Why You Need To Be Careful With Net Revenue Retention

Written by
Ross Andrewsarrow icon

Why You Need To Be Careful With Net Revenue Retention

Written by
Ross Andrews

We will be the first one to tell you we love a great revenue retention breakdown. For most early-stage startups looking at revenue retention can reveal a treasure trove of information about how your customer are behaving, how they like your product, and how long they stick around. Net Revenue Retention (NRR for short) is one of the most popular and commonly discussed metrics for recurring revenue/subscription startups and is typically used as a measuring stick for the health of a companies revenue stream. The issue being simply looking at the top line retention percentage can be misleading, we will explain…

First, we want to review the formula for NRR which you can always find in our SaaSy Math resource:

Formula: (Initial MRR - Churned (Cancelled) MRR - Downgrade MRR + Expansion (Upsell or X-Sell) MRR) / Initial MRR

Net Revenue Retention is used to calculate how much revenue from businesses, or particular group of their customers, is left after their initial purchase. It is meant to be a pulse check for recurring revenue businesses to assess how sticky their product or service is, do they have product-market fit, and how the economics of their product or service performs in the market. Long story short, do you customers pay you enough and stick around long enough for this business to become profitable.

In theory the higher NRR the better. A startup with 110% annual NRR versus 90% annual NRR is retaining 20% more revenue and therefore in the short term seems like a better bet for growth and success. The issue becomes when you look at the components of those 110% and 90% retention numbers.

The formula for NRR contains churned and downgraded revenue as well as expansion revenue. Churned/downgrade revenue is the result of customers either canceling their subscription or knocking down the amount they buy from you, either way it results in lost revenue and potentially lost customers. Expansion revenue is the result of customers with an initial subscription either upgrading their plan, adding more licenses or products, or buying an additional SKU.

Let’s say that the 110% NRR startup lost 20% of their revenue to churn, 5% to downgrades and 35% of it was the result of expansion/upgrades. Great right?!? Then we look at the 90% NRR startup with 5% churn, 10% downgrades and 5% expansion/upgrades. What is going on here?

For our 110% NRR startup in the short term revenue retention is growing which looks great on paper at the top line. The issue becomes those massive churn numbers. 35% revenue expansion/upgrade is great, unless you are churning 20% of your revenue each month, why? With that high of revenue churn you quickly will find yourself losing bad-fit customers so fast that you eventually will run out of accounts to upsell too. Once that happens and your 35% revenue expansion suddenly drops to 5-10% because you have already upgraded all the best accounts your overall NRR will plummet to 80-85% which is not a great sign for a recurring revenue business. We call this a “false bottom” where a startup masks a churn issue by driving upsells in the accounts that do stick around.

Now, this isn’t all doom and gloom, both startups in this case could succeed, you just need to look at the data and make the necessary adjustments to address what the data is telling you. For the 110% net retention startup. They need to isolate the 35% of accounts that upgraded. Clearly these are customers that you have strong product-market fit, take what you know about them and use it to put a marketing and sales plan in place to attract more customer that match their profile and next thing you know that churn number will shrink instead and the businesses revenue retention will only improve.

Net Revenue Retention is a powerful metric to assess the health of early-stage recurring revenue startups. Startups and investors alike need to be careful when reporting or making decisions on top-line retention numbers though because they can sometimes not tell the whole story. Breaking revenue retention down into the components that make up its whole can help you better analyze the long term trajectory of a startup and diagnose potential solutions to any shortcomings.

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