Daniel Elman
January 3, 2023
Net Revenue Retention (NRR), also called Net Dollar Retention (NDR), is emerging as a key northstar metric for evaluating SaaS companies as it gives insight into both the current state and the future trajectory of the company. NRR is supplanting annual recurring revenue (ARR) among the most valuable metrics because it provides visibility into how quickly a company is growing but also how well the company does to keep newly acquired customers from churning.
Usage-based pricing inherently offers levers for businesses to improve NRR by reducing churn and driving organic account growth. In challenging economic conditions, companies that are most successful in reducing churn and delighting existing customers will be the long-term winners.
To understand how NRR is traditionally calculated, consider a group of customers that have been using a solution for a year. NRR is given by dividing the monthly recurring revenue (MRR) from that group of customers for this month by the MRR for that group from the month one year ago.
For some group of customers A, calculated for month of December last year:
In a usage-based business, recurring revenue is difficult to measure since customers do not have to commit to any long-term contract, but instead simply pay for what is used billing period-to-billing period.
Some companies simply remove the pay-as-you-go option, and have customers pre-pay for usage with prepaid credits. In this situation, the recurring prepaid spend (or the prepaid spend divided by month) can be used as the recurring revenue in the traditional model. Other approaches include comparing the spend by quarter instead of month, annualizing the previous month’s usage-based spend and using this as a basis for ARR, or simply comparing the annual (usage-based) spend for a set of customers year-over-year.
For example, Twilio compares revenue from a set of customers from Q1 this year with the revenue from that same set during Q1 of the previous year. To calculate the NRR for the full year, it takes the average across the four quarters for the year. Snowflake compares the annual revenue for the current year generated by the customers who signed up exactly 1 year ago or greater with the revenue generated by those same customers during the previous year.
In all cases, regardless of the specifics for each calculation, the businesses are essentially identifying a set of customers and modeling how that customer’s spend on the platform evolved over time.
Understanding how NRR is calculated in a usage-based world, we can see that there are a two approaches a business can take to improve the metric; namely, to improve overall retention (decrease churn) or to increase the revenue generated per existing customer (land and expand). Usage-based pricing is a lever that allows businesses to positively impact NRR from both directions.
