Why are software companies valuable? Put another way, why have we spent so many years valuing software companies using revenue multiples, instead of the profit multiples that are more common in other industries?
There are several key reasons. First, software companies have very strong gross margins; software is cheap to sell once you’ve written the code. Secondly, and more to the point today, is the fact that modern software companies are set up to sell more of their product to existing customers over time.
This is often achieved through selling more seats (individual use licenses) to extant accounts or, in the case of on-demand pricing, more total usage of a service over time. Regardless of the method, what matters is that software companies today tend to see limited gross churn (customers dropping their contracts) and positive net dollar retention (the sale of more product to existing customers over time).
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Net dollar retention (NDR) is, essentially, gross churn from existing customers plus upsells from the same, measured over a set time period. The resulting metric, measured in a percent of prior revenue, helps investors understand just how much built-in growth momentum a company has. The greater net dollar retention that a software company has, the more efficient its growth will be (selling more stuff to already-landed customers is cheaper than securing net-new accounts).
NDR matters, and investors, focused on more efficient growth than last year, are likely putting more emphasis on the metric. So, what should startups target when it comes to NDR results? Even more, do those expectations match what startups are actually reporting? And who has better net retention, public software companies or their startup rivals?