My Final Verdict on Multi-Year, Prepaid Deals – Enterprise Irregulars

After years of experience with and thinking about multi-year, prepaid SaaS deals, my mental jury is back in the box and the verdict is in: don’t do them.

Why? Multi-year, prepaid deals:

Are not the norm, so they raise eyebrows among investors and can backfire with customers [1].

Complexify SaaS metrics. SaaS businesses are hard enough to understand already. Multi-year deals make metrics calculation and interpretation even more complicated. For example, do you want to argue with investors that your CAC payback period is not 18 months, but one day? You can, but you’ll face a great risk of “dying right” in so doing. (And I have on more than one occasion [2]).

Amplify churn rates. An annual renewal rate [3] of 90% is equivalent to a three-year renewal rate of 72%. But do you want to argue that, say, 79% is better than 90% [4] or that you should take the Nth root of N-year renewal rates to properly compare them to one-year rates? You can, but real math is all too often seen as company spin, especially once eyebrows are already raised.

Turn your renewals rate into a renewals matrix. Technically speaking, if you’re doing a mix of one, two, and three-year deals your “churn rate” isn’t a single rate at all, but a matrix. Do you want to explain that to investors?

Tee you up for price knock-off at sales time. Some buyers, particularly those in private equity (PE), will look at the relatively large long-term deferred revenue balance as “cashless revenue” and try to deduct the cost of it from an acquisition price [5]. It’s not typically a huge amount of money but nevertheless, it’s one more item to negotiate, and if not discussed up front, someone might try to knock it off what you thought was a final number.

Can reduce value for strategic acquirers. Under today’s rules, for reasons that I don’t entirely understand, deferred revenue seems to get written off (and thus never recognized) in a SaaS acquisition. So, ceteris paribus, an acquirer would greatly prefer non-prepaid TCV (which it will get to recognize over time) to deferred revenues (which it won’t) [6].

Can give pause to strategic acquirers. Anything that might cause the acquirer to need to start release pro forma (e.g., adjusted EBITDA) has the potential to scare off a strategic acquirer, particularly one with otherwise pristine financial statements. For example, having to explain why revenue from a recently acquired startup is shrinking year-over-year might do precisely that [7].

Can “inflate” revenues. Under ASC 606, multi-year, prepaid deals are seen as significant financing events, so – if I have this correct – revenue will exceed the cash received [8] from the customer as interest expense will be recorded and increase the amount of revenue. Some buyers, particularly PE ones, will see this as another form of cashless revenue and want to deflate your financials to account for it since they are not primarily concerned with GAAP financials, but are more cash-focused.

Will similarly inflate remaining performance obligation (RPO). SaaS companies are increasingly releasing a metric called RPO which I believe is supposed to be a more rigorous form of what one might call “remaining TCV (total contract value)” – i.e., whether prepaid or not, the value of remaining obligations undertaken in the company’s current set of contracts. If this is calculated on a GAAP basis, you’re going to have the same inflation issue as with revenues when multi-year, prepaid deals are involved. For example, I think a three-year 100-unit deal done with annual payments will show up as 200 units of RPO but the same deal done a prepaid basis will show up as 200-something (e.g., 210, 220) due to imputed interest.

More than anything, I think when you take these factors together, you can end up with complexity fatigue which ultimately takes you back to whether it’s a normal industry practice. If it were, people would just think, “that’s the complexity endemic in the space.” If it’s not, people think, “gosh, it’s just too darn hard to normalize this company to the ones in our portfolio [8] and my head hurts.” Put differently, “there’s just too much prepaid ‘hair’ on this deal for my taste.”

Yes, there are a few very good reasons to do multi-year, prepaid deals [9], but overall, I’d say most investors and acquirers would prefer if you just raised a bit more capital and didn’t try to turbo-finance your growth using customer prepayments. In my experience, the norm in enterprise software is increasingly converging to three-year deals with annual payments which provide many of the advantages of multi-year deals without all the complexity [10].

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Notes

[1] Especially if your competition primes them by saying – “those guys are in financial trouble, they need cash, so they’re going to ask you for a multi-year, prepaid deal. Mark my words!”

[2] “But payback periods are supposed to be risk measures of how long your money is on the table …”

[3] Renewal rate = 1 – churn rate

[4] That is, that a 79% three-year rate is ergo better than a one-year 90% renewal rate.

[5] Arguing that while the buyer will get to recognize the deferred revenue over time that the cash has already been collected, and ergo that the purchase price should be reduced by the cost of delivering that revenue, i.e., (COGS %) * (long-term deferred revenue).

[6] Happily, the deferred revenue write-down approach seems to be in the midst of re-evaluation.

[7] If the acquired company does a high percentage of multi-year, prepaid deals and you write off its deferred revenue, it will certainly reduce its apparent growth rate and possibly cause it to shrink on a year-over-year basis. What was “in the bag revenue” for the acquired company gets vaporized for the acquirer – and explaining that to analysts and investors might be a “last straw” factor on the deal.

[8] Or our other subsidiaries, for a strategic acquirer.

[8] Minute 1:28 of the same video referenced in the prior link.

[9] Good reasons to do multi-year, prepaid deals include: (a) they are arguably a clever form of financing using customer money, (b) they tend to buy you a second chance if a customer fails in implementation (e.g., if you’ve failed 9 months into a one-year contract, odds are you won’t try again – with a three-year, prepay you might well), (c) they are usually a financing win/win for both vendor and customer as the discount offered exceeds the time value of money.

[10] You do get one new form of complexity which is whether to count payments as renewals, but if everyone is doing 3-year, annual payment deals than a norm will be established.