Decoding SaaS Transactions: The Ascendancy of Gross Retention Over Net Retention

In the ever-evolving landscape of software M&A, strategic adaptation is paramount. Recent years, marked by a surge in SaaS adoption and shifting economic policies, have introduced a distinctive dynamic to the market. At Kaizen, our mission is to decipher these market shifts, offering insights to SaaS founders and operators. Today, let's delve into a significant debate gaining prominence: Gross Retention vs. Net Retention.

Understanding the Shift: Gross vs. Net Retention

As the M&A landscape transforms, strategic buyers and private equity investors are placing increased emphasis on gross retention, supplanting the historically predominant net retention metric. Recent surveys conducted by Kaizen reveal a noteworthy shift, with a majority of respondents considering gross retention a crucial metric, surpassing the importance previously assigned to net retention.

Why the Emphasis on Gross Retention?

Gross retention serves as a measure of a company's efficacy in preserving existing revenue by minimizing churn rates. Calculated by assessing lost Annual Recurring Revenue (ARR) and contraction ARR relative to the ARR at the beginning of the year, gross retention has emerged as a more accurate indicator of long-term durability.

While both gross and net retention are vital for analyzing and valuing SaaS businesses, the heightened significance of gross retention is attributed to its direct insight into a product's stickiness and mission-critical nature—qualities sought by buyers and investors in M&A targets.

The Nuances: Gross Retention vs. Net Retention

Net retention figures can be inflated by a robust sales and upsell function, providing reliability in favorable markets. However, in less fertile sales environments, gross retention offers a more insightful view of a company's resilience to economic challenges. Robust gross retention ensures minimal revenue loss, allowing future success to contribute to growth rather than compensating for losses.

Illustrating the Shift: A Comparative Example

Let's consider two companies, Company A and Company B, both experiencing 35% annual ARR growth over five years. While both companies thrive in a favorable market, the real difference emerges when market conditions become challenging. In a hypothetical scenario where upsell percentages are halved and new ARR growth drops, Company B, with a strong emphasis on customer retention, outpaces Company A in maintaining growth stability.

This example underscores the ascendancy of gross retention, ensuring operational flexibility and lower risk amid economic uncertainty. The narrative shifts from a focus solely on growth to a more nuanced understanding of a company's ability to weather market fluctuations.

Operational Flexibility and Valuations: A Synergistic Outcome

Investing in improving gross retention proves pivotal for companies, as showcased in the example. Even when facing challenging economic climates, a company with strong gross retention can achieve impressive growth, ensuring a higher probability of executing forecasts and presenting lower risk to investors.

In conclusion, the shift towards prioritizing gross retention over net retention underscores the importance of long-term stability and customer churn mitigation. This shift not only aligns with market demands but also translates into higher valuations for businesses, positioning them favorably in the dynamic landscape of SaaS M&A.

For a comprehensive understanding of SaaS metrics crucial to your company's valuation, consult Kaizen's expert advisors for additional insights.