Why Annual Plans are Crucial for Reducing Your Churn
Oct 31 2016
When setting up a pricing strategy, most companies go with the tried-and-true monthly plan because it allows for more rapid feedback on their product and their product market fit. It also creates less friction for new customers who are still unsure of their willingness to pay. For a new company, this is ideal because more customers mean more data to help fine tune your product.
One finding that may surprise business owners is that a higher % of annual contracts strongly correlates with lower % churn. This means that rather than just defaulting to a monthly subscription, companies should consider offering an annual contract instead.
In this article, we'll dive into how exactly annual contracts help reduce churn and why they're crucial to helping your business succeed.
First, let's take a look at the correlation between a higher percentage of annual contracts and a lower gross churn rate.
The data is segmented by % of customers on annual contracts. Looking at the average % churn for each group:
0% annual contracts: 9% churn
.01-10% annual contracts: 7.5% churn
10.01-25% annual contracts: 7.5% churn
25.01-50% annual contracts: 6% churn
50.01-75% annual contracts: 5% churn
75.01-100% annual contracts: 3% churn
While this may not seem like much, they are monthly churn rates meaning that by the end of the year they will compound drastically. For a company with 0% annual contracts and a median churn of 9%:
1-(1-0.09)^12 = 0.677
This 9% churn rate compounds to losing 67.7% of your customer base in a year.
For companies with 75.01-100% annual contracts and a median churn of 3%:
1-(1-0.03)^12 = 0.306
These companies only lose 30.6% of their customer base, less than half of what companies with 0% annual contracts lose.
Surprisingly even with these clear statistics, in the 2016 survey of SaaS companies conducted by David Skok, he found that only 45% bill for a period of one year or more. This means that over half of SaaS companies aren't taking full advantage of the benefits of annual contracts.What those 55% of companies need to realize is that with an annual contract, there's only one opportunity for a customer to churn out, as opposed to 12 with a monthly contract. But while that's the most obvious reason annual contracts help reduce churn, it isn't the only one.
LONGER STAGES OF CHURN
Depending on how long they've been with your product, every customer experiences one of three stages of churn.
Early stage churn: The testing phase. Customers are learning to use your product and deciding whether or not to stay with it.
Mid-term churn: The plateau phase. To keep customers from getting bored, you need to constantly make sure they're experiencing the core value of your product.
Long-term churn: The upgrade phase. At this point customers have a history with your product, so you need to upsell and upgrade to get them to invest even further.
While there are ways to prevent customers from churning at each stage, on a monthly plan each stage can be as short as a few weeks. The methods of preventing each stage take time and money, something you don't have much of when you're waiting for the next paycheck or only have a short period to make the changes. When each cycle is a year long, you have a much longer chance to prove your value and you don't constantly have to worry about someone leaving after just a few weeks.
What makes annual contracts even more appealing is that with monthly you have all three types of churn. But with annual you only really have long-term churn, meaning you can put all your effort into fighting that.
Annual Contracts Attract More High-Value Customers
Annual contracts show that your customers are willing to commit to your product. If they're willing to make such a big monetary commitment, they're likely more invested in using your product to win and less likely to churn out after a short period of time. These customers believe in you.
In his survey, Skok also found that larger contracts tended to have longer contract terms. In fact, over 85% of contracts larger than $100k lasted longer than one year on average. For contracts larger than $250k, 100% lasted at least a year.
Higher-value customers aren't afraid to make that investment.
In fact, by requiring a larger investment up front, you can ensure that your customers are all healthy businesses who can afford it. This will weed out any potential customers who may churn because of “unavoidable reasons.”
Because they're more invested, your annual contract users will also be your most active users. Having more active users will:
By addressing any issues that are brought up, you can fix them before they cause customer attrition.
Annual Contracts Give You More Time to Keep Them Interested
The one downside of annual contracts is that it can present the illusion of growth when you're actually shrinking. When an annual customer churns, the churn will compound, pile up and hit you harder than you've planned for.
This means that while annual contracts have many great benefits, it doesn't mean you can take it easy and assume you have a whole year to prove your value - this is why tracking your annual contract value (ACV) is so important.
You need to continually check in with your customers and address any issues that may occur. You don't want unhappy customers who are forced to stick around because they paid for a whole year. This may cause negative feelings to compound just as much as your churn.
LONGER CUSTOMER LIFETIME
On the flip side, though it's undeniable that some customers will churn, those on annual contracts have a much longer lifetime. Even if your average customer churns at 10 months, you still effectively get two extra months with an annual plan.
This longer lifetime also means that you have a longer buffer zone between when a customer cancels and when their subscription actually ends to win them back. For a monthly subscription, 45.5% of all churned customers cancel on average 3 weeks before their subscription is officially finished. For an annual subscription, this period may be even longer for you to figure out what pain point caused them to cancel, fix it, and bring them back.
We can compare the payback period for a company with a CAC of $5,000, and a monthly subscription price of $500. On a monthly subscription, we see that it takes 10 months to break even, and it's not until November that a profit is made. That means you're in the red for 10 months and waiting on each paycheck before any improvements can be made to your product.
With an annual subscription for 12 months, the customer pays $6,000 up front. That means you're already making up for the CAC and have a positive net cash flow to invest in your product starting from January.
This upfront cash flow will allow you to direct more efforts to fixing any pain points that may be causing friction for your users. Having the money on hand to invest in your product and customers will help make sure your annual customers don't churn, as you can use this money to help them over the year.
Annual contracts are really a chance for you to build a connection with your customers. They are clearly willing to invest in you and in return, you should be providing every possible resource to help them win. By working together with your high-value customers, you can address any points of friction, lower your churn rate, and work towards building a relationship in which you both succeed.
Founder & CEO of ProfitWell, the software for helping subscription companies with their monetization and retention strategies, as well as providing free turnkey subscription financial metrics for over 20,000 companies. Prior to ProfitWell Patrick led Strategic Initiatives for Boston-based Gemvara and was an Economist at Google and the US Intelligence community.