Procurement Practice #2: Making Sense of the ACV, TCV, and NPV for SaaS Negotiations
This post aims to study SaaS vendors' tendency to provide ACV offers and suggest an uncommon negotiation argument.
It's meant to identify recurring revenue and prioritize customer accounts with the most significant revenue potential.
It's an alternative to the legacy TCV, or Total Contract Value, which is simply the sum of all annual fees throughout the contract duration.
Another obvious benefit of the ACV-based agreement is bringing future revenues forward as you blend projected subscription fees with ongoing ones.
For example, a 3-year agreement with annual fees of $150,000 (baseline), $200,000 (year 2,) and $250,000 (year 3) results in an ACV of $200,000 (while the TCV is $600,000, as usual.) That means a customer will pay $50,000 license fees from year 2 upon signing.
As we're taking long-term contracts, it's logical to consider the Net Present Value of revenues, i.e., what it would cost in "today's" money at the end of a contract period minus a discount rate (cost of capital.)
It's super-easy to calculate the NPV as long as you know the discount rate.
Based on the current economic situation, more than the typical WACC (Weighted Average Cost of Capital) will be required since many SaaS companies are owned by venture capital funds (e.g., 2022 WACC in the UK is up to 6.8%.)
We selected two cases – a startup SaaS vendor (phase A, as per the article above) with a moderate probability of success (50%) and a market discount rate of 10%. That gave us a venture capital discount rate of 52%.
In the second case, we assumed an established SaaS business (phase B) with a low risk of failure (90% success rate) and arrived at a venture capital discount rate of 22%.
An even more straightforward approach would be to use the table from this article, where a 52% discount rate was found between the early-stage and early-growth SaaS companies, while 22% meant the well-established late-stage business.
Thanks to lower risks, that benefit came at 3% for an established vendor.
Naturally, you may request to capture the portion of that benefit through a discount, which will be well-justified.
We cannot guarantee that such an approach constitutes the SaaS negotiation best practice.
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The definition and purpose of the ACV
ACV, or Annual Contract Value, is a critical metric that shows you how much an ongoing customer contract is worth by averaging and normalizing its value over one year (minus one-time fees, e.g., setup or training.)It's meant to identify recurring revenue and prioritize customer accounts with the most significant revenue potential.
It's an alternative to the legacy TCV, or Total Contract Value, which is simply the sum of all annual fees throughout the contract duration.
Another obvious benefit of the ACV-based agreement is bringing future revenues forward as you blend projected subscription fees with ongoing ones.
For example, a 3-year agreement with annual fees of $150,000 (baseline), $200,000 (year 2,) and $250,000 (year 3) results in an ACV of $200,000 (while the TCV is $600,000, as usual.) That means a customer will pay $50,000 license fees from year 2 upon signing.
Present Value of SaaS fees.
It's super-easy to calculate the NPV as long as you know the discount rate.
Based on the current economic situation, more than the typical WACC (Weighted Average Cost of Capital) will be required since many SaaS companies are owned by venture capital funds (e.g., 2022 WACC in the UK is up to 6.8%.)
Due to the high risks of their diversified investment portfolios, venture capitalists expect the discount rate to be as high as 20-70%.
Discount rates of venture capitalists
This article explains the mathematical logic behind venture funds' exorbitant discount rates. You may only consider tables I and II from there, which provide the discount rate estimates for specific probabilities of investment project success and "normal" market discount rates.We selected two cases – a startup SaaS vendor (phase A, as per the article above) with a moderate probability of success (50%) and a market discount rate of 10%. That gave us a venture capital discount rate of 52%.
In the second case, we assumed an established SaaS business (phase B) with a low risk of failure (90% success rate) and arrived at a venture capital discount rate of 22%.
An even more straightforward approach would be to use the table from this article, where a 52% discount rate was found between the early-stage and early-growth SaaS companies, while 22% meant the well-established late-stage business.
NPV benefit estimates due to the ACV
So, we calculated the ACV benefit for the startup SaaS vendor, which came to 7%. That is the improvement of the Present Value of the contract revenue during its 3-year lifetime due to the application of the ACV pricing.Thanks to lower risks, that benefit came at 3% for an established vendor.
Naturally, you may request to capture the portion of that benefit through a discount, which will be well-justified.
We cannot guarantee that such an approach constitutes the SaaS negotiation best practice.
However, it may serve as a custom negotiation argument, enriching your traditional toolkit. This post may also explain SaaS vendors' ACV-based pricing preferences.
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