Most software-as-a-service (SaaS) products are billed on a monthly basis. But many offer discounts for one year or two year upfront commitments.
A few examples:
- Optimizely – 10% off for a 1 year commitment, 25% off for 2 years
- Olark – 10% off for 1 year, 30% off for 2 years
- Kissmetrics – 20% off for 1 year
This strategy makes sense. A long-term commitment means more guaranteed money upfront. It also means stronger buy-in from your customers: your product goes from “that thing we can drop at any moment” to “that thing we better get value out of, because it’s here until 2016.” But what exactly is the value of an upfront contract? How generous of a discount should you offer? We’ll attempt to answer these questions with data.
One benefit of a long-term deal is lower customer churn. This refers to the percentage of your customers who cancel their accounts each month. If your company has been around for a while, you may have a good idea of what your churn rate looks like. You can use this to model what a long-term commitment is worth.
Let’s say your monthly churn is 3%, or each month 3% of your users cancel their accounts. Phrased another way, this means a given customer has a 97% chance of staying on board each month. For an individual customer paying $100 per month with no long-term commitment, here’s how much you can expect to earn in a year:
Annual Earnings = $100 + $100 * 0.97 + $100 * 0.97^2 + ... + $100 * 0.97^11 = $1020.52
If we had no churn, the customer would pay us a full $100 * 12 = $1200. So the maximum discount we can offer and still be making money on average is:
$1200 - $1020.52 = $179.48 $179.48 / $1200 = 14.96%
So we can offer up to about 15% off for an annual up-front payment, if our monthly churn is 3%.
It’s simple to do the same thing for even a more complex churn model. Our business might have 4% churn in the first month after a customer signs up due to a high learning curve, but 0.5% churn every month thereafter. If we wanted to offer a discount for a 2-year upfront commitment, we could calculate this as follows:
Annual Earnings = (monthly price) * (1 + 0.96 + 0.96*0.995 + 0.96*0.995^2 + … + 0.96*0.995^22) Annual Earnings = 21.9 * (monthly price) Discount = 1 - Annual Earnings / (24 * monthly price) = 8.75%
In this scenario we could offer up to 8.75% off for a 2-year upfront deal and still come out ahead (based on churn).
Getting money upfront means having more money in the bank now. This can have a huge effect on the growth and health of your company. Tomasz Tunguz from Redpoint Ventures has an excellent article demonstrating how upfront payments can improve cash flow at a SaaS business.
Customer acquisition cost (CAC) in a SaaS business is high. An adwords campaign might cost several dollars per click, have a signup conversion rate of 5%, and a trial to paid conversion rate of 10%. That means a CAC in the hundreds or even thousands of dollars. The lifetime value (LTV) of that customer will be much higher, but a monthly billing plan means it will pay itself off slowly.
You only have a limited budget available to you at any given time to spend on growth. Billing your customers upfront means more money to spend on growth sooner. So how much is this extra cash upfront worth, from this perspective? Let’s make a few assumptions about a hypothetical SaaS business:
- You have $10,000 in starting capital, with no customers yet
- Your CAC is $1,000 and your customers pay $100/month with no churn
- You spend as much as possible on growth without going bankrupt
- Operating expenses (servers, payroll, etc) are $0/month
I won’t detail the math here, but here’s a graph showing how your user base grows over time in three different scenarios:
With standard monthly billing, we grow steadily to 68 customers by the end of two years. But when we offer a 30% discount, we have almost 250 paying customers by the end of year 2, more than making up for the discount. Even with an aggressive 45% discount, we’re able to invest more money into growth sooner.
This is of course a gross simplification compared to what an actual SaaS business looks like. But you can use a similar process to figure out how much upfront payments would help with growth and cash flow.
Tradeoffs with prepaid contracts
Some customers may need more time to fully realize the value of your product, and may even commit to an annual prepay after they have a few months of heavy usage under their belt. There are many approaches companies take, each of which involve some tradeoffs:
- Some SaaS companies only allow year-long or longer contracts. This makes the most sense in enterprise sales where the CAC is enormous and companies are more willing to commit to a longer timeframe.
- Many companies maintain a monthly billing schedule while encouraging people to commit to a year by displaying the discounts prominently on their pricing page. Optimizely is a good example of this. This optimizes for conversions, but most customers won’t commit to annual prepay right out of the gate when a monthly billing option is also present.
- There are also hybrid approaches. Datanyze only allows annual contracts for some plans, but gives the option between month-to-month or upfront billing. The former case only reduces churn, while upfront billing also helps them with cash flow. There’s a discount for the latter option.
Reducing customer churn and improved cash flow are the two biggest reasons to charge upfront. Also, there are several other reasons that we didn’t cover here: less billing uncertainty, lower transaction costs, etc. It’s an option you should encourage and incentivize if running a SaaS business.