Multi-Year Deals: The basics

Multi-year discounts in SaaS are frequently used as just another negotiation tool. Sitting alongside closing by an earlier date and willingness to do a reference call or case study.

Therefore, all too frequently the only person who gives them a second thought is the Sales Rep calculating its impact on their commission.

But after looking at the knock-on effect of these discounts we’ve found that SaaS companies could be leaving huge amounts of revenue on the table, both in cash flow and valuation.

So, should you offer multi-year discounts or not? Well, like many things in life: it depends. But fear not, we’ve put together this summary to help you think through the fundamentals for you and your business.

Multi-Year Deal Definition

Let’s set some groundwork first.

When we talk about a multi-year deal it is in reference to a customer purchasing a SaaS solution for more than 12-months. In SaaS if a deal is more than 12-months it is most likely in increments of 12-months, and this is how we have approached this discussion e.g. 1 year, 2 year, 3 year, etc.

The Status Quo

You may not even be aware of how many of your deals from last quarter were multi-year, or how many of your customer base are currently on one, so let’s look at what it’s like at the best private SaaS companies.

Every year KeyBank works with the leading venture capital funds to have their SaaS investments complete an anonymised survey looking at their revenue across a wide array of metrics. We’ve looked at the 2019 report (pre-covid) to see what the distribution of multi-year contracts is at these high-growth, venture-backed private SaaS companies.

The key takeaway is simple:

• 53% had contracts that were typically 1-year in length, while 42% had more than 1 year

This validates our approach to looking at the data from the perspective of companies selling contracts in yearly increments.

Benefits of Multi-Year Deals

Churn “Reduction”

Renewal/Churn is dependent on a contract coming up for renewal, so the idea that if a customer has less chance to cancel a renewal they are less likely to leave is a simple but accurate one.

You can think of it this way: at the point of renewal your customer is ‘exposed’ to your churn rate. So reducing the number of times they are exposed increases your likelihood of keeping that customer. Therefore, longer contracts resulting in fewer points to renew (over the same time period) would lead to fewer customers leaving even if your renewal rate was identical.

But how big an impact does it have?

Based on a 90% renewal rate (at the renewal point) at the end of a 10 year period the business that offers only 2-year contracts has 26% more customers, 17% more cumulative billings collected (direct cash flow impact), and 24% greater ARR.

Moving from 2-year contracts to 3-year contracts is also beneficial (8% more customers, 5% greater cash flow, and 9% higher AAR), but the big jump comes from moving from 1-year to 2-year contracts.

(If you’re looking to calculate your own Churn rate, check out our blog post on how to do it here.)

Closing Deals

Kahneman and Tversky in ‘Thinking Fast and Slow’ taught us about heuristics, biases, and other important research in the field of decision making, but to quickly summarise: humans are not entirely rational.

When you walk into Costco and see a 50” big screen TV down to $399 from $799 you think you’re making a $400 dollar saving if you buy it… but what if you hadn’t gone into Costco planning on buying a TV? From that perspective you actually just increased your spending by $399 from $0.

And what about those magic ‘two for one’ deals in supermarkets? The second one is free! Right…?

It’s not too different when talking about multi-year SaaS deals. There’s no doubt that multi-year deals are a valuable negotiation tool but this needs to be balanced out by what it is frequently partnered with: discounts.

Finding the balance between the two by understanding the positive and negative impacts can be found in the Implications section of this report, but we’ll get to that.

Competitor Lock Out

Some would argue this is a component of renewals/churn but it’s important enough to warrant its own section.

When a customer doesn’t renew with you they may not replace your offering in their tech stack, or they may swap you out for a direct competitor.

There are several different situations in which a long-term contract can be beneficial, we’ve outlined two common reasons below:

• Protectionist: stop others entering your market

You have the first mover advantage but know there are others looking to launch soon. By locking down these early adopter customers you are reducing your competitors' initial addressable market. This in turn limits their potential ARR.

• Expansionist: build on your early success to monopolise the market

Logos may be becoming more important for your business. You’ve tapped out the early adopters or industries and are now looking at what you can expand into. If you can find and lock down a few leading logos in a new space and build a marketing campaign around them you could sweep the industry fast.

If however you loudly tell the industry that one of their members is now your customer, run a campaign, include them in all your decks and on your homepage...only for them to leave you a year later for a competitor, then your entire expansion in that vertical could be in jeopardy.

Cashflow

This is rarely considered, and very rarely acted upon, as highlighted in the KeyBanc report referenced earlier where only 2% of respondents said that this is something they did, but when offering a multi-year deal you can ask for the entire payment upfront.

This brings forward future cash flow to the present day and allows you to use that cash to make the investments necessary to grow your business.

Something to consider.

Negatives of Multi-Year Deals

Loss of Revenue

Saas businesses when considering the potential loss of revenue of a multi-year deal often only consider the impact on Year 1 ARR if there is a discount applied. There’s no thought about the impact beyond that year.

But a multi-year deal has longer lasting implications that need to be considered in terms of revenue impact, regardless of whether there is a discount or not.

Firstly, you’re giving up the ability to increase prices with inflation year on year. This could be a small percentage, but as your business grows could add up to a significant dollar figure.

Secondly, you are giving up the right to get a customer aligned with your list pricing every 12 months, and in turn increasing the gap between their expectation of cost and the reality of cost.

While it’s fine in the short term as they are exposed to fewer renewal events, this then compounds the problem because after several years they are informed that after being a loyal customer for x years, and giving you their vote of confidence by signing a multi-year deal before, the cost is now going up 20-30%.

You’ve also likely massively improved the product over the years, but getting a customer to take a 21% jump compared to two 10% jumps over 2 years means that unless you’ve been communicating both the value you’re delivering and the regularly updating list pricing it will be an uphill battle. One that will likely result in you having to give a discount on list price at renewal even if they only renew for one year.

In summary, you anchor this customer to the initial price they pay much more heavily on a multi-year customer. So that initial multi-year contract eats into future ARR and creates more work for the Customer Success team down the road.

Potential Expansion Limitation & Reduced Customer Experience

This depends on how much your Customer Success team is firefighting vs. being proactive. We’ve included it because no matter how proactive your Customer Success team wants to be they will undoubtedly have to trade some level of proactivity for firefighting.

When a Customer Success Manager needs to respond to two identical companies, one expiring in 3-months and the other expiring in 15-months, they are likely to prioritise the company who is close to renewal.

This can lead to two issues due to the knock-on effect of reduced attention on the longer-term customers.

Firstly, it’s possible you’ll miss potential expansion opportunities. The less time you spend with a customer, and the less you look at their data, the less chance there is of identifying further ways you can help them.

Secondly, consider the fact you are potentially setting up your customers who have shown you the most faith and offered you the most revenue (over the length of the entire contract) less attention than a 1-year contract customer, and in turn a potentially worse customer experience. Obviously this is not something you would set out to do, but it is a real repercussion of multi-year deals.

It’s important to clarify the above is certainly not a reason to not do multi-year deals. If your Customer Success team is so stretched that the above occurs regularly then multi-year deals, or the lack thereof, will not be the cause of your downfall.

We’ve raised it because our focus is on giving you a complete understanding of the risks and benefits of multi-year deals so that you can pick what is right for your business, and then build the right systems in place to support them.

Having now considered all of the benefits and negatives of multi-year deals we can bring them together.

Implications

Churn Balancing Act

We’ve covered the benefits and negatives of multi-year deals, the two sides of the same coin. On one side you get more security in your revenue, on the other you get more revenue. But how do they fit together?

Let’s assume that longer-term contracts actually give you a worse renewal rate, how much worse could your renewal rate be while it is still better to have customers on longer-term contracts? That depends on what’s more important to you, ARR or cash flow.

To get the same cash flow over a 10-year period when 1-year contracts churn at a 10% rate when exposed to a renewal event, you could have a churn rate of 23.1% with 2-year contracts, or 40.3%(!) with 3-year contracts.

But, if we look at ARR under management it doesn’t last forever. From year 9 the ARR under management is greatest on the 1-year contract, and it continues to pull-away.

Now you see why it’s a balancing act. Longer-term contracts secure your revenue better, but if there is a higher churn associated then you need to be aware of how much future ARR you are giving up in return for that security.

Now we’ve looked at two of the variables: Churn and Contract Length, we can look at the third. Discounts.

Discounts

We now finally reach what most people in SaaS would have assumed would be the first (and potentially only) topic to connect to multi-year discounts: discounts.

With a churn rate of 10% on 1-Year contracts, 15% on 2-Year contracts and 20% on 3-year contracts it’s possible to offer a 9% discount on 2 year contracts and a 13% discount on 3 year contracts and still come out with the same total $ collected.

What the right discount is for your business depends on your objectives, but it’s important to find the right floor that you are communicating to your Sales team, which leads on to commissions.

Commissions

You also need to factor in the cost of a sale. If you know that multi-year deals are beneficial for your company you may want to reward your sales team more for them to drive the behaviour that you want.

One important factor here is to remember that you get what you measure, and you definitely get what you reward. So you need to think through how your commission structure works with your discount structure. Otherwise you could end up in a position where you are giving your reps higher commission to provide a worse deal for your company.

These traditionally only impact the first year of your contract and so have a reduced effect on ARR compared to discounts alone.

Your Guide

Part I: Present Day Value

First up you need to decide what’s more important to you. Cash flow today, or later, easier metrics for a VC to read. If you are planning on bootstrapping then multi-year deals with the full amount paid upfront could be a game changer for your business.

There are a few voices out there saying that multi-year deals that are paid upfront are less attractive to VCs and PE because it screws with their metrics. We believe a good VC will be able to figure it out.

Part II: Security or revenue maximisation?

The other part to consider is where you fall on the below 2x2 matrix to determine whether multi-year contracts are right for you. Or more accurately, are multi-year contracts what you should be trying to drive your customers towards?

We’ve summarised what your approach should be, based on the two most important variables: Need for Revenue Security (due to high churn, or threat of competition, etc.) vs. Need for ARR.

The above matrix allows you to position your company in the best way for what you need, while also ensuring you get alignment from your customers, and employees.

To state the obvious: this topic (and perhaps nothing in the world) can be summarised by a 2x2 matrix. This is our way to keep it simple as a guiding principle.

But what about churn?

You’ll notice there is no mention of Churn in the quadrants. That’s because it is much more company specific.

Sure, if your churn rate is high then multi-year deals will cover that up for a bit, but it will also likely just kick the can down the road until it blows up. Multi-year deals are not a solution for long-term churn. Instead they are two variables that interact with each other.

Summary

Reading this is probably the longest you’ve spent thinking about multi-year deals. With these new insights you can take a step back, determine what the right approach is for your company, and go drive alignment along that vision inside and outside of your business.

Once you’ve signed that customer, Planhat is here to help you connect all your customer data, get actionable insights and drive customer experience. Planhat brings all the insights and tools you need to manage renewals, reduce churn, and boost expansion.

Want to discuss this further? Reach out - we’d love to discuss this and hear your thoughts.