Why Cash is King!
Updated: Oct 16, 2020
One of the first things I often discuss with my SaaS founders is the pros and cons of monthly vs. annual subscription plans. This choice is always a trade-off between short term revenue growth, so-called MRR (monthly recurring revenue), vs. receiving more cash, so-called collections, on day 1 in exchange for a discounted annual offering.
The discussion is always a tricky one. Founders naturally want to optimize for revenue growth. Especially in the early days, when the scale of their business is still small, and, hence, monthly churn is limited. They don't like the idea of leaving future revenue on the table for more cash now. I mean, they just raised some cash and want to grow their MRR aggressively to raise some more. So, are VCs telling them to move slower?! Let's take a step back.
Why Cash is King
I like the way Steve Cakebread, the CFO who took Salesforce public, puts it. He joined Salesforce in 2002, shortly after the dot-com crash. At the time, hardly anyone else was doing subscriptions. He quickly realized the value of annual subs plans: 'You need to look at cash flow! It might seem reasonable to charge your customers at the end of every month for your service, but it’s absolutely havoc on your business model. I’ll never forget that when I accepted the job at Salesforce, the company had about 14 or 15 million dollars of cash on hand. When I started a month later, we were down to 10 million. I knew we had to move away from monthly payments in arrears to annual payments up-front because we had a cash flow problem.'
Cash is the lifeblood of any startup. Cash simply allows you to invest in growth, do all kinds of acquisition tests, and ultimately figure out how to grow efficiently. And, of course, it takes away a lot of pressure from founders. The most effective way of maximizing cash in SaaS is to ask customers to pay annually and at the beginning of their contracts.
I did some modeling to illustrate this (👉 see google spreadsheet here for you to play with). The chart above is the result. It contrasts 5 scenarios of a hypothetical startup’s cash position over 24 months: Monthly Payments, Quarterly PrePayments, Annual PrePayments, Quarterly PostPayments, Annual PostPayments.
In the simulated case, the company generates EUR 50K in MRR in month 1, grows by 12% month over month, and burns EUR 200k per month in month 1. The startup has just raised EUR 2M in financing. No additional financing round is simulated in the model. As you can see on the chart, at months 12 and months 24, the startup’s cash position converges on the same point. But in between, there are massive differences in cash.
The impact of the change in the company’s health is hard to overstate. In one scenario, the startup charging monthly fees just scrapes past bankruptcy. With annual Prepay plans, the company’s coffers are filled with more than $2M cash at the beginning of year 2. Finally, the company that charges quarterly or annual postpay fees runs out of money without further external financing.
The conclusion is straightforward. The annual prepay plan is the most advantageous position for the company, generating negative working capital. Customers are essentially financing the company’s growth by lending the startup money at virtually zero interest. The startup can take this capital and double down on growth.
Breaking the churn spiral
Cash is one thing. Retention is another one. At Salesforce, Steve realized that 'besides cash, we also had a commitment problem. We were getting killed by all these small businesses skipping out on the service. They just weren’t committed to the product. But, then, all of a sudden, when people start paying for the service upfront, they actually started using it. That was a big challenge in those early days, just getting people to log in and use the thing. We thought we could sell it and be done with it, but then we realized up-front payments were absolutely critical to driving usership and retention. we knew that monthly subscription numbers didn’t really mean anything in terms of the company's overall financial health. We knew we needed to orient everything around ARR (Annual MRR Run Rate).'
So, annual plans put you in a better cash position but also can reduce churn substantially. Here the observation from Kyle at Openview: 'One portfolio company spent years trying to improve churn. The most important lever was shifting 70% of new cohorts to annual.'
Annual plans give you more time to impress your customers. What does it tell you when someone stops using your product? Well, it means that they no longer find enough value in your product or that they just forgot about it. Customers tried the solution in the first place because you are solving a problem for them. Annual plans give you the time to figure out how to do so much better. How might you solve your customer’s problems 10x better so they will never forget about it? What exactly are your users trying to do with your product that you can make 10x easier? How might you expand the breadth of the problem you are solving for your customers?
When somebody pays for something, they are motivated to use it. So let's remind them of the value of your product. For B2B players, make sure your customer success team is following up with non-active users. For B2C players, make sure to implement a great CRM system to run retargeting campaigns. Consumer products are evolving fast. There is consistently new stuff to get customers excited about. Potentially, combine it with other incentives to come back, such as loyalty programs.
For B2C SaaS founders, this focus on annual plans is even more critical as they have a higher churn than B2B players. Consumers are tens of thousands of different individuals at many different moments of their relationship of getting to know you. It is impossible to manage all of them in the early days of a company. Annual plans are a handy way to offset this inevitable churn, break-even on acquisition costs on day 1, and grow much faster by reinvesting the collections they generate early on. Acquisition budgets can essentially be expanded without increasing burn substantially. For B2B players, this is rare, but not impossible, as you can see here.
Here some B2C SaaS benchmarks of annual plan discounts. There is no one size fits all. The only thing we need to make sure, of course, is that the pricing shouldn't be lower than the CAC of an annual subscriber in the mid-term. There are, of course, exceptions to the rule. Very few companies, such as Peloton or Netflix, have such a low monthly churn that the unit economics of annual plans are just not attractive enough.
Figuring out how to sell annual plans is extremely hard. It just takes time to run the necessary tests. So let's do so early on. We have seen too many companies trying to grow too aggressively while they did not have monthly churn under control yet (See my post on churn here). It often takes companies up to 12 months (4-6 months is best in class) to figure out how to move from monthly to annual subscriptions. But, once you crack it, life is so much better. With ~70% 1+ year subscriptions, our company WIX, for example, has become an insane cash machine with collections exceeding revenues consistently, allowing them to reinvest aggressively into growth at scale. We have a ton of benchmarks of B2B and B2C SaaS companies. Please feel free to reach out if you would like to discuss.
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Last week, my entire team met in Greece for the first time after 6 months of zooming... There are only 3 countries in Europe, all in the same region, where all of us can go to right now. We had a great time bounding. This also meant that I remove splinters from my partners' feet with all kinds of tools 😜. Nothing beats hanging out face to face... A big welcome also to our new French colleague Mathieu who joined the team last week. Looking forward to working together!
Life is awesome,
Other content I have found useful
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- A great overview by Antenna of monthly churn benchmarks of American video streaming platforms: