SaaS contracts and cash flow

SaaS contracts and cash flow

Summary: Many customers are willing to pay up to three years in advance for SaaS contracts, which can make a huge difference to the vendor's bank balance. But what are the potential pitfalls?

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In a wide-ranging discussion of the mechanics of the as-a-service model at last month's EuroCloud UK meeting (disclosure: of which I'm chair), the liveliest debate sprang up around the topic of SaaS contracts. Sitting at the back, I let others do the talking, but now's my chance to add some observations of my own on this important topic, drawing on some of the work I see being done in the industry.

Workbooks.com CEO John Cheney, who was a panelist in the debate, made out a strong case for selling multi-year contracts based on his experience at a prior venture, BlackSpider Technologies, an early SaaS provider of email and web security, which was acquired by SurfControl in 2006 (itself later bought by Websense). He argued that the high startup costs of operating and growing an as-a-service business generate such a huge funding requirement that you have no choice but to sell one-, two- and three-year contracts to get cash in the business. Booking long contracts doesn't increase the bottom line — the revenue can only be recognised as it is incurred — but getting the upfront payments in the bank certainly boosts the cash balance. He described how salespeople at BlackSpider had been heavily incentivized to sell multi-year contracts, while commission rapidly tailed off if contracts were shorter than one year. Many customers preferred to sign up for long-term contracts, he explained, because it gave them budget certainty along with the satisfaction of achieving a keener price.

While I'm all in favor of funding a business from customer revenues rather than having to rely on external venture capital or private equity, I felt the success of this strategy perhaps depends on market conditions. I suspect it works best when selling to IT buyers who are used to funding infrastructure on perpetual licences and who therefore set their budgets on the basis of paying a one-off sum to provide for a three-year requirement. It may not work so well when selling to business people who want to measure results before committing expenditure for such a long period. That in turn raises the question in my mind whether relying on multi-year contract sales would lock a vendor into a business model that has more in common with on-premise IT and perpetual licensing than it does with the future mainstream of as-a-service IT. Once customers get more accustomed to pay-as-you-go contracts, will it get harder to sell multi-year deals? In some markets I think it will.

The question vendors have to ask themselves is whether they're making the kind of sale where customers want to make an evaluation and are then happy to lock themselves into a multi-year contract. I can see it working well for IT infrastructure, ERP and other structural investments. It may go against the grain for more tactical purchases such as CRM, analytics, performance management and so on. Clearly, too, it will work far better for a sales pipeline that relies heavily on direct, person-to-person selling rather than one that is highly automated and largely marketing-led. But let's not get sidetracked into that discussion, which opens up a whole new avenue of debate that is best left for a separate blog post (in addition to the one I already promised on sales compensation strategies).

The other consideration when selling long-term contracts is that the as-a-service model does have more 'gotchas' built into it than perpetual licensing (something highlighted by the SaaS Customer Bill of Rights published last year by Alimeter Group analyst Ray Wang). Vendors need to be sensitive to customer concerns and, if they are going to sell multi-year contracts, they should loosen some aspects of the lock-in that customers are going to worry about, as exemplified in RightNow's recent launch of a new type of SaaS contract: "forward price visibility, being able to adjust numbers of seats in line with usage, the right to walk if the vendor doesn’t meet commitments and ... cash refunds for breaches of the SLA."

The other thing to bear in mind is the need to stay flexible. During the depths of the downturn last year, SaaS ERP vendor NetSuite started offering shorter payment terms as a way to close deals. Of course, after its IPO it has plenty of cash in the bank and few SaaS vendors are in such a financially comfortable position. That gave it the flexibility to maintain growth in new customer numbers (and thus continue building its monthly subscription revenue) by shifting from a policy of asking for upfront payment for multi-year contracts to allowing some customers to pay monthly or quarterly. Effectively, it sacrificed money in the bank in exchange for maintaining growth in its revenue numbers.

One final thought harks back to the discussion that emerged at EuroCloud UK's February meeting, which veered onto the topic of SaaS billing and whether the industry should adopt pricing and billing models more akin to those seen in the telecoms industry. Perhaps that's part of the solution — a long-term contract that commits to a base level of usage and then has a variable element for higher levels of usage. Combined with an incentive for payment in advance and the ability to opt out in certain conditions, and we may be getting close to a workable as-a-service contract model. No doubt this will be on the EuroCloud UK agenda at April's meeting, which is looking at opportunities for collaboration between cloud and telecoms providers.

Topics: Cloud, Banking, Data Centers, Emerging Tech, Enterprise Software

Phil Wainewright

About Phil Wainewright

Since 1998, Phil Wainewright has been a thought leader in cloud computing as a blogger, analyst and consultant.

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8 comments
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  • RE: SaaS contracts and cash flow

    Your point about market conditions and specific applications influencing the sales cycle is on point, of course. In the case of my company, Intermedia, we find a hybrid contract model works well. For our direct mid-range and enterprise customers, we ask for 6-mo contract because while we don't charge for onboarding, large-scale migration often requires engineers and support to meet client needs (Intermedia specializes in hosted Exchange, collaboration, unified communications and mobility).

    On the partner side, however, everything is month-to-month and pay-as-you-grow. Our 4500 partners love this because they are free to establish own policies without facing commitments to us, their provider. Most partners pass the month-to-month offer straight to their SMBx, others repackage Exchange hosting into unique bundles (which may be subject to longer-term contracts)
    ilyanator
  • RE: SaaS contracts and cash flow

    As customer advocates ourselves we feel its important for
    customers to have flexibility from their software vendor.
    We have a similar viewpoint on a blog post we did: Cloud
    Spending - Fact or Fiction - you decide

    http://tinyurl.com/yljvh86
    dylanp70
  • RE: SaaS contracts and cash flow

    Phil

    There may be another benefit of the multi-year contract in
    some cases, when you sell to public organizations.
    They have two independent lines of budgets, for CAPEX and
    OPEX; it's often impossible to move money from one to the
    other.
    By going multi-years they could keep the expenses in the
    CAPEX budget and "amortize" it over 3 or more years.

    I have seen this problem often in Europe over the last
    months.
    Louis Nauges
  • Telecom billing and SaaS

    Phil,

    Your point about the potential commonality between SaaS and cell phone plans that have a base fee + overage makes a lot of sense. This is but a small part of how cell phone companies do billing.

    The telecoms billing systems can keep track of thousands of offers and carry this billing forward for the length of the subscriber's contract. In effect, the cell companies are testing (and tracking) a combination of price levels and offering.

    Most SaaS companies are loath to do this and few have billing systems that can keep track of all this. Whether a SaaS company is B2B or B2C, a good billing system is the key to flexibility and getting their packaging and pricing right.
    jimg@...
  • SaaS Contracts and Customer Alignment

    Hi Phil,

    Great post...in particular "vendors have to ask themselves is whether they?re making the kind of sale where customers want to make an evaluation and are then happy to lock themselves into a multi-year contract."

    I think it is the "happy to lock-in" that is the magic bullet in determining your contract strategy. In the end, no vendor will do well by selling in a fashion that makes customers unhappy.

    The key is to align your customer's preferences with your own cash flow requirements, which can be easily measured by your company's own cost of capital.

    The simplest solution is to offer the contract periods that meet your customer's needs and then add discounts/premiums that reflect your cost of capital, e.g., if your cost of capital is 20%, you might give a 15% discount for moving from monthly to annual, and 30% discount for a 2 year contract relative to monthly (1 - (1/1.2)^2) etc. This is how we <a href="https://www.xignite.com/Shop/ProductConfig.aspx?product=webservices&service=XigniteQuotes">price subscriptions at Xignite</a>.

    Similar logic can be easily applied to your <a href="http://chaotic-flow.com/saas-sales-compensation-made-easy/">SaaS sales compensation model</a> (can't wait to see your take on this controversial and confusing issue). Whether it is contract strategy or sales compensation, SaaS companies sell subscriptions, not licenses and need to make financial decisions using recurring revenue and lifetime value based on <a href="http://en.wikipedia.org/wiki/Net_present_value">NPV</a>, not total contract value.

    In the end, the long term contracts appear to lock in the customer, but they don't. Customers will only sign if they are "happy with the lock-in" in which case they would most likely stick around that long anyway due to the natural lock-in created by the product itself. The primary benefit of long term contracts is advance payment, in which case the value is easily measured by cost of capital and can be handled by discounts for longer contracts. There is no good reason to try and force your customers into contracts they don't like.

    Joel York
    at http://chaotic-flow.com
    york_joel
  • RE: SaaS contracts and cash flow

    One issue that affects a start up SaaS company's ability to generate multi-year contracts is the customer's perception of the start up's viability.

    Until a SaaS provider reaches a point where they are perceived as a long term player, many companies are wary of paying cash out for contracts with a term longer than 1 year - whether you offer it or not.

    One issue I ran into running Siebel's OnDemand division was that customers wanted multi-year contracts but only wanted to pay for 1 year at a time. If the company was smaller, we had a hard time justifying trying to collect against the long term agreement if the customer elected to terminate early -- so they got the benefit of paying a lower rate for a long term agreement but didn't suffer any negative results if they cancelled before the end of the agreement. We did not have that problem with larger companies.

    I like the idea of using flexible billing software (e.g. Zuora) to enable different payment terms/contracts. This needs a lot more exploration.
    bcleveland@...
  • RE: SaaS contracts and cash flow

    As great as this post is it doesn't answer the question that I am currently facing.

    I run a mid-sized distribution company that wants to move to the cloud for business software. We are looking at Microsoft, Infor, Netsuite and Blue Link. Microsoft and Infor state that they are rolling out their SaaS offering in the near term but who knows as it appears that always takes longer than what software vendors state.

    The issue that we face is simply a lack of knowledge when it comes to the contract and how we can limit our risk with a SaaS product. Does anyone know where I can find a resource that understands these new software contracts? We need to know exactly where we can 1. get the best possible deal and 2. get educated on what is expected in the future.

    Cheers,

    Marvin Sumarian
    distributionrules
  • RE: SaaS contracts and cash flow

    Marvin,

    I found your post while searching on google and I might just have the answer for you. A little while back a friend of mine was in the exact same situation where not only did he not know about cloud computing of SaaS products but was very worried about the security, data ownership and so on.

    He was able to use a resource that he found and I have used since as well that was very helpfull. Not only were they able to negotiate a great deal on both of our new software applications but we were very well educated on what to expect in the future. It might not be right for you but it's worth checking out. The website is <a href="http://http://www.negotiating-software.com/negotiating-software-2.html">www.negotiating-software.com</a> , check it out and see if it will help you. If not, i'd google negotiating saas contract or license agreements or any other terms you can think of.

    There are not many companies out there that handle the actual negotiation of software contracts so getting educated by a consultant who isn't being paid by software vendors might be difficult.

    Hope it helps,

    Criag Berube
    saascloudguru