“Companies that get confused, think that their goal is revenue or stock price or something. You have to focus on the things that lead those” - Tim Cook.
While the Apple share price has rocked up and down over the years, the company has had no trouble in retaining their revenue (thanks to a strong army of total superfans). So it’s no surprise that the CEO’s philosophy speaks to the individual components related to company growth and sustainable success, rather than quick fixes for short term results.
As such, proving that your business can manage all of the smaller items on your reports is what will get investors excited … and total contract value might just be the most important metric to help you get there.
Total Contract Value definition
Total Contract Value (TCV) refers to the entire revenue generated from one particular contract (or customer), including one time charges such as cancellation costs or an onboarding fee. It measures how much value a contract is worth once executed.
TCV is easy to calculate, and only considers actual revenue generated (rather than predicted revenue). It is therefore preferred to customer lifetime value (LTV) by investors and analysts alike, since it is far more accurate, and doesn’t leave room for any nasty cancellation surprises.
A heavy favourite metric among SaaS businesses, TCV reflects a different side of the subscription-business model to most other SaaS metrics. Instead of defining your income by annual contract value (ACV) or monthly recurring revenue (MRR), TCV is calculated by using the prepaid amounts over the lifetime of the contract. It is therefore useful in predicting the long-term financials more accurately than some other measures.
How to calculate TCV
The formula for calculating TCV is as follows:
(Monthly Recurring Revenue x Contract Term Length) + One time fees per contract
This means that two of the biggest impacts on total contract value relate to the monthly subscription price (MRR) and the length of the contract. While professional service fees will make a minor difference, they are the least important aspect of the TCV formula.
Example of calculating TCV
Let’s take a look at a couple of scenarios to help you understand how an investor might prefer one method to another.
Imagine you run a software company with a £100 per month subscription fee. The average customer signs up for 4 months before cancelling their account, resulting in a £50 cancellation charge. Alternatively, you offer a reduced monthly fee (£75) if the customer prepays for a 12-month subscription, with no fee at the end of the contract.
In the first case, TCV= (100 x 4) + 50 = 450.
The second case results in a TCV of (75 x 12) = 900.
By focusing on increasing the term of the contract, you have effectively doubled the revenue generated per customer. So, even though you miss out on collecting a one-time cancellation charge, it becomes insignificant in the overall revenues.
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Importance of TCV
As mentioned, TCV has a number of similarities with LTV. In fact, it is common to get the two metrics mixed up, since they both seem to be measuring the same thing. However, LTV is based on the predicted income from a customer over the course of their lifetime. Meanwhile TCV is based on actual bookings and revenue across the subscription period.
Benefits of TCV
More accurate calculations
The accuracy across calculating TCV is much higher than customer lifetime values. This is because LTV tells us the revenue predictions over the course of the lifetime, but TCV is limited by the length of the contract. It does not assume those who subscribe this year will put their money on the table again next year. The benefit here is that TCV is harder to manipulate or inflate, which means that investors tend to receive a more accurate insight.
Optimising budgets and channels
Secondly, TCV allows financial teams to truly optimize the budget and banish unnecessary expenses. The accuracy of the metric speaks to the growth of your company, so you’ll know as soon as possible when the growth does not match expenditure. TCV can help inform the efficiency of each of your sales channels: where you should be doubling down versus which channels are not as effective.
Identifying your customers
Finally, and perhaps most importantly, TCV can be integral in helping you understand your customers. Breaking down TCV by the demographics of your customers will enable you to create more authentic customer personas, which should inform your marketing. In this way, you can tailor your marketing to each segment of customers based on their behaviour.
TCV in Practice
For example, you calculate that the average value of the contract for those aged 26 and below is double the TCV of 40+ year olds. Plus, it is much cheaper to acquire new (young) customers from Instagram ads with a low cost-per-click, than older customers who won’t convert without a referral.
(By dividing TCV by customer acquisition cost (CAC), you are calculating the efficiency of your new customer attraction and onboarding).
Therefore, the TCV per segment tells you to double down your sales and marketing on targeting millennials who are much cheaper to acquire as customers, and are more likely to spend. Your resources should be diverted from baby boomers in order to decrease expenses and increase revenue at the same time.
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Considerations for SaaS Startups
While TCV is widely-agreed upon as one of the most useful metrics for SaaS startups, there are some pitfalls that subscription-based businesses should be aware of.
There is debate over whether TCV should only include prepaid subscriptions, since there is a chance that customers could cancel their contracts (resulting in a drastic change to the data). Since prepaid income is fixed, it provides a more valid and reliable rate of revenue. However, only including the prepaid portion of revenue completely ignores a large sum of the overall values. TCV should be the largest number associated with any analysis or reporting. For this reason, it is generally agreed upon that TCV calculations should include non-prepaid subscription services too.
The problem with deferred revenue relates to the revenue recognition principle. This is a GAAP (Generally Accepted Accounting Principles) that states we should be counting our income after it is earned, not when cash is received. It simply means that analysts should calculate TCV based on this principle, rather than what is already in the bank (or expected to enter the account).
As a SaaS startup, convincing investors that your business success will be sustainable can be one of the most difficult aspects of a funding application. Even so, it’s clear that Tim Cook’s philosophy rings true across the industry, and that total contract value gives an accurate and well-rounded insight into the overall revenue of your business (and how it’s likely to grow).
We hope you enjoyed this article. Please leave a comment to get involved in the conversation or get in touch with Fundsquire to start discussing your own funding!
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