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- [00:02]
A
Welcome to the Path to Exit, a podcast to help software and Internet founders understand the process to raise capital or sell their business.
- [00:20]
B
Hello and welcome everyone. I'm Mike Lyon, Founder and managing director at VistaPoint Advisors, and this is the Path to Exit. This show is dedicated to helping founders of software and Internet businesses understand what it takes to raise capital or sell their business and how to do it well. My guest today is Sara Beth Sandweiss, a senior associate at VistaPoint. Sara Beth has advised on a wide range of transactions during her time as an analyst and associate, given her a front row seat to how buyers evaluate software businesses. In this episode, we'll discuss new trends we're seeing with buyers and investors placing greater emphasis on retention metrics and software evaluations, common mistakes founders make when calculating them for a transaction, and and what this shift means for founders preparing to sell or raise capital. Please enjoy my conversation with Sarah Beth. Sarah Beth, welcome to the podcast. I think this is your first time.
- [01:04]
A
Yeah. Hey Mike, it's great to be here. I'm excited to cover this topic today.
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B
Well, let's get started. Maybe start high level with what are generally the top metrics that impact valuation for a SaaS business and what are we starting to see when it comes to retention?
- [01:16]
A
So historically, valuation in software has been driven primarily by growth, retention, gross margins, and then market size and sales efficiency metrics. Over the last few years, we've seen this emphasis shift depending on the market environment. In 2022 and 2023, profitability and cash efficiency were really important because capital was so expensive. Now, what we've been seeing in the last year and what we anticipate going forward has been a shift towards the importance on retention. It used to be a supporting metric to growth and now it's really a gating metric. When investors are thinking about doing a transaction, buyers still want growth, but they increasingly ask how durable is that growth? Retention really answers that question. A company growing really quickly but losing customers will trade very from one growing slightly slower but with strong expansion and low churn. The way when I was working on the buy side we thought about this was think about your business as a bucket. Growth is all the new water that's coming in, but churn is the water that's leaking out. So if you have a big hole because of your churn, the more water you pour in, you're just not going to grow efficiently because you have this leaky bucket and buyers want to see a bucket that holds more water. So that's how we often thought about retention when we were on the buy side.
- [02:21]
B
Leaky bucket is a great analogy. And I think the thing you should know as a tech founder is the buy side is very, very good at determining if a business is what they consider really a recurring revenue business. Obviously, everyone's trying to masquerade as recurring revenue these days because the multiples are really high. So some of these metrics are almost like a gating item, meaning you have to clear it to be considered a recurring revenue business and get those multiples and then once you clear those thresholds, valuation increases, those metrics do better. But espe, you talked a little bit about how things are changing. Why do you think buyers and investors are zeroing on these metrics a little bit differently? Like you mentioned profitability, you mentioned maybe some tweaks in how people are thinking about retention. Why is the buy side changing how they view this over the past four or five years?
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A
I think there's a couple reasons that we've seen this shift. First and foremost, there's a sense that there's a lot more players out in the market and AI is going to further expand that idea that it's very crowded, there's a lot of people out there competing. So retention has become a proxy for product market fit and how you compete. Because if you're retaining a lot of your customers, people are enjoying what they're getting out of the product. That's a pretty good sense for these investors that you have achieved product market fit. Second, the last couple of years, cost of capital has been a lot higher. So investors can't just rely on growth. They want to be able to justify those valuations. And that comes with some of our talk about the margins and EBITDA focus as well. While you don't have to be making a ton of EBITDA at the beginning, especially in the market that we play in these earlier founder led businesses, they do want to know that if push came to shove, they could turn this into some cash flow or having at least predictable cash flows. And so you spoke a little bit about how retention has been so important and that's how you define if it's really recurring revenue that has played a role because of the cost of capital as well. The other thing is that growth has just become harder and more expensive with all of the presence of AI and the ability to do the outbound motion a lot more easily. And it's achievable for almost any founder. It's a lot harder to get some of the growth that founders were achieving five years ago because of our Ability to do email outbounding, cold calling, all of that. You just need a smaller team often than you did back then. And so because of that, revenue that you've already won and is going to stick around is a lot more valuable to a founder than having to rely on growth going forward.
- [04:29]
B
Absolutely. And I think one of the ways buyers think about this is in a low interest rate environment where the cost of capital is relatively cheap. Think of that as like a growth on environment so you can grow a little bit less efficiently. Maybe you can have worse retention and worse margins. I remember in 2020 or 2021, founders actually felt like if they were profitable, it was a negative in terms of valuation because they were seeing so many of these high growth but high burn companies raising money. That actually wasn't ever really true, but it kind of felt like that versus now we' a market where the interest rates are a little bit higher still and profitability is really important. I think once we see interest rates really low again, you'll be back on in a really growth on environment. So it's important to kind of monitor the interest rate environment as you're thinking about how important these metrics are and which ones are most important at the time because it's cyclical. Maybe talk a little bit about the key retention metrics and what's considered desirable for these metrics in this new market we've been talking about.
- [05:26]
A
So there's three metrics buyers are always focused on. We'll start with net revenue retention. This measures how much ARR from a cohort grows or shrinks over a year. This includes both expansion, churn and downsell. And to give you a sense of like what we think about being the most desirable metrics here, anything over 100% is going to be stable. Anything north of 110% is excellent. When you fall below 90% or even in that 90 to 100% range, you're going to raise more concerns. Although net retention is easier to influence because upsell is something that investors often find an area that they can add a lot of value, whether that's through pricing, just increasing pricings, or repackaging, selling by modules, by seats. So there's a lot of areas that investors can see influencing that. But I would say north of a hundred percent is really where we think about being like the base benchmark. Gross retention is the second metric. So gross revenue retention, this measures revenue retained by the company just from churn and downsell. So when you think about this, that's the percentage of your revenue that's staying from last year to this year from that cohort without any upsell. What we think about for the benchmarks here is anything above 90% is excellent, super strong. Anything above 80% in that 80 to 90% is the rough floor that we think about now. This depends also on who you're selling into. If you're selling into enterprises you're going to want to see retention that's higher, those are generally stickier, they're harder to switch, there's a higher cost to entry and so we'd want to see those performing better. If you're selling into SMBs, there's just naturally more involuntary churn in that market. And so we generally see retention for those businesses slightly lower. So those we would see in the 80 to 90% range below 80% it does suggest a churn risk and it is harder to get a deal done because of that leaky bucket that we spoke about at the beginning. So last one is logo retention. This is the percentage of customers that stay year over year. And this is just a helpful proxy especially for founder led businesses who generally will not say no to revenue. It's helpful to see how many logos you're keeping, but it's less important than the gross revenue retention. And we often see with founder led businesses who are not going to turn down revenue that your logo retention might lag behind your gross because you might have a small churny customer base that is just naturally going to leave the platform because they're not a fit, they're going out of business themselves. So while we track logo retention, we generally see with a lot of businesses we work with that it might slightly lag behind gross retention.
- [07:41]
B
Great overview on all the retention rates and I think we talked about this a little bit but we have seen the shift from the growth on environment where people were really focused on your NRR because it gave them a good sense for how much free growth are you going to get next year to now in a slightly different environment, much more focus on the because that's more focused on how many customers are you losing or downselling. So we've seen a shift in those being the lead retention metric. I also think just internally looking at some data, obviously there's a lot going on in different transactions but over the past couple years we've definitely seen a higher degree of competitiveness for transactions where the growth was maybe 85% and above versus if you're in the lower 80s, 80 to 85 material decrease in terms of how competitive those transactions can be. And I Know that sounds like a subtle shift, but 5 points of gross is actually a pretty big number and it also impacts valuations. Maybe talk a little bit about some of the most common mistakes founders make when they're looking at this data. Pretty much all SaaS founders know this data is important, but talk about some mistakes you've seen and frankly some of the risks we have to take in a process sometimes when that data is not super buttoned up.
- [08:51]
A
A few recurring issues that we see talking to any founder is that there are 500 ways to run retention and everybody thinks about it differently. So coming across with a consistent formula and definition for how you look at retention retention, because if you're speaking to investors about it, you want to be able to describe how you're thinking about retention because they will think about it in a different way. Every investor does. We all think about it different ways and we spend a lot of times with our clients running it in different ways to see what the best view on retention is for the businesses we work with. So I think the consistent formulas and the definition you're using is super important. If you're not annualizing it to be clear that you're just speaking in monthly numbers. If you're thinking about it on a quarterly basis, just being clear on that, because we all think about it differently. So quoting hey, I have 95% retention is hard for us and investors to really know what time period you're thinking of and what that performance really reflects. The other instances are aggregating all your customers together, which is masking churn and important segments. Or they might be not normalizing for one time events. So when we get customer cubes from a lot of our clients and prospects we work with, we'll see that they have onboarding charges in there or they might have a one time service billing that they have in there and those are included in your customer cube and those are naturally going to show up then as churn a year later or whatever timeframe you're looking at in Churn. So those one time events and any unusual churns, we would want to exclude those from the customer cubes we work with and from retention. The other biggest issue that we see, and we worked with a client where we had a huge issue on this, is a lot of times you might have a software that plugs in and tells you your retention on a dashboard and you're quoting your retention off that. And to you it looks phenomenal. It's high 90s or mid 90s gross and logo and over 100% net. But then you don't have the data to back up that retention. And a lot of that is to do with these different software companies. They don't always have a full customer cube in the back end and they're just plugging into your CRM or your billing or accounting system. And so then we are working with you to try and get that retention and the customer cube to back that retention up. And we had a client we worked with where they had already told this to a buyer that was on the table and had submitted an ioi. And so we had to get a customer cube that matched this in order to make sure that IOI was still viable. And so we spent probably 200 hours over two weeks with the team and we took the backend accounting system they were using, QuickBooks, and we had to go through line by line on the memo data in order to properly spread the revenue because they didn't have a system that actually tracked. Here's how much we invoice, here's the term of the invoice, which are really the two most important things, along with the amount. And then for them, they had five different products. And we knew that people were going to want to look at this on a product basis. And so we also had to segment by product. So that was just a lot of work that we had to do in a short timeframe because we needed to back up these retention metrics that they'd already shared with potential buyers. Generally, we would like to do this in advance of talking to investors so that we can spend a lot of time not only preparing the customer cube, but finding what cut works best. Now, this business that we worked with had great retention just from a base customer cube aspect. But a lot of ones we work with, we want to cut retention off of a certain customer segment or a timeframe. Hey, if they've only been with us for two months, they might not have onboarded properly, so we want to exclude them. There's a lot of different ways that we can cut retention, not just in the 500 different ways you can run retention on a core customer cube, but also just segment your customer base to really highlight the best performing segment and what you think about as your true icp. So that's an area that I think is really important for founders.
- [12:05]
B
I think sometimes founders know how important these metrics are and they get focused on how they stack up to their competitors or other businesses. The most important thing is to have good raw data, because as SB said, you can calculate these things a bunch of different ways. And the worst possible and frankly most stressful situation to be in is the one she just described. The founders weren't really paying that much attention to the underlying data. So they're quoting metrics from some software package they have, but that's not good enough for buyers. Right? They want to go to the raw data and trying to build all this stuff on the fly is stressful and leaves you open to a lot of scrutiny. So, for example, if you gave them your metrics, you signed an LOI and then they do diligence and find out the retention's different, they're either going to not do the deal or dramatically retrade you. This is something you can get ahead of. And I think founders need to think to themselves as having to be fluent in this data. It's not that you outsource it to someone or you look at some software package that doesn't really understand how it's calculating it. This is key. And as Espy said, ideally we can spend a month with this data, spread that a hundred hours out over a month where it's not as stressful for the founder and the team on their side that's working on the deal. But this is probably the biggest mistake we see founders make and where frankly, they just have a blind spot. They think they're good here and they really don't know. So SB, having said all that, maybe talk about some specific step founders can take to deal with this upfront and be organized. So when you then get into the nuances of how to cut the data and calculate the retention, what are some things, for example, you look for when we're talking to a new prospect to figure out how they're doing on these Revenue by customer cube.
- [13:38]
A
So the first thing is we would like a clean customer level revenue tracking monthly. So this is every customer they've had what their MRR is each month. Often that means you need to align your billing, CRM and accounting data early so that those are all syncing and tracking properly. The other things we'd love to have is the contract amount, the contract term and the product, because that's often a helpful area that we can segment. If you have multiple products, which product is performing the best. So we'd like really clean data. If there's any segmentation, whether that's on customer size, product geo, end market, vertical, those kind of segmentations are really helpful in a clean basis. And what we've seen as an easy way to see if your revenue by customer is hopefully on the right track. Is looking at your MRR if you're on an accrual basis. And you can do this often in QuickBooks or any of the tools you're using to track your accounting. But if you're looking at an accrual basis, your MRR should be pretty closely aligned with your summed customer cube. So if I took the sum of my December mrr, that should tie pretty closely to my December revenue on my P and L. And now they might be 5% off, I think as a small benchmark. But really anything more than that is going to raise a red flag to us that there's something off in your customer cube likely, whether that's your booking annual billings one time, but we often think about that as a pretty easy proxy. So anything north of, I would say, like I said, 5%, but really we'd like to see that within 3% of your revenue on your P and L.
- [15:02]
B
And that's something everyone can check. Right? And just to repeat that you take the revenue by customer by month, the implied MRR from that based on the customer cube data and then if that matches pretty closely with the P and L, you're in good shape. If that's off by 7, 8, 10%, you definitely have a problem somewhere. And Sarah Beth, I think you said typically that's the customer cube data that's wrong, right? Not always, but that's probably the likely culprit.
- [15:24]
A
That's usually the likely culprit. Now if you're on not on an accrual basis, that's going to be a different story. But yeah, it's generally going to be the customer cube that we see issues in.
- [15:33]
B
And again, these software packages are nice, but you want to be able to hand calculate that same result from the raw data because the analysis from some of these software packages, it's only as good as the raw data. Right? It's just doing math and there's some other AI tools coming to market that are helpful in kind of spotting some of these errors. But again, I think founders want to be fluent. In today's episode we explored why retention metrics play such a big role in how software business is valued. Some common mistakes founders make when calculating retention and frankly the raw data. And really with some better preparation and cleaner data, how you can set yourselves up better for a stronger outcome when raising capital or pursuing an exit. Sarah Beth, thanks so much for joining us on the podcast.
- [16:13]
A
Thanks Mike. VistaPoint Advisors is a founder focused investment bank that advises software and Internet founders through M and A and capital raise transactions. We are a fully unconflicted investment bank who only works for founders on the sell side, so you know that we're always representing your best interests. Securities offered through VistaPoint Advisory Member Finra SIPC this has been provided for informational purposes only. It is not intended to address all circumstances that might arise. Testimonials from past clients may not be representative of the experience of other clients, and there is no guarantee of future performance or success. Clients are not compensated for their comments. If you have any questions about the process of selling your business or raising capital, reach out to a member of our team or check out the four Founders section of our site by visiting Visiting four Founders Guide.