Good day PROs!
Welcome to this week's GTM Short, where we discuss the unintended consequences of singularly pursuing NRR as the North Star metric. When combined with Growth at all Costs, it has made a mess of things.
Expect What You Inspect
For good reason, the capital markets have become infatuated with Net Revenue (Dollar) Retention (NRR/NDR) as one of the magic metrics for evaluating software companies.
NRR is up there with the "Rule of 40" (growth rate % + free cash flow margin %).
What's interesting is that while NRR is certainly a contributor to valuation, every study we've seen shows an R^2 of ~0.45, which is … well … meh.
Having said that, some of what may be pushing R^2 lower are some of the extreme outliers where valuations are impacted by company-specific variables. Examples below include Bill.com and Shopify.
NRR as the North Star metric really started to get legs when we entered the "era of efficiency," which is a clever way to describe shaking off the hangover from binge drinking on free money for the last TWELVE+ YEARS!
In an environment where capital actually is once again "expensive," the fixation on the way in which a company generates revenue makes sense. After all, what is more efficient than generating incremental revenue from existing customers?
Even when NDR/NRR is declining (from our drunken stupor days), the metric is still considered THE metric to manage.
Source: Open View
So, what happens when capital starts flowing to companies based on a single metric?
You guessed, it.
Every (software) company everywhere starts managing to the metric.
But in so doing, this kicked off a waterfall of unintended consequences. Once the money spigot turned off, we started taking a hard look at the fundamentals of the business and how we allocated capital.
In software and services businesses, capital is people and how those people spend their time.
Customer Success in the Crosshairs
According to a benchmark report produced by SaaS Capital, companies seem to universally allocate roughly 10% of ARR to Customer Success (CS). Keep in mind, however, that this is skewed because the study includes "high growth equity backed" companies that spend 120% of ARR (or more) on operations!
In our experience as advisors and board members, we have seen the allocation of capital to Customer Success creep ever upward, in some cases to as high as 20% (personally, I think the 10% is understated, especially in the PE-backed lower middle market).
At the end of 2023, as companies began reviewing the business in preparation for 2024 planning, we started to hear a lot of questions about the efficacy of CS. In an era where NRR is going down and when we need to drive a more efficient business, why are we spending so much on CS?
CS is now under the microscope because, in an era of "cheap" capital focused on NRR, we allocated increasing amounts of resources to a function that "owned" NRR, without really stopping to ask, "what outcomes do we help drive for our customers?"
Buyer Led CS
In our humble opinion, Customer Success needs to reimagined. It is still vitally important, but can not operate as it has in the past.
If we are honest with ourselves, because capital was "cheap" and abundant, we threw bodies at problems. We wanted to move fast on Product development, releasing new features to keep with our competitors (who are also drinking from the open bar of capital).
CS is the epicenter of this decision.
Sales is closing deals with false expectations. Have CS reset expectations.
Product is confusing to onboard. Have CS own onboarding
Product is hard to navigate. Have CS run "new user" training.
Marketing is pushing cross sells (see "NRR"). Have CS call customers.
And so on.
As a result of all of these manual motions, we trained CS teams to be masters of process. Given that many CS professionals are early in their career, they began to believe that the process was the point!
So instead of refining existing processes with fewer people, let's instead start with a clean slate.
Customers churn because they did not (or no longer get) the expected value from the product. Hint, this is NOT because they didn't use your features! It could be for any number of reasons; business changed, people changed, priorities shifted, etc.
Take onboarding as an example. We have our process through which we run new customers. It may change at the margin based on the customer, but most likely we have our script.
But the success of that onboarding is totally reliant on the internal "strength" of the champion and the aptitude and readiness of the organization to adopt (and embrace) the inevitable changes that come with a new product/service.
If that's true, should we not have a version of onboarding for an inspired champion that is going to need to show quick wins to build momentum within the organization?
This version would be different from one involving a tenured champion working for an organization that readily adopts new tools and processes, right?
But What About NRR?
We started this post wondering if NRR was still the North Start metric. The short answer is yes. However, not in isolation.
A system can not be measured by one metric alone.
A metric (or better, a portfolio of metrics) is simply a tool to assess the 'investability' of a business. Manage to the inputs and we will produce the outputs.
The perfect business model would be one that minimizes the amount of friction a Buyer has to endure to get started with a Product/Service, then quickly gets to a moment of value.
From there, the Product/Service is priced and packaged in such a way that the Buyer "pulls" in additional functionality and sharing in the value created through increased revenue to us.
All of this is accomplished with our most expensive and least scalable resource, people, serving as force multipliers across the Buyer's journey to add leverage to key points of the flywheel.
Build and measure that 👆
What do you think?
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