Recent data reveals that net retention rates at software companies have significantly dropped in recent quarters, shedding light on the slowdown in revenue growth within the tech sector. This decline is not surprising, as net retention is a fundamental component of the Software as a Service (SaaS) economic model and is currently facing considerable pressure. As we discussed last week, software firms are grappling with two conflicting demands: they need to tighten costs while preventing a steep decline in growth, all while their existing customers curb spending.
For those unfamiliar, net retention—also known as net dollar retention or net revenue retention—measures how existing software customers’ spending evolves over time. A normalized score of 100% suggests that a company’s current customers are spending the same amount as before. A score above 100% indicates increased spending, while anything below reflects a decrease.
Enterprise software companies typically aim for a net retention rate comfortably over 100%. A higher net retention rate is crucial because it enables companies to drive revenue growth not only through acquisitions but also by securing future income from existing clients. Given the high margins associated with software revenue, improved net retention can significantly boost gross profits, helping counterbalance operational costs.
Conversely, falling net retention complicates the SaaS economic model, making it increasingly challenging for software companies to maintain profitability while pursuing growth.
Now, let’s look at the numbers. According to Altimeter investor Jamin Ball, the median net retention at public SaaS companies has fluctuated in recent quarters as follows:
- Q1 2021–Q4 2022: Between 120% and 121%
- Q1 2023: 116%
- Q2 2023: 111%
While a decrease from 120% to 111% seems like a mere 7.5% drop, it actually represents a staggering 45% decline over just two quarters. This confirms the troubling trend we identified last week, which turned out to be worse than anticipated.
Worse still, since these figures reflect median net retention rates, it's likely that at least half of public software companies reported rates lower than 111%. As more companies present their quarterly results, we’ll gain further insight into these trends, but the outlook appears grim.
With declining net retention, lagging growth, and numerous SaaS firms still operating at a loss, one has to wonder: Is the software industry genuinely a viable business model? The situation may be more complex than it seems.
Are Software Prices Too Low?
For instance, a subscription to Slack can be as low as $7.25 per user each month. While this is the most economical option, it's astonishingly affordable. Users can upgrade to $12.50 per month for additional features and have the ability to negotiate enterprise plans, as seen with my parent company, Yahoo.
Although I can’t pinpoint exactly how many employees Yahoo has, a bit of quick math reveals that, with billions in revenue, the cost for Slack subscriptions likely remains minimal. In fact, Slack has become an indispensable tool for many teams, including mine.
While it's advantageous for companies like Yahoo, it poses challenges for Slack and its parent organization, as they handle substantial commerce for relatively little in return. If Slack were a physical product, it would likely command a greater share of our overall expenditures; for instance, if it were an operational cost alongside fuel for a trucking business, it would take a more significant cut of our gross margins.
This brings to mind Slack’s recent revenue growth rate of just 20% year-over-year during Salesforce's latest quarter. One has to question whether this figure is so low because the market expects to pay a modest sum for the substantial benefits derived from the software.
A Potential Industry Shift
How did we reach this point? The answer isn’t straightforward, but venture capital influences could be a contributing factor. Due to historically high net retention rates, startups have been able to offer lower prices for their products, as customers would inevitably increase spending over time—benefiting from the influx of venture funding. This has conditioned clients to perceive software as cheaper than a standard lunch expense for each user per month.
However, declining net retention disrupts this pricing strategy.
Revitalizing Net Retention through AI
So, how can software companies enhance net retention, raise prices, and bolster revenue? Enter artificial intelligence (AI).
One of the most noteworthy developments in 2023 comes from Microsoft. At Microsoft Inspire, the company announced several exciting initiatives:
- Expanding Bing to introduce Bing Chat Enterprise, which will enhance workplace productivity through AI-powered chat.
- Microsoft 365 Copilot pricing set at $30 per user per month, signifying a substantial increase in value within the productivity suite.
Is $30 per month steep? Yes, especially considering that Microsoft 365 E3 already costs $36 monthly. The introduction of innovative AI features could drastically escalate the perceived value, effectively doubling user expenses.
Provided the market embraces these changes, Microsoft sets a high precedent for pricing AI features—a potential game changer for other software companies. By encouraging increased customer spending, this shift might help improve net retention rates, revitalizing the financial health of SaaS businesses.
An uptick in AI-driven products could foster more considerable customer acquisitions, turning new client engagements into profitable ventures. This presents a promising outlook for software companies struggling with current results, as the demand for powerful generative AI solutions looms on the horizon.
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