(Most of this article was extracted from the Software Equity Group's (SEG) research: 'The Impact of Net Retention on Valuation for Public SaaS Companies' JULY 30, 2020) The correlation between customer retention and business valuation Revenue growth and recurring revenues driven by customer retention are two of the most important financial metrics to buyers in the M&A market. Growth reflects a company’s ability to differentiate and compete to win new customers in the market. Retention reflects the value of the unique selling proposition and overall customer satisfaction which, in turn, impacts on the lifetime value of a customer to the business.
At the onset of the COVID-19 pandemic, SEG surveyed 50 PE firms and 25 strategic buyers, asking which of these metrics is more important. The overwhelming response was retention.
Why Retention?
To visualize the importance of retention on valuation let's imagine two companies as gardeners growing & selling flowers with the same market value and same fertiliser costs. Company 'A' grows annuals, Company 'B' grows perennials. Every year Company 'A' has to find new bulbs to plant to replace his dead stock. Company 'B' however harvests its flowers year after year without having to find replacement bulbs.
In this metaphor, Company B is clearly in the best position, as it does not need to replace lost customers (or existing customers that are contracting/downgrading). On the other hand, Company A is constantly struggling to replace lost customers just to keep in the same place.
Correlation
Using the SEG SAAS Index of 4th June, 2020 (which tracks 90+ publicly traded SaaS companies) it can be shown that Companies with higher retention rates saw correspondingly higher EV/Revenue multiples. The average multiple for this group was 16.7x (excluding an outlier, Zoom). Impressive results, considering the average EV/Revenue multiple for the SEG SaaS Index was 8.8x at the end of Q2 2020.
Of the companies tracked, Twilio had the highest net retention rate of 143%. This strong net retention is a major reason why the company boasts a 20.3x EV/Revenue multiple, 130.6% over the 2Q20 SaaS Index median. The companies with the top five highest EV/Revenue multiples include Zoom (70.2x), Crowdstrike (35.0x), Zscaler (33.4x), Slack (29.4x), and Cloudflare (25.5x). These companies boasted an average net retention of 124%.
Conclusion
Perhaps it's not surprising that businesses with 'mission-critical' differentiated applications and strong customer support also build high retention rates. But it's particularly notable that these businesses also command much higher valuations.