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Are Multi-year Contracts Bad Business?

by | Aug 5, 2019

THE BIG DEAL: Everyone loves the excitement of the “The Big Deal”. Aaron Rodgers 5 year $165M contract makes a great headline.  And as much as any particular deal can be debated (and often are) multiyear contracts in sports make sense.  The question is: Do Multiyear contracts, or even annual ones, make sense in the world of SaaS?

Multiyear Deals = Good – Month To Month = Bad… Right?

Multiyear deals may be great for the salesperson closing the deal depending on how they count towards quota, accelerators  and bonus plans, but for the company, I question the value. A recent Study from SaaS Capital found that “despite having slightly higher churn, companies that contract on a month-to-month basis had significantly higher growth rates than companies with other contracting methods”.

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So what exactly do you give up in churn by going with a high growth month to month contract strategy?

On average companies on month to month contracts grow 27% faster in exchange for a 4% increase in churn.

Traditional Arguments…

Cash is King: For many SaaS companies, Cash isn’t King.  Revenues, Renewals, TAM, SAM, SOM and your Series “A”, or “C” get a lot of effort and energy. Being cash flow positive, not so much.  Now I’m not saying cash isn’t important.  I’m sort of old school as in: “when you’re out of cash, your out of business”, and clearly if you sign annual contracts and take all of the cash up front, the increase in working capital can be compelling.  On the other hand, when it comes to SaaS companies, we only need to look at Salesforce who, although having just had a killer quarter, was running in the red for most of the last 5 years.

More Revenues: The last “S” in SaaS is service, and services are delivered over time.  From a GAAP perspective even if you get $24,000 up front for a two year contract, you don’t get to recognize that revenue.  It’s done on a “straight line basis” of probably $1,000 per month over the two years.  And although you do have that $24,000 in the bank, at the end of month one $23,000 sits as a liability as deferred revenue.  As for the discount often used to lure the customer into the multi-year deal, if you established your weighted average cost of capital (WACC) and use it to calculate your discounts the trade off is pretty straightforward, but in many cases the discount given is just what it takes to close the “Big Deal”, pricing all too often being more of an art than a science, especially for younger companies.

Additional Thoughts…

Perfunctory Renewals: Having been involved with service businesses for many years (both software and other technologies) I’ve always been a huge fan of perfunctory renewals.  Basically the “non-event” renewal.  I always try to address renewals at a company by focusing on the first interaction with a new customer.  How value and credibility is established, and then lay out what will happen over the next year or two.  Define the value path which is core to the journey we are taking the customer on.  If you do all of this, you have the best chance to make your renewal a non-event.  One thing that does get in the way though, is the discussion around an annual (or multi-year contracts). If perfunctory implies something done as part of a routine or duty, why do we create an annual event called the renewal that takes what should be a no brainer, and turn it into a decision point, a discussion, and all too often a negotiation.  Let’s face it, $5k being payed out this month for something I get value from is probably not going to be a priority on my list.  The need to put a signature on a contract for $60k might however raise a few questions.  The most important one not being if it should be kept, but rather if it is worth that much money.  In addition to the whole “let’s talk price” this sort of annual event can trigger a search for competing technologies that might not happen had the “renewal event” not been on the calendar for Q4.

Conclusions…

I think it would be a bit premature to suggest that month to month is the way to go for SaaS companies.  At the same time, the assumptions that an annual contract is “Better” and multi-year deals are “Best” is something that should not be taken for granted.  Think about it…  If you are really adding value, making your customers successful, month to month business practices might make a lot dollars and sense 🙂