Why are software companies valuable? In other words, why have we spent so many years valuing software companies using revenue multiples, rather than the earnings multiples common in other industries?
There are several important reasons. First, software companies have very strong gross margins; software is cheap to sell once you’ve written the code. Second, 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 by selling more seats (individual use licenses) to existing accounts or, in the case of on-demand pricing, more aggregate usage of a service over time. Regardless of the method, the point is that software companies today see limited gross churn (customers dropping their contracts) and positive net dollar retention (selling more products 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 period of time. The resulting metric, measured as a percentage of past sales, helps investors understand how much built-in growth momentum a company has. The greater the net dollar retention a software company has, the more efficient its growth will be (selling more stuff to customers already landed is cheaper than securing net new accounts).
NDR matters, and investors focused on more efficient growth than last year are likely to put more emphasis on the metric. So, what should startups focus on when it comes to NDR results? In fact, do those expectations align with what startups actually report? And who has better net retention, public software companies or their startup rivals?
