How Much More Should I Charge Monthly SaaS Contracts?
One of the most overlooked benefits of a subscription business model is the positive cash flow impact of having annual contracts paid in advance. Your customers are literally financing your business growth for you. This is the cheapest source of financing for any company, no matter what size. For early-stage companies, this free financing is invaluable.
But there is often pressure from the sales organization for payment terms that are more customer-friendly. Quarterly or even monthly payment plans are requested, especially in a small business or consumer market. The question arises—how much higher should subscription costs be charged for quarterly- or monthly-pay SaaS plans?
The answer is more than most companies charge. Besides the time value of money, there is the churn impact. Customers generally only churn at the next payment date. So if they pay monthly, they can (and do) churn every month.
The answer is more than most companies charge.
Consider a company with a cost of capital of 20% that has historically experienced a 25% annual churn on annual-pay contracts. How much more should it charge for quarterly- or monthly-pay SaaS contracts to have the same economics of an annual contract?
|Annual Churn||25%||27% (a)||28% (a)|
|Annual Contract Value||$1,000||$1,000||$1,000|
|Present Value, no price premium||$2,412||$2,050||$1,974|
|Annual Contract Value||>$1,000||$1,180||$1,220|
|Present Value, with premium||$2,412||$2,412||>$2,412|
(a) To apply annual churn rate to quarterly or monthly SaaS contracts, the monthly churn has to be adjusted. This results in the same number of customers at each anniversary date.
One way to look at it is to consider the net present value at the company’s cost of capital and solve for the premium required to make the net present value equal across all three scenarios. With no change in price (meaning the monthly contract equals the annual contract value divided by 12), the net present value of the monthly pay SaaS contract is 19% lower. The break-even from a corporate finance perspective is to charge a 22% premium for monthly-pay customers. And this is for the case when churn rates are expected to be broadly the same.
The break-even from a corporate finance perspective is to charge a 22% premium for monthly-pay customers. And this is for the case when churn rates are expected to be broadly the same.
This ignores the fact that monthly-pay customers tend to churn at higher rates. More realistically, not only do they churn at higher annual rates, but the churn is more pronounced in the first few months. All of this suggests that the premium for monthly pay customers should be much higher than the 22% calculated above.
When considering more customer-friendly payment terms, the cost of capital and churn considerations all suggest the company should charge a much higher price to have the same economics.