Subscription services offer discounts if you pay annually, because annual contracts — particularly those with upfront payment — benefit their business in several ways.
Why annual billing?
Primarily, companies prefer annual contracts because they can grow faster. Subscription companies, particularly young startups, prefer pre-pay annual contracts because the business receives a boost in cashflow. And with the predictable revenue of a subscription model made even more predictable through a year-long commitment, these companies can more confidently forecast and make decisions concerning their growth down the line.
How do annual contracts help grow a subscription service?
Especially helpful to early or small companies looking to scale. Growth requires cash. With pre-paid annual billing, the upfront influx of cash can be reinvested in the company. More development time on the product? Hiring an outbound sales team? Expand markets? This cash investment fuels new growth and new business, while the company simultaneously fulfills the annual contracts and serves existing business. Otherwise, the company would have to wait for incremental payments of cash, as with monthly billing, or an after-the-fact lump sum of cash, as with post-pay annual contracts.
“Managing cash collections and structuring sales contracts are some of the most impactful initiatives a SaaS company can undertake to maximize their chances of success, particularly in the early days of the company’s life.”
–Tomasz Tunguz, on how the upfront cashflow from annual contracts can help subscription businesses
Important to note: Increased cashflow does not necessarily mean a sudden boost in revenue. This is because subscription businesses follow a specific revenue recognition schedule. To learn more, take a look at our Ultimate Finance Cheat Sheet, tailored for the subscription model.
A secondary but also important benefit is that it helps reduce churn — and this has positive impact on the rest of the subscription metrics. With an annual contract, the customer is committed, and the team isn’t spending energy or resources on chasing down and locking in revenue at the end of each month. With the higher retention rate, the company also retains the money it spent in acquiring those customers in the first place. In this way, annual billing stabilizes or lowers Customer Acquisition Cost, and in turn, helps increase Customer Lifetime Value. The ultimate bottom line for a subscription service, though, is recurring revenue. And the combination of all the healthy metrics above results increases the company’s Monthly Recurring Revenue.
Ultimately, faster growth and healthier metrics present a much better picture to investors for future fundraising.
If you’d like a rundown of these metrics and how each impacts a subscription business, check out our Ultimate Metrics Cheat Sheet for SaaS and subscription businesses.
What are some challenges of annual billing?
The company needs to demonstrate value enough to warrant the commitment of a year contract. This may take the form of a longer free trial, more involved demos with training aspects, etc.
With monthly subscription contracts, the lower payments don’t cause any sticker shock. The pay-as-you-go structure doesn’t intimidate the customer. To overcome these potential barriers to purchase, companies might try the following:
- Offer some kind of “money back guarantee” to ease the friction of paying upfront and give buying confidence.
- Sweeten the deal with a small discount on an annual contract, which is quite common these days.
- Display pricing strategically. Some companies display monthly prices on their site, to benefit from the customer perception of the lower price, but then force annual payment. Or, if the company offers both monthly and annual billing, it’s common to display “monthly cost when billed annually” by default, to highlight any discount with the annual plan.
So, the challenges with annual billing primarily lie in the front-end of a customer’s journey, convincing them to take the leap and sign on for a year. After that, the challenges are the same for any subscription service on any billing schedule: satisfying the customer, making sure they are using the product successfully — or that the service matches up to their expectations, and keeping them on board.
Of course, these common challenges are easier to address when the company is cashflow positive. Like I said up top, that cash can be reinvested to improve the product or service faster, or tend to customer success and support more thoroughly. So those subscription services with annual billing might be better equipped to serve customers and keep them happy.
This answer was originally published on Quora. View the original thread here: Why do subscription services offer discounts if you pay annually instead of monthly? What do they gain from that?