Author - Yannick Oswald
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 recurring revenue).'