundamental issue here is that by looking at just MRR, and not taking margins into account you are essentially missing half the reason why Venture Capital exists. Startups with recurring revenue typically charge lower monthly fees to increase access to a larger market, a larger market means larger earning potentials which is exactly the sort of thing that venture loves.

When you lower the sticker price of software, especially as an unproven startup, the revenue trough gets bigger. What is the “Revenue Trough”? Well, it costs money to acquire customers, say $1,000 per new customer. If you charge $99/month for a tool you’ve built after you grab a customer in month one you are $991 in the hole (or trough). You need to collect that $99 for 11 months to actually turn a profit (at this point you have collected $1,089. At which point, from an MRR perspective you have “paid” your CAC back and on a customer economic basis you are technically making money. Now Venture Capital literally is built to fill in that trough. A VC give you $1M because this new $99/mo tool you’ve built is going to be big, and that $1M helps cover the $1,000 CAC cost so you can use that money and fill in that revenue trough gap as you acquire customers faster and faster without feeling the cash pinch.

Remember, the faster you grow, the faster the trough grows, revenue is only growing $99 per customer but your CAC is growing $1,000 for each new customer meaning the revenue trough grows exponentially. (All of this is ok, it’s a reality of startups and it is why venture capital exists, to help solve these cash gap issues early in a startup's lifecycle).

At the end of the day, it is really a math exercise. How much cash do you need to bridge the gap to profits on a customer-by-customer basis (after all, profits are how a business funds its own growth)? The issue is, in the above example, if you assume 11 months for each customer both you and your investors will be wrong and the math will be off. Yes, each customer pays you $99/mo but that isn’t how much you get to keep as a business because after you have acquired a customer you need to keep them. Recurring revenue is amazing because well, it’s recurring, you get to collect it month-over-month and it is highly predictable. The kicker is it costs money to keep those customers happy and paying and that tends to be the one piece of this math equation that we tend to overlook, retention margin.

Retention margin is how much revenue is left from that $99/mo after you have supported your existing customers and they stick around for another month and pay another $99. Customer Success, Service, Marketing, and other activities to support your existing customers all fall in this per-view and those costs add up. Some of the best startups we have seen have retention margins in the 70% range, so let’s give this startup the benefit of the doubt and assume they have 70% retention margins. That is $69.30 that they actually get to keep each month out of the $99. Not bad, the issue is if we look at that $1,000 CAC then that means you are no longer pay that back in month 11, you're now paying it back in month 15 ($69.30 x 15 = $1,039.50). And remember, CAC grows exponentially faster than revenue does.

We just want this to be a resource to help founders entrepreneurs not walk into a trap. Make sure you take the time to look into your margins even early on because as you start to scale those customer economics matter and it will help you better plan and finance yourself as you grow and scale. Have questions about how to find your retention margins and how they impact your startup? Shoot us an email at hello@talkinsaasy.com, we are always happy to chat with other startup folks!

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