Imagine you’ve won the lottery jackpot.
(No really, go ahead and actually dream about winning it and what you’d do with all that money – it’s good for your mental health!)
Lottery winners are typically faced with two payout options. They can get their $100 million jackpot in annuities (with the total payout spread across 20 or more annual payments) or as a one-time lump sum. The catch with the lump-sum is that it pays out less money than the total sum of your annuity payments; you’re essentially giving the lottery a ‘discount’ for getting all that money up-front. The debate over annuity or lump sum payouts in lottery has interesting merits for both sides.
What does winning the lottery have to do with Software-as-a-Service (SaaS) billing? A lot!
SaaS customers typically sign annual (or multi-year) contracts with the vendors, and then are billed monthly for that service. Yet, there is a growing movement among the SaaS industry toward making upfront payments for the entire value of the annual contract the norm.
As a SaaS company, here’s why you want to solicit upfront payments as often as you can.
The Nature of SaaS Businesses
The beauty of SaaS customers is that because of the recurring revenue model, you could see a ton of value from them down the line, especially if they become loyal lifelong users. Its not like selling someone a TV, where they pay for the television set and then you never cross paths again.
On the other hand, it’s a lot easier to sell a TV than to sell SaaS products. The Cost to Acquire a Customer (CAC) for most SaaS products is substantial, requiring a heavy investment in sales and marketing. To make your CAC palatable, you have to the Lifetime Value (LTV) of the customer has to be substantial; they must remain customers for a long time, paying their recurring bills to you regularly.The nature of this LTV:CAC relationship that all SaaS businesses experience leads to two realities and scenarios:
- In the early years, faster growth leads to steeper losses. This seeming paradox is because of how expensive it is to acquire customers and how long it takes to recoup the value from those customers. Look at this example, where the green line is more in the “red” before month 25 than the other two. However, the faster the growth in customer acquisition, the better and steeper the curve will look once it becomes positive.
- Because of these early losses and the necessary investments to acquire customers, and because most of these early-stage SaaS companies tend to operate with limited working capital and cash-in-hand, they tend to reside in what SaaS expert David Skok calls the Cash Flow Trough.
This is one of the biggest challenges for SaaS startup founders – being patient during this time in the Cash Flow Trough and accepting that it’s part of running a SaaS company. However, that’s probably easier said than done. Your time in the Cash Flow Trough will be marked by penny pinching, making every dollar count and more than your fair share of worries about whether you’ll have enough money to even keep the lights on.
How Upfront Payments can Solve the Cash Flow Trough
You’re in the Cash Flow Trough because you don’t have enough cash-in-hand. What should you do? Get more cash! Make it so that your customers are paying the entirety of their annual contract upon signing the papers, which means that instead of waiting to collect that money over a year, in 12 different installments, you can have all that money in your pocket immediately. Just like if you took the lump-sum option when you won the lottery.
The biggest and most obvious advantage is that you have more cash to work with. This cash can then be reinvested into your company to fuel and accelerate your revenue growth – by increasing marketing spend or hiring more sales reps, for example – or in R&D to keep improving your product. There are several other, less tangible benefits of receiving upfront payments:
- This guarantees your billing for the entire duration of the contract. Even when customers pay on a month-to-month basis, there is no guarantee that they’ll continue doing so in three months time. This avoids the need to have to chase down those delinquent customers.
- Upfront payments also signal that the customer has a higher level of comfort with your company and your product. Customer happiness is where brands are made or destroyed, and this will get your relationship off on the right foot.
- They’ll be more financially committed to ongoing use of your product. The more a customer uses your product – and the more it becomes that they can’t live without your product – the less likely they will be to churn when the time for renewal comes up.
- Speaking of renewal and renegotiation, upfront payments mean that your customers are now subject to only one decision point to renew or not, instead of potentially 12 discrete decision points, i.e. every time they make a monthly payment.
The only real downsides to upfront payments are on the accounting side. You have to recognize revenue, driven by Generally Accepted Accounting Principles (GAAP) and report financials on a monthly basis to your board, investors and outside parties such as banks. This means you need to keep very accurate books, which includes recognizing revenue, so there might be a big disconnect in a given month between what your bookings are and what your cash flow situation is. There’s also a greater onus to spend this newfound cash prudently – irresponsible SaaS companies might go on a spending spree with upfront payments that they might otherwise not when collecting month-to-month.
Those downsides are mitigated by the huge benefits of upfront payments though. Getting customers to commit to upfront payments, especially as an early-stage startup, isn’t going to be easy. You need very skilled sales reps, perhaps incentivized to get upfront payments. You might also find yourself in the position of giving more and heavier discounts than you’d typically like to, just to convince the customer to pay upfront. It’s up to you to figure out the balance between giving up the discount and continuing to collect month-to-month – is a 20% discount worth having that cash in hand?
Upfront payments, while not necessarily easy to acquire, can be a massive asset, especially at early-stage SaaS startups. Start asking for them more often and you might see the financial health of your company improve drastically.