What is Annual Contract Value?
Also referred to as ACV, the annual contract value is one of the SaaS metrics that splits the total value of a customer contract into an average value every year. ACV normalizes the total contract value throughout the contract duration to show you the average income you receive from that subscription agreement every year.
Annual recurring revenue (ARR) and monthly recurring revenue (MRR) are SaaS metrics that can help you examine your revenue derived from customer contracts over the contract duration. However, they are not the only SaaS metrics that can help you achieve this.
Another revenue metric you can use to analyze your data and better understand the effects of sales and marketing initiatives is annual contract value (ACV). Gaining a deeper understanding of the effects of sales and marketing can help you highlight strategic insights for your business.
Calculating Annual Contract Value (ACV)
You can calculate the annual contract value for your customer base in many ways. However, at the highest level, the formula for annual contract value is the total contract value divided by the total number of years in that contract.
Therefore, Annual Contract Value (ACV) = the total contract value / total number of years in that contract.
For instance, consider a scenario where a new client signs a three-year contract with you for $50,000 per year of service. Breaking it down, their payments per year would appear as follows:
Year 1 = $50,000
Year 2= $50,000
Year 3= $50,000
Applying the ACV formula, (ACV) = the total contract value / total number of years in that contract
Here, the sum of their contract value over three years = ($50,000 + $50,000 + $50,000) = $150,000
Then, total years in the contract = 3
Therefore, to calculate the actual contract value for this customer, you will divide the total contract value of the customer by the total number of years in the contract.
ACV = $150,000 / 3
ACV = $50,000
From the example above, you can see how your SaaS pricing strategy affects your annual revenue from this customer. It is due to the calculation of the average amount you receive from them yearly.
Visualization of ACV by quarter
Different Ways Company Owners Can Look at their ACV
You can examine the annual contract value in your company in many ways, such as:
- The total ACV of all clients
- The ACV total for a specific period
- Individual ACV per client (like in the example illustrated above)
- The average ACV of all clients
- The average ACV for a certain period
All these metrics give you an insight into the performance of your company. However, your understanding of your company's performance will vary slightly depending on which metric you use.
Note: it does not take much time to calculate ACV for a single customer, but using spreadsheets to find company-wide averages and totals can be time-consuming. But financial analytics software makes it simple to calculate metrics like annual contract value.
It can also calculate your annual contract value in a highly detailed way, such as by industry, product line, client size, and more. Financial analytics software can achieve this because it combines all your CRM data making it simple to calculate your ACV.
The Importance of Annual Contract Value (ACV)
By using annual contract value as a strategic finance tool, you can gain a better understanding of your SaaS business in the following ways:
- ACV can assist you in understanding the actual value for each client when you have variable pricing
- ACV also provides information about the types of SaaS products you provide, allowing you to adjust your growth strategies accordingly
1. Understanding the Actual Value For Each Client When Using Variable Pricing
SaaS providers are moving more and more toward consumption-based pricing (offering pricing tiers based on usage variables). This pricing strategy affects your ACV calculations by causing annual revenue from individual customers to fluctuate. The actual income you receive from a contract varies every year for many reasons such as:
- Add-on services and features
- Discounted pricing
- Variables affecting product usages like user licenses, features, queries, and the number of integrations
- Cost of onboarding and other one-time fees
However, the annual contract value provides you with a clear picture of the financial worth of each company by normalizing the total revenue throughout the contract duration. In turn, you can see how your pricing strategy affects the value of a particular customer or group of customers when you examine historical data.
2. Provides Information on SaaS products Types you provide to Allow you to Adjust Growth-Strategies
SaaS companies come in a wide range of sizes and shapes. However, you can divide the SaaS sector into two major groups based on annual contract value. The two major groups include the high ACV and low ACV.
High ACV companies are those companies that rely on bringing in fewer contracts with higher annual contract value to generate revenue. They are more prevalent for B2B businesses that cater to enterprise-level organizations.
On the other hand, low ACV companies are those companies that rely on bringing in a higher number of contracts with low annual contract value to generate revenue. It happens more often in B2C sectors, particularly with paid mobile apps.
It is possible for SaaS companies that offer products that people and organizations of all sizes can use to have both high and low ACV product tiers. You can see this in companies such as HubSpot and Salesforce. Companies like this have free Tier meant to increase customer acquisition for future growth and raise annual contract value.
Knowing which ACV strategy applies to your company can help you concentrate on the right initiatives. In turn, it will prevent you from following industry trends that are ineffective for your business model.
How to Use ACV to Improve Decision-Making
The annual contract value is one of the most important financial ratios for the strategic analysis of a company. In particular, you can use ACV to enhance sales and marketing decision-making by better understanding the factors that affect your revenue. You can use ACV in the following ways to improve decision-making:
1. Benchmarking New Contracts
One of the best sales strategies you can employ is offering pricing discounts; they are often helpful for bringing in significant clients. But the question is the amount of the pricing discount to give.
When creating new customer contracts, keeping track of the average ACV per customer for previous years can give you a starting point. With ACV, you can see the impact of first-year discounts on your overall revenue from a new client. It is helpful as a guide to assist you with your cost-benefit analysis even though you do not have to use it as an unchangeable strict rule.
On the other hand, the total ACV per quarter can help you understand how trends in seasonal customer acquisition affect your revenue. For instance, if your sales teams offer more discounts than usual to meet year-end quotas, you might notice a decline in ACV in the fourth quarter.
2. Assessment of Upsell Opportunities
According to the 2021 SaaS Metrics Report by Key Bank Capital, 36 percent of net revenue for most SaaS companies comes from current customers. Upselling also continues to grow in importance as a source of income as businesses expand.
Tracking per-customer ACV insights enable you to spot profitable upsell opportunities. For instance, consider a scenario where you have an engaged customer with a below-average ACV. Your account management and sales teams can collaborate with customer success to offer an upgrade.
3. Performance Evaluation of Sales Representatives
The best sales representatives do not always need to offer discounts to close deals. Your profits suffer in the long run if your sales representative over-use pricing as a customer acquisition strategy.
However, you can get an insight into how well each of your sales representatives is doing by analyzing the average annual contract value by the account owner. Additionally, you can check account manager performance to see which sales representatives consistently spot chances to cross-sell and upsell to your current client base.
Average ACV by owner can also assist businesses with multiple product lines in choosing how many sales representatives to assign to various size prospects.
4. The Distribution of Resources for Sales and Marketing
There is no ideal annual contract value to strive for actually. Instead, the metric (annual contract value) aids in your comprehension of how your strategic initiatives will affect revenue. It can assist you in the long run in investing in strategies that generate the most growth at the lowest cost.
Sales teams can use ACV to determine which accounts need more attention than others. For instance, no business owner would want their sales representatives to spend months pursuing low ACV prospects when they can devote more time to an account with a higher ACV.
Annual contract value can help marketing understand top-of-funnel objectives better. You need a high number of leads at the top of the funnel if ACV strategy and conversion rates are low.
On the other hand, enterprise marketing funnels with high ACV prospects need a more focused account-based strategy. That is, a strategy that relies more on lead qualification and other sales funnel metrics than on lead volume.
Annual Contract Value Versus Other SaaS Metrics
Aside from annual contract value lies so many other significant metrics in the SaaS industry that CEOs and investors frequently use. Some of these metrics and how they differ from annual contract value are as follows:
ACV Versus Annual Recurring Revenue (ARR)
Annual recurring revenue, also known as ARR, is a subscription metric that measures yearly income. It provides information on the total revenue you bring in annually from all your subscription accounts.
Annual recurring revenue accounts for revenues from new bookings, upgrades, and renewals. It also accounts for customer churn (revenue lost from clients who stop using your service).
SaaS companies and startups use annual recurring revenue to measure growth over time and forecast future income. ARR is a more fundamental financial metric than ACV that investors and businesses use to benchmark growth.
ACV Versus Total Contract Value (TCV)
Total contract value, also known as TCV, represents the total revenue you obtain from a fixed-term contract. The ACV formula uses the total contract value. From ACV formula = the total contract value / total number of years in that contract. Therefore, you can calculate your ACV if you divide TCV by the years in that contract.
TCV calculation depends on clients you have already secured or won. It is also a tool for providing an accurate report of the revenue generated by multi-year contracts with a specific end date. Furthermore, you can use TCV to focus your customer acquisition efforts by examining which customer segments generate the most revenue.
ACV Versus Customer Lifetime Value (LTV)
Customer lifetime value, also called LTV, is a SaaS metric that forecasts how much profit you will make from a potential client while they use your service. The formula for calculating Customer Lifetime Value (LTV) is:
Customer lifetime value (LTV) Formula
TCV And ACV are the accurate (not estimated) calculations of the revenue generated from signed contracts. On the other hand, the LTV is a forecasted value that considers your costs and churns rate. Also, while LTV measures profit, TCV and ACV measure income.
Investors and analysts use LTV to evaluate your company's health and growth prospects. They can analyze all these because the metric forecasts future profits. LTV is often assessed with your customer acquisition cost (CAC) to ascertain how effectively you allocate resources to generate profits.
Financial metrics are essential when assessing your growth and making an investor pitch. However, they are also helpful tactical tools that can help you optimize your limited resources.
By using ACV, you can understand the annual value of your current contract. In turn, it can help you improve your marketing-decision making, identify the best upsell opportunities and make the best use of your sales strategy.