Customer loyalty: Annual & Net Recurring Revenue (ARR/NRR) are among the most important value drivers

The key figures Annual Recurring Revenue (ARR) and Net Revenue Retention or Net Recurring Revenue (NRR) discussed in this article provide potential company buyers with information about the proportion of recurring revenue and scalability of the software company.

Why is this topic relevant to me as a software entrepreneur?

As discussed in previous articles, SaaS business models are often highly valued, particularly due to their good scalability. However, not every SaaS company generates all of its revenue through subscription models. Many software companies offer hybrid models (SaaS and licensing) or additional consulting and ancillary services for their software.

The key metrics discussed in this article, Annual Recurring Revenue (ARR) and Net Revenue Retention (NRR), provide potential buyers with insight into the proportion of recurring revenue and the scalability of the software company.

This article thus concludes the topic of key metrics in the software sector with a summary of the discussed metrics and more general valuation drivers in an indicative valuation matrix.

What do I need to know about it?

Annual Recurring Revenue (ARR): As already discussed, recurring revenues represent one of the most important value drivers for SaaS companies from an investor perspective. For this reason, the Annual Recurring Revenue (ARR) or Monthly Recurring Revenue (MRR) metric has become widely established.

This metric is calculated by multiplying the number of all active customers bound to a subscription model by the average annual or monthly revenue per customer. For example, if a product with a 3-year contract was sold for €150,000, the ARR for this customer would be €50,000 (€150,000 / 3 years).

Due to the attractiveness of recurring revenues, it is not uncommon in practice for investors to consider only recurring revenues for their valuation (the “ARR multiplier”). Some financial investors even define a minimum percentage of ARR in their investment criteria, above which a software company is even considered a potential target.

Net Recurring Revenue (NRR): Due to its relevance, the development of ARR over time is often a focal point of any due diligence in the software sector. To illuminate this development from various perspectives, a so-called Net Recurring Revenue (NRR) analysis is often conducted.

Here, sales per customer are analyzed over several periods (e.g., months or years) and typically classified into the following categories:

  • Sales from new contracts: Customers acquired in the current period
  • Sales from existing contracts: Customers who
    • extend their contract (“extensions”)
    • upgrade their contract (“upselling”)
    • downgrade their contract (“downselling”)
  • Terminated contracts: Customers who have churned (“churn”)

According to the diagram above, the NRR for year 1 is calculated from the revenue in year 2 excluding newly acquired contracts, divided by the revenue in year 1. In other words, the share of revenue in year 2 attributable to all customers who were already customers of the company in year 1 is calculated.

In the diagram, the NRR decreases from 90% to 79% over the observation period. The individual subcategories provide insight into the reasons behind this development. This example clearly shows, on the one hand, that the company has a consistent churn rate of 20-25% in both years. On the other hand, the decline in NRR from year 2 to year 3 appears to be driven primarily by a higher proportion of downsells. The next step would be to examine the reasons why many existing customers reduced their revenue (e.g., switching to lower-priced models, limiting their usage, etc.).

How can I use this information to my advantage?

In preparation for a sales process, entrepreneurs should ideally understand the individual drivers and historical developments of their company’s NRR and, if possible, exploit optimization potential during the sales initiation phase:

  • Upsell/Downsell: A higher upsell or a lower downsell, in particular, contributes to increasing NRR. These also signal to investors high scalability of sales.
  • New Customers: If companies in the growth phase generate a high proportion of revenue from new customers, it is important from a buyer’s perspective that the newly acquired customers were not acquired through one-time sales, but rather through long-term contracts, thus having a positive impact on ARR.
  • Customer Churn: As discussed in previous articles, cancellations not only have a negative impact on customer lifetime value. They continue to be an indicator that the company’s scalability and profitability will remain limited in the future, as the company will have to continually incur high acquisition costs (CAC) to acquire new customers for further growth.

Furthermore, classifying revenue trends into the aforementioned components can support entrepreneurs and managers of software companies in their ongoing corporate management, even independent of a potential sales process.

General Value Drivers

Finally, entrepreneurs should be aware that, in addition to industry-specific financial metrics, there are other, general value drivers that influence company value regardless of the respective industry and should be considered by a seller when setting their own price.

The above presentation summarizes the evaluation factors discussed in our article as well as general ones and their impact on a possible evaluation, thus concluding the topic of essential key performance indicators in the software sector.

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