Beyond Churn - Tapping Potential Expansion Revenue
Now that your churn is under control, do you know your Potential Expansion Revenue?
In this article we examine expansion revenue, defining the term: PER (Potential Expansion Revenue). We detail its vital importance in SaaS business, relevant metrics, and approaches to increasing PER to grow your NRR.
We recently started a growth assessment with a new client - an approximately $100MM ARR SaaS company. When we discussed Customer Success the CEO told us that her company currently had a Gross Revenue Retention (GRR) of 94-95% but that she wanted to reduce churn further by a few points (GRR is simply the % of customers who renew, so in this case the client had 5-6% of their clients who did not renew). I reminded her that 90-92% is the average for GRR and that mid-90s is close to best-in-class. (Of course, you can never get GRR above 100%.)
Beyond Churn
Bottom line, she wanted to grow ARR among current customers but was stuck on the idea of further reducing churn despite her already excellent churn numbers. “So, what about expansion” I posited. While it is always important to reduce churn, perhaps they could expand ARR from current customers more efficiently through some post-sales expansion initiatives. Her answer was, “Well, we really don’t have a whole lot we can upsell or expand with when it comes to existing customers.” The conversation then turned to other matters.
I have seen this problem before - the desire to grow revenue from current customers while churn is already low, but NOT understanding the potential for expansion revenues. To be clear, GRR needs to be in the 90%+ range. If it is below 90% the product is just not sticky enough, perhaps due to poor product-market-fit, mediocre user experience, sub-par on-boarding, or many other issues or combinations of issues. Those issues must be fixed before worrying about expansion revenue.
** But even if you have some GRR fixing to do, read on because there are some things you can do in parallel to help grow ARR from existing customers. Hint - It has to do with Potential Expansion Revenue.
Where is the Pool?
Let us bring in the other CS metric – Net Revenue Retention (NRR) - NRR = GRR plus all expansion revenue. As stated above, we want to see GRR over 90, and most consider a healthy NRR to be anything north of 110%. So, if you have a GRR of 90, you need another 20 points of expansion revenue to fill the gap and get NRR up to 110. But from what pool is this expansion revenue drawn and how? What do we call that pool of possibility and what are the levers we can pull to enhance that potential pool of revenue to improve NRR and the bottom line?
My research into this domain has turned up little useful data, but experience has taught many lessons. In fact, I have asked for information that explores the expansion opportunity in EVERY advisory engagement I have worked on. Sometimes unearthing the needed information takes some work, but it is indispensable data for gauging the potential for ARR growth from existing customers.
So, it seems time to formalize the measure of this pool of potential revenue, starting by giving it a descriptive name:
Potential Expansion Revenue (PER)
PER represents the pool of potential revenue that you could earn from existing customers by first implementing certain additions and changes in the product and sales domains (described below) then selling them to your customers.
Let us define the strategic Levers of Potential Revenue Expansion.
Usage (or Variable) Based Pricing
Usage-based pricing models expand revenue from existing customers simply by the nature of the model. Also known as consumption-based pricing, customers are charged based on their actual usage of the software or service. This can be measured in various units such as the number of users, the amount of data processed, data stored, or the number of transactions executed, etc. When customers use more, they pay more. This method usually works well for transaction-based systems and can be quite powerful so long as the customer recognizes the value they are receiving. Moreover, it can be exponentially powerful when additional use-cases are deployed.
One of the primary advantages of usage-based pricing is its flexibility. It aligns the cost with the value received by the customer, making it an attractive option for customers that experience fluctuating demand. This model can lower the barrier to entry for new customers because they can start with a lower commitment, then scale up as their need increases. This feature of the model can increase customer satisfaction and loyalty since customers only pay for what they use.
Amazon Web Services (AWS) is a prominent example of usage-based pricing. AWS charges its customers based on the amount of computing power, storage, and other resources they use. This model has been highly successful for AWS, attracting a diverse range of customers from startups to large enterprises, all of whom appreciate the flexibility and scalability of the pricing model.
However, usage-based pricing can also introduce unpredictability in revenue streams for the vendor, making it harder for them to forecast earnings. In addition, its variable nature also can make it difficult for customers to predict their costs. Unsure about their future usage levels, customers may be hesitant to commit. Moreover, if the price point does not match the value received, customers are prone to find workarounds using cheaper options, reducing their costs and your revenue. So, while it can be very powerful, careful analysis needs to be done when moving to or changing usage-based pricing.
Up-Selling
Up-selling is the practice of encouraging customers to purchase a higher-tier product or service than the one they currently use. This expansion lever often involves upgrading to a more advanced version with additional features, capabilities, or benefits.
Up-selling can lead to significant revenue growth as it maximizes the value extracted from existing customers. Customers who upgrade often have higher satisfaction levels as they receive more value from the advanced features. This lever also enhances customer retention, as upgraded products can better meet their evolving needs while also adding switching costs as more features are put into use.
On the downside, up-selling can sometimes come off as aggressive or pushy which can alienate customers. It requires a deep understanding of the customer’s needs to ensure that the higher-tier product truly provides additional value. There is also the risk of customers feeling pressured into purchasing features they do not need, leading to potential dissatisfaction and churn.
HubSpot has a well-defined tiered pricing structure across its various hubs (Marketing, Sales, Service, and CMS). Each tier (Free, Standard, Professional and Enterprise) provides incremental functionality like customer reporting, custom integration, enhanced security, advanced versions of features, etc. As clients require more of these capabilities, they upgrade to a higher cost tier that better meets their needs.
Cross-Selling and Add-Ons
This lever expands revenue by selling complementary products or features to existing customers. These can be separate products that enhance the primary offering (cross-selling) or additional modules that add functionality to the base product (add-ons). Implementing cross-selling and offering add-ons can significantly increase the average revenue per customer by providing more value and addressing a broader range of customer needs. This approach can deepen the relationship with the customer, making the vendor a one-stop solution for a variety of functions. This flexibility can attract a wider range of customers because each can select and pay for only what they require.
That said, an extensive range of complementary products or feature options creates the risk of overwhelming customers leading to decision fatigue and ultimately, dissatisfaction. Moreover, developing and supporting multiple products or modules can result in higher costs and complications in the product offering. In addition, when such add-on modules have been acquired through acquisition or partnerships, it is important to ensure that they integrate well with the core application. Add-on capabilities that do not add-on well are not assets, they become liabilities. These factors require careful planning and management to ensure a seamless customer experience and efficient operational processes.
Salesforce is a notable example of a company that excels in cross-selling. Initially known for its CRM software, Salesforce has expanded its product portfolio to include a variety of complementary tools such as marketing automation, customer service solutions, and analytics. By offering these additional products, Salesforce deepens its engagement with customers and increases overall revenue per customer.
Price Increases
According to a study by ProfitWell, companies that conduct frequent pricing experiments see a 25-50% increase in revenue growth. Harvard Business Review suggests that a 1% improvement in pricing can result in an 11% increase in operating profits.
Increases can be made across the board or targeted at specific customer segments or product tiers. During the low inflation environment of the past decade, people were apprehensive about putting annual cost increases in their standard agreements. With today’s higher inflation and interest rates, it is more acceptable to put annual increases in your contracts. Structuring contracts so they generate more revenue with no involvement from your CS or Sales team is always a healthy approach. It should be noted that some companies also negotiate for a price increase on renewals, but a better approach is to tie renewal price increases to the release of incremental functionality.
The primary risk of price increases is customer dissatisfaction – if customers feel they are not receiving enough additional value to justify the higher cost, they may decide to look elsewhere and may churn. It requires careful communication and justification to mitigate negative reactions. Additionally, in highly competitive markets, price increases might drive customers to seek alternatives, especially if the competition offers similar value at lower prices.
In 2021 and 2022, Atlassian announced an approximately 5% price increase across all cloud editions of Jira Software and Confluence. This adjustment was aimed at aligning prices with the added value provided through continuous product enhancements and new features. Remember, SaaS products should continuously evolve and improve. Adjustments to subscription rates recognize those enhancements.
The Formula
Usage-based Pricing, Up-selling, Cross-selling & Add-ons, and Price Increases are the four main levers of Potential Expansion Revenue. Now let us look at how to measure their impact.
PER is a metric that measures total potential revenue from expansions, that is, it represents the revenue gained if you were able to sell everything to every customer and increase prices to boot. As such, PER measures the pool of possibility, however, only the attainable part of that pool should make it into your budget.
Like GRR and NRR we express PER as a % of ARR.
Here is the formula:
Potential Expansion Revenue % (PER) = All Potential Expansion Levers/ARR
For example: If you have $100M ARR business with $220M in Potential Expansion Levers, your PER is 220%.
All Potential Expansion Levers = All Possible Usage-based increases + All Possible Up-sells + All Possible Cross-sells + All Possible Annual Price increases
These break down as follows:
All Possible Usage-based increases is applicable only if you have a usage-based pricing model of course. Even if so, it may be a little difficult to estimate. To benchmark your number, use a customer who has achieved maximum usage growth over the last year as the basis for your max potential. Segment by customer type if you can, then calculate the revenue change if all customer types reached this maximum usage growth.
Of course, your CS team will want to understand how and why this customer increased usage so much, and you should have playbooks which help them to replicate this growth with their other clients.
All Possible Up-sells – Here you just add up all the increases if people moved to the maximum plan. Since some tiers are based on company size or other metrics, it is a good idea to look a bit further on this and ensure that your figure is reasonable over the next year (e.g., if your tiers are based on customer revenue and a client is at $200MM with the next tier at $1B, it probably is not reasonable to assume they will achieve this much growth in a year and the potential for up-sell here should NOT be included in your estimates).
All Possible Cross-sells are more straightforward – just look at your customer base and add up all the additional modules, features, etc. for which you have an up-charge, but those that your clients do not already have today.
All Possible Annual Price increases – Here I would recommend the amount of price increase you are currently obtaining. Unless there is a mismatch in your pricing (and clients are receiving a lot more value than would be commensurate for what you charge), this figure will be <5% of ARR, so no sense in trying to define it overly precisely.
The Good, Bad and Ugly
Add it all up and you might just find that existing customers represent amazing potential growth. Is a PER of over 1,000% possible? Unbelievably, there are big companies out there with this figure, or even better. That kind of number is typically achieved through a usage-based pricing model with many use-cases or via a large suite of applications which can be up-sold. Not surprisingly, many companies with high PER numbers have both. They also have a well-trained team of Sales and CS professionals who know how to coach clients to valuable outcomes and expand their use of the current software or additional modules.
PER should be a large number because it is only possible to achieve a portion of your PER in any given year. Given that, a PER below 200% is underperforming. Companies here usually do not have usage-based pricing or a large set of additional applications to sell. If your PER is less than 200%, then you really need some planning and an action plan on how to increase your PER.
A PER below 50% makes it really hard to achieve over 10% in expansion annually. To achieve this, you need to close 20% of your total PER (of the 50%) in one year to get that 10% expansion of revenue. If your GRR is at 90%, the addition of 10% expansion revenue will only kick your NRR up to 100% - and you are just treading water. With those figures, all the ARR growth must come from new logos. Studies and experience tell us that the cost of acquiring new logos is 5-7 times as much as selling to existing customers. You really need some focused thoughts on how to improve your PER.
Actions Your Team Can Take to Improve Your PER
No one likes churn and no one wants to lose a customer, so make sure you understand the reason for churn and keep working to reduce it. That said, if your GRR is in the 90s you are doing well. If you are in the mid-90s, adding more expenses to reduce churn a couple more points may be exorbitant. Working on your PER to increase your expansion revenue would be money better spent.
What can an executive team do?
Usage-based pricing – Seriously investigate this, and if it works for your company’s technology then take advantage of it. Be cautious not to price your best customers, who use your software the most, out of the market. If unsure, run a pilot in a certain segment/geography and monitor the impact before bringing it to scale. If it works for your company, get some expansion playbooks so that not only your CS team, but the entire company understands how to move clients to greater and greater usage. This includes not just how they use the product today, but also additional use-cases which can start another usage cycle for an existing customer.
Up-sells – I would recommend an annual review of your tiers to see if there is a class of your existing customers who may be willing to pay more for your services. It is also good practice to review the cost of servicing each customer group, and if some are just too high you may want to risk a change to your tiers even if you risk losing a small group of these non-profitable customers.
Cross-sells – Look at your portfolio of products (or your main product if you only have one) and think about how you can expand that. Remember that it does not have to be a newly created product you build internally. There are SaaS companies for sale all the time and you should have a list of potential adjacent applications in mind in case the opportunity to buy one presents itself. In addition, partnerships are also a possibility. Sometimes a simple integration between two applications is enough, and many small firms are looking for go-to-market partners to help gain more leverage for their smaller salesforces. No matter the source of the technology, ensure that the proper sales enablement and expansion playbooks are created and fully understood by all your customer-facing personnel.
Price increases – Just do it! Higher inflation rates have been with us for a while and will likely persist. Passing along at least inflation level increases to your customers is something everyone is doing, and customers are becoming accustomed to it. Make sure you put these increases into your contracts, so your teams do not have to renegotiate them all the time. Get your customers used to a 3-5% or something connected to an inflation index, each and every year.
The Underappreciated Potential of Potential Expansion Revenue
Today some large SaaS companies are obtaining as much as 70% of their new ARR from existing customers. If your company is over $100MM you should expect that number to be 20-30%. Once you have hit this stage where product-market fit has been achieved and you are working to create consistent processes to scale your business, it is crucial to look at growing your ARR from your existing base. That means optimizing all the appropriate levers that will increase your PER, providing your CS and Sales teams with ample opportunity to generate the expansion revenue that can deliver the impressive NRR growth you seek.
By Duane Kotsen, Partner