A core plank of the SaaS economic model is under extreme pressure

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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.