The range and industry variety of SaaS companies make it quite difficult for the community members to agree upon anything unanimously. Agencies, experts, and even company executives usually have various opinions about metrics definitions and whether they’re essential. This divisive background brings us to the pit of confusion we have today.
Annual recurring revenue (ARR) causes less uncertainty. However, annual contract value (ACV) is one of the most debated metrics. Even when SaaS experts agree upon its definition, they always seem to disagree if ACV is worth tracking.
This article aims to diffuse the confusion about the annual contract value and show the differences between ACV and ARR.
What it Is
The annual contract value is a metric that accounts for the yearly average revenue from client contracts throughout the company. Suppose a client bought your service for $10,000 for 2 years. In this case, the ACV for this client is $5,000 (the whole amount divided by the years under contract). You can use this metric to efficiently track both the worth of an individual customer and all the company clients.
The annual contract value includes calculations for the whole year. This means that the six-month contract worth $8,000 has an ACV of $8,000. If the customer decides to renew, the number will grow.
On its own, this metric doesn’t tell you much. Still, when combined with other stats and calculations, it’s a powerful decision-making tool for making sense of your business health. Before we start describing why ACV is worth considering, let’s see how it works within the overall business mechanics.
ACV Strategy Fundamentals
A 2012 blog post by Boris Wertz has touched upon the customer lifetime value and described ‘The only 2 Ways to Build a $100 Million Business.’ In this piece, he vouches for two ways you can grow your business:
- High customer lifetime value
- The ‘viral effect’
The first route is relatively straightforward: the more a client pays while they use your service, the more revenue you have. The second way examines the possibility of a larger client pool with lower LTV.
This method expanded into a whole movement among the SaaS companies and experts. Due to the wide variety of software business models, more growth routes started making sense in the community.
Christoph Janz, a former internet entrepreneur, and an angel investor published an updated blog post based on this principle. He managed to improve these strategies for various software-based companies. The latest modification includes 8 customer types and company models in terms of customer value vs. ‘virality.’
The method is, of course, quite rough. It doesn’t include any ideas about the scale and industry of a given business. It also leaves out a lot of other variables. Still, this gives you a real grasp of the ACV strategy for your business.
Companies that go into this business model must realize that having an insane amount of active customers is the only way to scale. According to Janz’s chart, the monetization per client per year doesn’t even reach $1. This means only one thing: they have to have more than 100 million active accounts to get to their target.
Companies that make this list have a substantial social element within the software. WhatsApp is one of them. Earning about $0.06-$0.07 from one active user, it’s only sustainable due to the hundreds of millions of users worldwide.
This category includes companies that have up to $10 from one customer. Consequently, they need about 10 million active users to reach the goal of $100 million. These businesses need to find a way to combine the social aspect with customer-generated content.
A prominent example of this is Yelp. In the beginning, it was huge: the concept was new and went viral. Although it’s been declining in popularity, people still use it to this day.
‘Mouse Hunt’ is a friendly ACV strategy for software startups that cater to about 1 million active users. Assuming that only 10% of the whole customer-base stays involved over time, the companies need to reach at least 10-20 million people.
Almost all time management, team management, note-taking apps, and revolutionary SaaS-based solutions to everyday issues live in this tier. The note-taking app, Notion, started as a small company. It became viral due to its customizable, shareable, and marketable characteristics. It’s a moldable tool that can cover all needs, from a simple notebook app for a casual user to a powerful dashboard/planner for pros and teams.
Rabbits in SaaS aren’t easy to catch. Companies that aim at $1,000 ACV for each client should get about 100,000 of those. With a typical conversion rate around 10%, about 1-2 million clients need to sign up for the trial version.
These companies have a few things in common. First of all, it’s the lower virality level; then come the higher costs of client acquisition. Successful rabbit hunters share fascination towards sales funnel optimization, inbound marketing, and the efforts towards their net promoter score.
We’ve arrived at the 10,000 customers for $10,000 a year segment, which involves getting relatively high-paying clients. ‘Hunting a deer’ is quite similar to ‘acquiring rabbits’ in terms of sales strategies. The most common way to attract these bigger customers is to use larger clients as distribution points. Keep in mind that these partners usually expect enticing commission-based compensation.
Most SaaS businesses might not make it as ‘deer hunters.’ However, successful ones that do start by ‘chasing rabbits.’ They then grow into this category with the help of sales funnel optimization.
This category is all about solving a persistent problem for only 1,000 high-paying customers. Starting as an ‘elephant hunter’ from scratch needs a lot of time and investment. Your sales team will need an enterprise sales-oriented skillset, and the product needs to be exceptionally good.
It would be best if you also nurtured each existing client account to minimize cancellations and downgrades. After all, each of them is very expensive to get.
Brontosaurus and Whales
While going after larger clients is possible in the SaaS context, very few companies do that. Some sources mention Workday and Veeva as ‘brontosaurus hunters’ (ACV of $1 million per client). Palantir and Salesforce are probably the other two that go after clients with ACV ranging between $1 million and $100 million per client.
This strategy explainer has one purpose – to show you that low ACV doesn’t mean poor performance for the whole company. It just means the company needs a larger number of customers. The opposite is also true.
Customer acquisition cost is a fundamental driver for your ACV strategy. The balance between CAC and ACV is the main battleground if you want to set a KPI for your sales team.
A Few Things You Can Do With the Help of ACV
ACV works best within the context of other metrics. Its usefulness grows when you combine it with CAC, churn, customer success rate, and other data. Below are the improvement opportunities people miss if they neglect ACV tracking.
- Identifying the most valuable customers
- Optimizing marketing efforts
- Setting up a pricing plan that makes sense
- Tracking how healthy your company is
Overall, ACV is an excellent metric that helps you find insights and develop strategies for your business.
Why Is ACV So Confusing?
Some ACV explainer articles miss a few things, promoting a distorted reality about this fantastic metric.
First of all, when talking about ACV, don’t forget to note that the contract value works well in the companywide setting, too. However, it can also describe one customer journey, making it a powerful tool for a targeted client relationship.
Some definitions miss the fact that this is an average yearly metric, meaning that the number of years in a contract is of utmost importance.
As a companywide benchmark, you can’t fail to calculate the number’s average when accounting for all customers.
Avoiding the mentioned pitfalls will save you a lot of time and effort.
How to Calculate It?
Depending on the industry you’re in, the company might get many long-term contracts. Total contract value (TCV) is the metric that comes to help. It’s the cost of all the customer purchases over the years. This metric is the basis for determining the ACV in a SaaS company. Here is the formula:
Total contract value / Years in contract = Annual contract value (ACV)
It seems like calculating ACV for long-term contracts is relatively straightforward. What about a deal for less than a year?
If your company is a mouse or rabbit hunter, you might end up with many short-term subscription-based contracts. What happens to the ACV when you have a customer who has signed up for six-months? ACV still needs to account for the whole year, so you divide the TCV by one year.
Let’s return to the example above. Suppose a customer has paid $8,000 for the six-month contract and renewed it for three more months. How much would the ACV be if they don’t renew the contract? Let’s calculate.
Step 1. Determine the contract value over the 9 months: $8,000 + $4,000 = $12,000.
Step 2. Divide the total amount to the number of years: $12,000 / 1 = $12,000.
Now that we’re through with the short and long-term contracts and the formulas, you might start wondering where the one-time fees go. Once again, the community has divided views on this issue.
Some businesses include onboarding, implementation, and training fees in the first-year price, making it a bit more expensive than the coming years. Other organizations are a bit more conservative and charge for them separately.
What’s the Difference to ARR?
Now that you understand ACV intricacies, it’s time to dive into its comparison to ARR. But first, let’s define it.
In subscription-model companies, ARR is the annualized value of all subscriptions. A typical ARR formula includes:
- New business and upgrades (expansion)
- Downgrades (contraction)
- Canceled subscription (churn)
If we simplify, this metric substitutes the ‘revenue’ concept for a SaaS subscription company.
Depending on the business model, organizations might use the monthly recurring revenue (MRR) instead of ARR. The latter is more useful for long-term B2B clients. Annual recurring revenue needs a subscription-based contract. It should also have the ‘recurring’ component as its primary intent.
One of the most glaring differences is that you can apply ACV to one client and see the value over the years. ARR is useful to account for the whole revenue stream across the company.
Another difference is that one-time fees don’t fall under the ‘recurring’ category. Thus, ARR doesn’t include those. Depending on the company, ACV sometimes does.
Annual recurring revenue is a high-level metric. While it gives you the bird-eye view of the business model, pricing strategy, and cash flow sustainability, ACV shows you the ‘sales and marketing’ side of things. It helps you optimize the number of customers and improve the ARR in the long run.
As we can see, lack of precision in definitions has led SaaS experts and executives into dark territory. While tracking ARR is a no-brainer, ACV often gets neglected.
Although you can choose never to track ACV, it shouldn’t be a rushed decision. You shouldn’t just drop another three-letter acronym from your arsenal. Ditching ACV can leave you missing out on a few juicy details about your business.
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