In recent quarters, the software industry has been grappling with a significant issue: plummeting net retention rates. This critical metric, which measures how much existing software customers spend over time, has dipped below expectations, shedding light on the challenges faced by IT firms and their revenue slumps.
Net retention is a cornerstone of the Software as a Service (SaaS) economic model, and it's under substantial pressure. Software companies find themselves in a precarious position, balancing the need to tighten expenses while preventing the stagnation of growth as existing customers cut back on their expenditure.
Net dollar and revenue retention are normalized to 100%, signifying that a software company's existing clients pay the same amount over time. When net retention numbers surpass 100%, it indicates that existing customers are increasing their spending, which is a favorable situation. Conversely, numbers below 100% indicate a decline in spending.
For enterprise software firms, having net retention above 100% is crucial. A higher net retention rate implies that customers are not just sticking around but also increasing their investment in your products. This growth in revenue allows companies to offset their expenditures, especially since software sales typically offer high margins.
The recent data paints a concerning picture. According to Altimeter investor Jamin Ball, median net retention at public SaaS startups has taken a nosedive.
- Q1–Q4 2022: 120%–121%
- Q1 2023: 116%
- Q2 2023: 111%
What's more concerning is the stark drop from 120% to 111% in just two quarters, representing a 45% decline. These numbers are a cause for worry, especially considering that at least half of public software companies had retention rates below 111%. While further data is expected as companies report their quarterly results, the current scenario is far from ideal.
The question arises: Why is net retention declining so sharply? Is the software business really in dire straits? The answer is more complex than it may seem.
One possible factor to consider is pricing. Many SaaS products are offered at relatively low monthly costs. Take Slack, for example, with a basic subscription starting at just $7.25 per person. While there are higher-tier options available, these prices are still quite affordable. Negotiating volume discounts or opting for enterprise plans can further reduce costs.
