For High Alpha portfolio companies and other SaaS startups, an intense focus is placed on Annual Recurring Revenue (ARR). Investors focus on ARR as a barometer for how much traction the company has — and this is for good reason: ARR is a leading indicator for how much revenue the company will generate over the next year that is currently under contract.
In the early days, many companies will get creative with payment terms to incentivize customers to sign contracts that increase ARR. Deals with monthly payment terms or early termination options may be necessary to get your first few customers across the finish line. However, companies will realize the importance of cash flow in fueling growth sooner rather than later. Startups that can land most or all of their deals with up-front payment terms will realize benefits that compound over time compared to those that rely only on monthly or quarterly payments.
Why Should Companies Incentivize Up-front Payments?
- Immediate cash flow — With monthly or quarterly payments, your company doesn’t realize the cash flow from a new deal immediately. For example, if you have six months of runway left, and a customer is going to pay you $12,000 monthly, you will only receive half of the cash before your cash-out (or zero cash) date. Up-front payments allow you to fund investment in growth without taking on additional capital from investors that will dilute the ownership percentage of founders.
- Ability to invest in growth — Many first time founders make the mistake of saying “I need to sell $X in new ARR to pay for this investment”. What they fail to consider is the impact of cash flow on that decision. If a customer is paying monthly and has Net 30 payment terms, the vendor will not realize the total cash value of the contract for at least 13 months from when the contract is signed.
- Lower likelihood for churn — A customer has twelve de facto buying decisions per year when paying on a monthly basis. In contrast, a customer who pays up-front only has to issue payment once annually. Payment up-front indicates the value that customers place on the product, making them less likely to churn than in a monthly payment scenario.
- Less need to raise capital — For the reasons noted above, a company that can collect cash up-front rather than monthly is able to use the cash generated from customers to fuel growth rather than relying solely on dilutive funds from investors. The chart below compares the capital needs of a company that invoices all annual contracts up-front to one that achieves the same ARR growth but invoices monthly.
It may come as a surprise that even if the company has the same revenue, ARR growth, and expense structure, it takes over $100 million more in investment for a company that bills monthly to get to $225 million in ARR, the median for a SaaS IPO in 2021.
In 2021, the median Series D round raised was $100 Million. Founders and others already on the cap table will incur 10-15% dilution in an additional round of fundraising, which can be incredibly expensive in an exit such as an IPO or acquisition. The positive impact to founding teams in an exit scenario is massive if companies can support working capital with customer payments rather than dilutive capital from investors.
The team at High Alpha recognized the tension in the sales process created during the negotiation of payment terms. The seller wants up-front payment terms to use the money to support growth without taking on dilutive capital. The buyer of a SaaS contract wants to pay over the course of the year, matching their cash outflows with the contract’s term. Below are examples of how our companies have found ways to overcome objections from customers and incentivize up-front payments in the past.
How should companies incentivize up-front payments?
- Change sales compensation plans — Many of our portfolio companies have been able to drive change and incentivize the sales with up-front invoicing by tweaking sales compensation plans. AEs are driven by the behaviors incentivized in these plans, and outcomes can be changed if they are structured appropriately. The incentive plan should be structured to only pay out commission after the company is able to collect, not when a new deal is signed. This structure naturally incentivizes AEs to target deals with up-front payments as they want commission to be paid out as soon as possible following a new deal. If they are paid commission on a monthly deal, it could take 13+ months for them to realize the full cash value of commission. Additionally, a higher commission rate can be written into a commission plan to incentivize deals with up-front payments compared to deals paid monthly.
- Discount the contract to incentivize up-front payment — Some SaaS companies will discount contracts by 15% or more to incentivize customers to pay up-front. These companies recognize the impacts on growth that up-front payments can have. However, discounting contracts also comes with a discount to ARR, the number one factor in determining the value of a SaaS company.
Given the tension between buyer and seller, making the transition from monthly or quarterly payment terms to up-front billing is never easy. The Concept Lab team at High Alpha is exploring a solution to this problem that would allow sellers to have all of the benefits of up-front cash flows while allowing customers to “buy now and pay later”. If you have a passion for SaaS with a deep understanding of payment flow, please submit your info here to get in touch with us about this exciting opportunity.