SaaS companies need a constant influx of hard numbers and data to understand how effectively they’re able to generate revenue. Total contract value (TCV) is one of the most beneficial metrics to explore, although it’s also one of the most misunderstood. Read on to find out more about TCV, including benefits and potential issues. Let’s get started with a simple question: what is total contract value?
Total contract value is an important metric that measures how much a contract is worth after it’s been executed, including recurring revenue and fees (onboarding fees, professional service fees, etc.). It’s especially useful for SaaS businesses as it provides a clear picture of how much your business can expect to earn from an individual customer once they’ve put pen to paper and signed the contract.
How to calculate total contract value
Before you learn how to calculate total contract value, you’ll need to know the formula. Fortunately, the TCV formula is relatively straightforward:
TCV = (Monthly Recurring Revenue x Contract Term Length) + Contract Fees
As you can see, changing the length of the contract or increasing/decreasing your business’s monthly recurring revenue (MRR) can have a massive impact on TCV.
How does the TCV formula work in practice? Let’s see an example. Imagine Company A offers an information technology subscription service with a range of different prices and plans: Plan 1 (for individuals) offers a base price of £125/month for a one-year contract and Plan 2 (for enterprise) offers a base price of £1,200/month for a two-year contract, plus a £300 onboarding fee. You would calculate the total contract value of the two plans like so:
TCV Plan 1 = (£125 x 12) + £0 = £1,500
TCV Plan 2 = (£1,200 x 24) + £300 = £29,100
What’s the difference between TCV and LTV?
Although total contract value and customer lifetime value (LTV) might seem, on the face of it, to be measuring the same thing, there are some relatively significant differences between the two metrics. Put simply, LTV is based on projections, whereas TCV is calculated using real contract commitments. While this means that it’s not possible to calculate total contract value for evergreen subscriptions, as there’s no specified term length for the contract, TCV is backed by real figures, and therefore offers a more data-led insight into your business’s future earnings.
What are the benefits of TCV for SaaS?
Because TCV is based on true bookings, not projections, it’s a more accurate way to predict revenue and growth. This can help you budget accordingly and eliminate unnecessary spend. It’s also important to note that total contract value can help you optimize your marketing/sales budget – divide TCV by your customer acquisition cost (CAC) to see just how efficient you are at bringing in new customers. This should help you understand which marketing channels are pulling their weight, and which channels are hindering your company’s growth.
Total contract value can also help you to identify which customer segments are most profitable for your business. After you’ve gathered the data, you can focus your sales and marketing resources on the most profitable leads and hopefully bring in more revenue. Another benefit of TCV is the added ability to work out which contract lengths work best for which demographics. For example, if you find that a certain demographic is more likely to pay upfront for a longer contract than they are to pay one month at a time, you can optimize sales for longer contracts and boost your TCV.
Problems associated with total contract value
Despite the many advantages of TCV for SaaS companies, there are a few limitations that you should keep in mind. The principle of revenue recognition is an issue that frequently crops up. If the total contract value for a three-year contract comes out to £1,000 per year, you might assume that you’ve got a £3,000 customer on your books. But is that correct? This £3,000 is actually deferred revenue, because the customer could potentially cancel the contract halfway through and refuse to pay at the next billing cycle, wreaking havoc on your revenue predictions. You may have penalty clauses in all your contracts, but are you really going to be enforcing them? In cases like this, you may wish to consider only dealing with prepaid deals when using TCV for financial projections.
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