Monthly vs. Annual Contracts: Is It Time To Reconsider Your Annual Plan?
April 7, 2022
SaaS businesses love annual contracts.
Look no further than the data. Excluding the usage-based pricing pioneers, 68% of the Cloud 100 with public pricing are offering an annual plan with a prepay. On average, they’re discounting their product by 20-30% in exchange for that commitment and cash.
The simple logic has been: “You show your commitment to me with a longer contract and cash upfront, and in return, I will give you a discount.”
It sounds like a perfect arrangement for the customer and for you. Getting customers to commit to one, two, or even three years and pay upfront will improve retention rates, CAC payback, and cash, right?
Wrong, at least for retention and CAC payback. And in the end, perhaps cash too.
Monthly contracts win on long-term retention
If a customer signs up for an annual plan, you are most likely going to retain them for at least one year, barring a refund or early termination. This much is guaranteed. But, do companies with annual plans end up having better retention than companies with monthly plans?
The simple answer is no.
Looking at our 2021 Finance and Operating Benchmarks Report, gross dollar retention (GDR) doesn’t vary much, regardless of how much is on an annual (or longer) contract. Companies with 100% of their revenue on monthly/quarterly contracts have a median GDR of 90%, whereas companies with all of their revenue on annual or multi-year contracts have GDR of 85%. In aggregate, companies that employ monthly contracts are actually better at retaining their revenue than companies using annual contracts.
Even if we made the assumption that gross dollar retention was equal, the case for annual contracts is still flawed—because of the 20-30% discount, you need to see a big jump in retention to justify the markdown.
Monthly contracts also win on CAC payback
Another argument in favor of pushing customers to annual plans is that you can recoup most or all of the costs to acquire that customer. The idea is that your customers will definitely pay you for 12 months and if your CAC payback is ~12 months, you can ensure you’re not going to lose money on that customer.
Similar to retention, our data shows that this logic around CAC payback just doesn’t hold up:
Again, companies with all of their customers on monthly contracts exhibit better metrics than those with annual contracts. And the metrics certainly don’t improve as you move across the spectrum.
But my annual plan customers exhibit way better metrics than I’m seeing here!
If you already offer an annual plan, you’ll most likely find that those customers exhibit better metrics than customers on a monthly plan. This isn’t because annual plans are great at retaining customers, but rather because your more loyal customers are going to opt for those plans, stay on your software for longer, and ultimately exhibit better metrics. Meanwhile, customers that are less confident in the value of your product will choose monthly plans and likely churn faster. This self-selecting bias can quickly lead you down the wrong path of thinking that getting customers on annual plans will improve your metrics.
So should I kill my annual contract plan?
Cash is, and always will be, king. Furthermore, rising Days of Sales Outstanding (DSOs) can be a nightmare that brings your businesses to a screaming halt. If you’re not sold on this annual plan fallacy, you may want to at least consider reducing your discount or deemphasizing it in your GTM motion. Here are a few things to consider before you launch that quarterly sales SPIFF to incentivize annual pre-pay contracts.
1. You may be elongating your sales process
Working to have your sales team execute an annual commitment can lead to increasing levels of scrutiny and procurement involvement. Particularly in situations where you don’t have a robust free trial or freemium motion, this can lead to hesitation for buyers and allow time for fear, uncertainty, and doubt to creep in.
Pro tip: Let customers into your product and allow them to get to value before you start asking for an annual commitment. Not only will this allow you to decrease the threshold required to get this commitment (e.g. going from a 20% discount to a 5-10% discount), it also may increase the size of the overall contract as they discover new use cases.
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2. You may be undervaluing your product
Larger customers tend to prefer annual plans that simplify their budgeting and invoicing. However, the customers willing to pay for an annual plan may be the same ones willing to pay more for your product.
In the recent pricing surveys we’ve run, we see that customers that say yes to: “Would you consider purchasing an annual plan for a discount?” are also the customers that have a higher willingness to pay. Giving away an annual discount to the customers that are seeing the most value in your product is a surefire way to leave money on the table.
Pro tip: Evaluate your discounting structure for annual plans and ensure that you’re not over-discounting. Often, we find that diminishing returns exist above a 10% discount (e.g. 30% of customers would accept a 10% discount, and only 33% of customers would accept a 20% discount). The answer may be to decrease your discount or to use other levers in return for an annual plan.
3. You may be creating the wrong habits by relying on 1-3 year contracts
Companies with monthly plans need to consistently be providing customers value. You’ve likely seen that support ticket or a feature request from a big customer that gets escalated to your leadership team because “this customer is up for renewal in three months.” Building the habits of always providing value to customers across your R&D and customer-facing teams inherently helps create the right habits around retaining customers in the long run.
Pro tip: Build your customer-facing teams to focus on value for customers consistently, not just in the three to six months before the renewal. Churn issues certainly don’t get solved in the last three months of a contract. By pegging OKRs and/or employee compensation to product usage metrics, you can ensure that contract structures aren’t preventing you from building the right retention motion.