The Two Sides of Annual Upfront Payments and Multi-Year Contracts for SaaS

The Two Sides of Annual Paid Up Front and Multi-Year Deals for SaaS

So, you’ve made it through minimum viable product (MVP) stage and managed to convince a few clients to pay you for your product. Hooray! Your clients have paid you for the full year upfront and you’re excited, as you should be. After all, the time and resources to make an idea come to fruition, in the form of actual cash money, is a huge milestone and worth celebrating.

Now, suddenly, you must shift all that product development energy into building an actual business.

As you start to think through how to take this new-found traction and drive the business, you realize all the money and effort to build the product and find your first few clients are in your rearview mirror. Now you have a whole new set of challenges to address, including how to capitalize the business. Light bulb moment!

If you can get your first few clients to pay you for the year upfront, then certainly you can get more to do the same. What a great way to juice the Balance Sheet. Every time you add a client, it’s a double win; an add to the client roster and a measurable jump in cash on hand. It makes sense, so you do it. Now you have 20 clients and a great cash position.

Or do you?

A New Set of Challenges Emerge

A New Set of Challenges Emerge

Not to imply that taking annual upfront payments early on to capitalize the business is a bad idea, but like most things there’s another side to it. With your new-found cash position and client feedback, you dive back into the product to address all the need-to-have and nice-to-have requests from your clients. You feel compelled to deliver or even over-deliver, because they believed in your vision early, and frankly they expect it for the same reason.

Right at the same time you should be starting to think about how to scale your startup, you’re neck deep in fixing bugs and keeping clients happy because you want them to renew. It’s the right thing to do, but there’s a problem lurking around the corner…

A New Problem Lurks

A New Problem Lurks

All the focus on addressing your current client needs has taken away from the energy you used to get the first 20 clients. The sales pipeline has thinned, which you’re acutely aware of, but you’re struggling to find the time to address it yourself. Simultaneously, all the cash you received from the annual upfront payments is quickly being eaten by development costs and you still haven’t addressed the scale issue, particularly in sales.

You’re headed into your first set of renewals with little sense of the potential outcomes, because your customers wrote a check 12 months ago and the only feedback you’ve received is about what more they want and what doesn’t work. Well, guess what? You just took your nice recurring revenue SaaS business and turned it into a transactional model with all the accompanying stress. You have little in the way of predictable cash flow, which from a fundraising perspective raises questions.

Multi-Year Contracts

Multi-Year Contracts

For arguments sake, say you navigate this first scenario and successfully renew all your initial clients and raise a fresh tranche of equity capital to scale the business. Fresh off your first bout with what I like to call “transaction anxiety” (times 20 in this case) and in a cloud of entrepreneurial PTSD, you decide you never want to feel that way again. As such, you come up with another great idea: multi-year contracts! Why not? Sell it once and you won’t have to worry about renewals for 3-5 years. Revenue is dialed in and you’ve switch from annual upfront to annual contracts paid monthly or quarterly to smooth out predictable cash flow.

Once again, not a bad idea, but not without its downside. Let’s say multi-year contracts are selling like hotcakes. You’ve now grown 20 to 40 clients paying monthly or quarterly; cash flow is smooth, clients are happy, and investors are happy. For the next while, you’re on top of the world and finally allow yourself to say, “I think I’ve got this.”

Or do you?

The Downside of Multi-Year Agreements

Downside of Multi-Year Agreements

You’re now headed into your third year with 40 clients dialed in and looking to double revenue. Remember, you have investors now, reasonable or not they like to see you double up every year. Then it hits you. You have no shot to increase revenue from your existing clients, because you signed them all to multi-year agreements, so all that revenue growth must come from one place: new clients. Now you’re right back in the place you hoped to avoid by locking in multi-year agreements; filled with transaction anxiety, because you realize the only way to reach the goal is by doubling the client count you added in 2 previous years combined. This is compounded by the fact that some or your cost of goods sold (COGS) increased, creating downward pressure on gross margins. Ouch!

RELATED: How to Calculate Gross Margin and COGS for Your SaaS Business

Important to note that neither of these tactics are bad inherently, but you need to be aware of the up and down sides of the decisions. As a lender to SaaS and other recurring revenue tech businesses, we at Lighter Capital are sensitive to predictable future cash flow. While our growth expectations are far more tempered relative to equity investors, it still carries weight in the decision process.

Base Decisions on What You Want

Base Decisions on What You Want

The lesson here is one of which I share with my daughters (when I can get them to listen to me), which is to say, “Don’t base decisions on what you don’t want to happen; instead, base them on what you want.” By understanding the immediate and long-term impact of solving problems, you’ll save yourself unnecessary anxiety and be in a much better position to scale your startup the way you want.

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