Blog / LearnTuesday, May 5, 2020
There is so much jargon and so many different acronyms thrown about when it comes to SaaS that it’s easy to confuse yourself and your customers, when it comes to talking about various matters. In addition to causing confusion, you could also end up damaging your credibility if it’s not clear you know what you’re talking about. If you misunderstand anything in a business planning context you can easily get your numbers wrong and potentially even put your business at risk.
Let’s look at one acronym that often causes confusion and nail down an ACV definition.
ACV stands for Annual Contract Value. The ACV metric is a fantastic way for you to understand how your SaaS business is performing, but it can be confusing to have 100% understanding of it, particularly in the context of tracking revenue streams coming into your business.
We can define ACV as being the average annual contract value of a specific customer subscription or contract.
For example, if you do a deal with a corporate client to use your SaaS platform for 10 years, at a cost of $100,000, the ACV is $10,000. Depending on how your business sells your service, you might bill monthly or annually anyway, which would make your ACV sales easy to calculate. However, if your business is flexible and combines payment plans and subscription types, ACV is a great way to analyse performance in a uniform way, as you can calculate and see the revenue each customer brings in on a consistent basis.
At the basic level, calculating ACV is simple.
You simply take the total contract value and divide this by length of the contract. We did this in the example we gave above:
For your accounting and reporting processes you might calculate your ACV by starting with monthly recurring revenue (MRR) or break down ACV into MRR.
To calculate your MRR when you already have your ACV, you simply divide your ACV by 12.
If you’re calculating MRR first, you do the same calculation as earlier, but you need to express the length of the contract as months rather than years.
Therefore, the calculation would be:
While these are the base calculations that you will use to calculate your ACV, there may be other fees that you charge as part of the contract.
For example, if there is a set-up cost to use your software, or a cost to undertake training before using it, you might decide to include this in your ACV.
Typically, businesses who include these sums in their ACV will include them in the year they occur (i.e. year one). Let’s say that on top of the contract value, your clients need to pay a further $10,000 for training and set-up costs. This would then make the ACV in year one of the contract $20,000, with the remaining nine years as $10,000 as calculated earlier. From a reporting perspective, your business would then have consistency in knowing that the first year of a contract will always have a higher ACV. If the set-up, training, and other costs are fixed, you can also count on achieving this revenue for each new client that signs up for your service.
As an alternative to calculating the first year ACV as being higher, you might also choose to spread the upfront costs across the length of the contract, or even calculate these as a separate revenue stream. If you do the latter, you’ll be moving into calculating Annual Recurring Revenue (ARR), which we’ll take a closer look at shortly.
You should also consider how you will treat any further upselling or cross-selling from your team during the contract period. What happens if your client asks for further training or wants to upgrade to a better version of your service? How these factor into your ACV calculations will depend if they’re a one-off cost or represent an increase in their recurring billing and depend on how you treat these within your tracking of internal revenue streams.
Use our ACV calculator at the top of this page to calculate your ACV for your business.
To finalise and calculate your true ACV, you need to add together your ACV results for each client, and then calculate the average figure.
In our earlier example, our client gave us an ACV of $10,000. We’ll call them customer one.
We also have a customer with an ACV of $5,000, and another with an ACV of $30,000.
Therefore, $10,000 + $5,000 + $30,000 = $45,000. $45,000 / 3 customers = ACV of $15,000.
While ACV is a fantastic metric to use, you get the most out of it when you use it in conjunction with other business metrics.
For example, businesses with a higher ACV will often also have a high customer acquisition cost (CAC). This happens because a higher investment is made into customer acquisition, whether that’s through inbound marketing, outbound sales, or by other means, in order to secure higher value orders and contracts.
When you’re benchmarking against other SaaS companies, you shouldn’t obsess too much over ACV. This is because you might have a lower ACV but could also have a lower CAC, therefore your margins and profitability could be better. Your total contract value (TCV) could also be higher than your competitors, for example if you manage to secure clients on a longer-term basis.
If you do use ACV internally as a standalone metric, you can potentially look at clients that give a lower ACV than your average benchmark figure, and then investigate why, with a view to increasing your revenue from these clients.
ACV is often confused with ARR.
The main difference with ARR is that you’re adding up the revenue your customers give you each year.
Using the same calculation as earlier, your business’ ARR would therefore be $45,000 from those three customers.
You also wouldn’t include any of the one-off charges in your ARR, and simply treat these as a standalone revenue stream.
Unlike ACV, ARR is generally a universally agreed metric in the context of how it is calculated and used.
ACV can be a difficult metric to use and to benchmark against others in your specific SaaS niche.
What really matters when it comes to using ACV is that you’re clear, and consistent, in how you use it and which other business metrics you use alongside ACV. So long as you and all your team members know this, you will be able to use your accurate ACV calculations as a useful business metric to help inform strategic decisions and to aid future revenue and overall business growth.
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