You’ve decided to offer annual subscriptions to your software solutions. Great! You’re on track to maximizing recurring revenue, not to mention increasing your liquidity multiplier if you’re planning for an IPO or acquisition.
But, of course, the next big question is, “Do you offer incented multi-year subscriptions?”
Possibly not for the rest of this year. You are already grieving over a large sum of deferred revenue that is going to disappear into retained earnings come January 1, 2018 (thank you ASC 606). Moreover, once 2018 hits, multi-year subscriptions won’t be fully ratable, so it’s probably best to only offer annuals, right?
Well, let’s first consider a few key factors:
- If you were to offer multi-year subscriptions, how much would you need to incent your customers?
- What is your expected annual subscription renewal rate?
- How do you plan to compensate your sales team to keep your top performers?
- What is the expected operational cost to obtain those renewals?
Your answers to these questions and associated analysis (as outlined below) should help you determine the profitability of offering multi-year subscriptions.
Incentive for Multi-year Subscriptions
Discount, of course, can drive behavior. We’ve seen this as low as 0% (the company prefers to sell annual only) and as high as 20% for prepaid subscriptions (they want to lock in the business and want the cash). Since a multi-year subscription also locks in the price for the given term (no 2-5% annual increase), 5-10% incremental discount is usually plenty. We recommend including a payment plan agreement (PPA) so you can monetize the subscription upfront, while letting the customer pay over time. Let’s step into the math by assuming an annual subscription list price of $250K with a 25% discount for annual and 30% for three years. We’ll assume a 3% increase per year for the annual and a 6% cost to monetize the three year subscription.
Note: the “third-party extended payment discount” covers the cost of interest and is part of the overall discount strategy. In our experience, less than 20% of customers will opt for extended payments. For the other 80%, the planned discount is upside to take as margin or leverage in the negotiation (e.g., to pay for a value added service).
So far, so good? If this was all there was to it, we’d probably want to wait the extra couple of years for ~$100k. Let’s dig a little deeper.
Expected Renewal Rate
The upside of an annual subscription includes the aforementioned liquidity multiplier and an easier, OpEx-oriented entry point for your customers. Unfortunately, it can also mean an easier exit. Also, don’t get fooled by faux dollar-based renewal rates that are inflated by increased sales into your install base. The renewal rate you need to focus on is the one that measures the binary outcomes—they renewed the contract in some form or they did not (they churned). Fortunately, you have data for this—look at your maintenance renewals as your high-end expectation. For this example, we’ll assume that maintenance renewals are coming in at 95% and hedge a couple of points, using 93%.
This is where the rubber hits the road on driving behavior. We’ve seen a lot of variation, including:
- 3X on year one ACV (annual contract value) during the initial push to move from perpetual to annual subscription
- 1X on year one ACV, but with partial compensation for the first renewal
- Tiered commissions to incent multi-year contracts
- No compensation impact on the extended payment discount to drive upfront cash.
Let’s use something in the middle—5% commission rate, with a 2X multiplier on year one ACV for the annual scenario and 5% on upfront cash for the multi-year with third-party extended payments. We will keep it simple by not factoring accelerators (bonus commissions for those that have already achieved their annual quota.) We will also assume a 2% renewal commission.
Here the cost of commissions is essentially a wash. Nevertheless, you can see how buying a transition from perpetual to subscription could be costly if offering a 3X multiplier on ACV (especially when accelerators hit). Conversely, it could be costly in agent turnover, if you’re not paying enough commission for one-year subscriptions (especially if you’re not providing customer and sales incentives for multi-year subscriptions).
Operational Cost of Renewals
Many customers prefer long term contracts to lock in budget certainty and to avoid the more frequent operational expense to procure. There is also a real cost to selling annual renewals, including (but not limited to) sales, legal, order management, billing and collection. Again, you may be able to benchmark maintenance renewal costs. Some of this may be handled via auto-renewals, but we have clients that measure the time to prepare a renewal in weeks (if not months) versus hours or days. Let’s assume four weeks of labor time among all parties involved at an average fully-burdened annual labor rate of $75,000.
Now the gap is about $44K; but wait, what’s this new column? Since this activity is occurring over three years, it makes sense to look at the NPV (net present value), so we are comparing apples-to-apples and looking at the impact in today’s dollars. I used a 10% discount rate, which is a common rate that companies use when considering the expected return on an investment. We now see that the multi-year subscription is slightly more profitable
It’s great to chase a liquidity multiplier, but not necessarily at the risk of lost profit, dissatisfied customers and missed sales. If your solution is sticky, your renewal rates are in the high-nineties and your cost to manage renewals is under control, great! If, however, your renewal rate is in the low-nineties and your total operations to sell renewals is a work in process, be careful with over-compensating in preparation for that liquidity event as you may be reducing sales and profits.
In the end, we always believe that making it easier for customers to buy is paramount, so there should be a place for both models. Also, come January 1, 2018, ASC 606 will still allow for a substantive portion of multi-year subscription revenue to be ratable, so not a complete deterrent to broader goals. Just remember to consider all factors when plotting your go-to-market strategy. As always, TFP is here to help.