Contract length: It’s a real tight rope, isn’t it?
On the one hand, there’s the need to create a low barrier to entry. Free trials, short contracts, and usage-based pricing all make it very easy for customers to sign up.
But how do you get them to stick around?
SaaS businesses making less than $10 million a year see a median churn rate of 20%. This obviously makes retention a major concern. While there are many factors that contribute to your business’s churn rate, contract length is one that many companies might not consider enough.
Multi-year contracts of around 2.5 years in length or more have an average churn rate of 8.5%. Unfortunately, only about 11% of SaaS contracts fall into that sweet spot on average. Month-to-month contracts, on the other hand, have a churn rate of over 16%.
It’s clear that longer contracts equal a lower churn rate, but why? And how should it influence your business model?
Why Churn Rate Works This Way
One simple reason that longer contracts reduce churn is they vastly reduce the number of decisions a customer has to make about your product. Annual customers are likely to stick around for at least a year, no matter what happens.
Monthly customers, on the other hand, are in a position to re-evaluate how they feel about your product every few weeks.
With short-term contracts, a single moment can impact your future with the customer. That’s a big deal when 54% of customers would leave a brand after one bad experience. This is especially true in the case of products that are easier to ‘rip and replace’ like a video conferencing platform compared to, say, a CRM or billing platform.
Longer contracts also inspire customers to use your product more—they’ve made an investment and they want to get their money’s worth, after all.
A 2019 report revealed businesses are wasting roughly 27% of the money they spend on software. In other words, it’s not uncommon for businesses to buy more than they need and regret it later. Customers that use your product enough to derive real value from it are less likely to churn.
This isn’t to say long-term contracts are fool-proof.
Interestingly, at the 1.5-year mark, the average churn rate actually spikes to 15%—one percentage point higher than even month-to-month contracts. While it’s impossible to say exactly why this is, one reason may be it’s the point at which businesses decide whether to rip and replace or go in for the long haul.
So, what’s the sweet spot? The happy middle that keeps you and the customers content?
To really understand the relationship between contract length and churn rate, you have to think about why customers leave in the first place.
Why Churn Happens in SaaS
Regardless of contract length, there’s usually an inciting incident of some kind that inspires a customer to leave. Consider the most common reasons customers churn.
- Weak customer service: About 58% of consumers will switch companies to find better customer service. No matter the length of your contracts, customer service has an enormous influence on retention.
- Barrier to use: Software usually comes with a learning curve. However, the harder it is for a customer to onboard and adapt to your product, the more likely it is they’ll churn. By encouraging clients to stick around and supporting them through the learning curve, longer contracts give your customers the chance to derive better results from your product.
- Poor product-market fit: Naturally, if your product doesn’t align with the needs of the customer, they’ll churn out. Monthly subscribers may be looking to test the relevance of your products to their needs. Annual subscribers may go in with more confidence that you’re a good fit for them. To that end, carefully targeted marketing and sales contributes to a lower churn rate.
- Price vs. value: Finally, price. While most customer considerations don’t begin and end at price, it’s always a factor. If the customer isn’t deriving enough value from your product in relation to the price they’re paying, they’ll likely leave eventually, regardless of contract length.
Pushing for longer contracts may help eliminate some of these churn factors. However, that doesn’t mean you should de-emphasize short-term contracts from your business model.
Can You Still Be Flexible?
Many SaaS businesses are finding success with low-barrier-to-entry offerings that transition into long-term relationships.
- On24: Despite offering demos and shorter-term contracts, On24 customers are mostly signed up for annual contracts. In fact, 27% of On24 customers are signed up for multi-year contracts.
- Microsoft: Microsoft Office has 200 million long-term users, despite offering short contracts, free trials, and reduced cost upgrades.
- Salesforce: Salesforce offers free trials and month-to-month subscriptions, but features a 91% customer retention rate. Most contracts are annual and many extend to between 3-5 years on the enterprise level.
It seems low-barrier-to-entry opportunities are still a great way to bring customers in—especially if you’re targeting the right customers.
By quickly creating a customer experience that segues those relationships into longer-term contracts, you may be able to increase your average contract length and reduce your churn rate.
The Downside of Long-Term SaaS Contracts
Let’s say you’ve locked a customer into a three-year contract. This is great, right? The likelihood of churn is statistically low, and you have ample time to recuperate customer acquisition costs (CaC) and turn a healthy profit.
There’s a downside though.
If you’re using a traditional pricing structure it means you won’t be able to increase the price of your product for three years.
Given the average SaaS business increases prices by 5-7% annually this can amount to a pretty significant difference over time.
That can be a real problem, but there are a few ways to work around it.
- Land and expand: Long-term contracts can be a great way to spring into a “land and expand” business model. By leveraging your relationship with existing customers to cross and upsell, you can increase their contract value and avoid revenue stagnation.
The likelihood of selling to an existing customer is roughly 70%, making this a dependable way to boost revenue. - Built-in price uplifts: Of course, price uplifts are a pretty common feature of many SaaS contracts, so build in that annual lift from the beginning. Customers may actually be more comfortable signing long term contracts if they can be completely certain what price they will be paying several years into the future.
No Simple Solution When it Comes to Contract Length and Churn Rate
So, how does your contract length impact your churn rate?
While it’s true that contracts of 2.5 years or longer feature the lowest churn rate, it’s equally accurate to say this is just one small part of a much bigger picture.
SaaS businesses that wish to reduce their churn rate through contract length should focus on developing a business model that makes it easy for customers to hop on and desirable for them to stick around. By eliminating pain points from your customer experience, you can reasonably expect to reduce churn regardless of the length of your contracts.
Quick FAQs about SaaS Contract Length and Your Churn Rate
Q: How does contract length impact churn rate in SaaS businesses?
Contract length significantly impacts churn rate in SaaS businesses. Longer contracts, such as multi-year agreements, tend to have lower churn rates. For instance, contracts of around 2.5 years have an average churn rate of 8.5%, compared to over 16% for month-to-month contracts. This is because longer contracts reduce the frequency of decision points where customers might choose to leave.
Q: Why do longer contracts result in lower churn rates for SaaS companies?
Longer contracts reduce churn rates because they minimize the number of times a customer has to decide whether to continue using the product. Customers with longer contracts are more likely to invest time in adapting to the software and extracting value from it, leading to increased satisfaction and lower likelihood of churn.
Q: What are common reasons customers churn in SaaS businesses?
Common reasons for customer churn include weak customer service, barriers to using the software, poor product-market fit, and perceived lack of value relative to the price. Addressing these issues can help reduce churn rates, regardless of contract length.
Q: Can short-term contracts still be beneficial for SaaS businesses?
Yes, short-term contracts can be beneficial by lowering the barrier to entry, allowing customers to try the product with minimal commitment. They can be a great way to attract new customers, who can then be transitioned to longer-term contracts through excellent customer service and support.
Q: What is the ‘land and expand’ strategy in SaaS, and how does it relate to contract length?
The ‘land and expand’ strategy involves initially securing a customer with a smaller contract and then expanding the relationship by cross-selling and upselling additional features or services. This strategy can help SaaS businesses mitigate revenue stagnation associated with long-term contracts by increasing the contract value over time.
Q: How can SaaS businesses balance short-term and long-term contracts to reduce churn?
SaaS businesses can balance short-term and long-term contracts by offering free trials and short-term contracts to attract new customers, then focusing on delivering a superior customer experience to transition them into longer-term contracts. This approach helps increase average contract lengths and reduce overall churn rates.
Q: What is the significance of built-in price uplifts in long-term SaaS contracts?
Built-in price uplifts are important in long-term SaaS contracts as they allow businesses to account for annual price increases. This ensures steady revenue growth over the duration of the contract and makes customers more comfortable with long-term commitments by providing price predictability.
Q: At what contract length does the churn rate spike, and why?
The churn rate tends to spike at the 1.5-year mark, reaching about 15%, which is higher than the churn rate for month-to-month contracts. This may be due to businesses reaching a decision point at this time, where they evaluate whether to ‘rip and replace’ the software or commit for the long term.
Q: Why is customer service crucial for reducing churn in SaaS businesses?
Customer service is crucial because about 58% of consumers will switch companies to find better customer service. Excellent customer support helps in resolving issues promptly, ensuring customer satisfaction, and reducing the likelihood of churn regardless of contract length.
Q: How do free trials and short-term contracts contribute to customer retention in SaaS?
Free trials and short-term contracts lower the barrier to entry, making it easier for customers to try the product. If the initial experience is positive, these customers are more likely to commit to longer-term contracts, improving retention rates. Companies like Salesforce and Microsoft have successfully used this approach to achieve high customer retention rates.
