SUBSCRIPTION FINANCE
Annual Contract Value: Everything Your Subscription Business Needs to Know
What is Annual Contract Value (ACV) ?
To put it briefly, ACV is the average amount of revenue generated per customer contract in a given year.
But what does that really mean?
For example: Let’s say you’re just starting your business and only have one customer. That customer decides to sign a $100,000 contract with your business for 5 years. In this scenario, the ACV with this customer would be $20,000.
But then, a week later, you acquire another new customer. This second customer also signs a $100,000 contract. But, this time, the contract is only for 2 years. Can you guess the ACV for this customer?
If you guessed $50,000, you’re correct! And that means you probably already knew or figured out the following formula:
Annual Contract Value Formula
Total Sum of Contract / Total Number of Years Under Contract = Annual Contract Value
But, unless you really are just starting out, you’re probably looking at more than one contract at a time. And you may want to know the annual contract value for all of your customers on annual subscriptions. So, let’s take a look at how you’d do that in the next section.
How to Calculate ACV?
To calculate ACV for all of your customers, simply divide your annual revenue from annual contracts by your number of customers in a given year.
For example: If your company generates $2,000,000 in revenue from annual contracts and has 500 customers, then your ACV would be $4,000 for that year.
Of course, that calculation only remains true in the years that follow if all of those contracts last for the same amount of time. What happens if they don’t? Well, let’s go back to the previous example where you have two customers on different length contracts.
If you remember, Customer A has a $100,000 contract for 5 years. And Customer B has a $100,000 contract for 2 years. Because the contracts differ in length, the annual contract value will be higher in the first two years.
Year 1: $20,000 (Customer A) + $50,000 (Customer B) = $70,000 annual contract value
Year 2: $20,000 (Customer A) + $50,000 (Customer B) = $70,000 annual contract value
Year 3: $20,000 (Customer A) + $0 (Customer B) = $20,000 annual contract value
Year 4: $20,000 (Customer A) + $0 (Customer B) = $20,000 annual contract value
Year 5: $20,000 (Customer A) + $0 (Customer B) = $20,000 annual contract value
Another thing to keep in mind is that if your company also charges one-time fees in addition to recurring fees, the first-year ACV might be higher than later-year ACVs in a multi-year contract.
For example, if there’s a one-time fee of $350 for Customer A in Year 1, the ACV for that year will be $2,350 instead of $2,000. To keep things simple, you can also consider excluding those one-time fees from your calculations of annual contract value.
Why Is ACV an Important Metric for Subscription-Based Businesses?
Annual contract value is an important metric because it can help you gauge the financial health of your business.
If ACV starts to decline, that could be a sign that you’re losing customers or that they’re spending less money on your service. On the other hand, if it’s increasing, it could mean you’re attracting more customers and/or they’re spending more money on your service.
But those details just give you numbers. The real benefit of tracking ACV is that it can help you make smarter business decisions.
For example: By tracking annual contract value, you can do things like:
More accurately budget and forecast your business’s income as you’ll have an overall idea of how much recurring revenue you can expect to bring in each year
Strategically negotiate deals with new customers since you can use ACV as a benchmark for what you’re looking for in a potential agreement
Better understand whether your customer acquisition cost is proportionate to how much you’re making in annual revenue
All of that being said, annual contract value isn’t the only metric you should care about. You’ll also want to track your annual recurring revenue (ARR).
ACV vs ARR: What's the Difference?
Annual contract value and annual recurring revenue are two different ways of measuring a subscription-based business’s income. And to get the most accurate picture of your business’s financial health, you need to track both.
As you know by now, ACV measures the average amount of revenue a company brings in from annual contracts in a given year. ARR, on the other hand, measures the total amount of recurring revenue a company brings in from all subscription types in a given year.
And that difference is key. Because it’s the reason ACV and ARR can vary significantly from one another.
For example: If you have a lot of customers who only pay for your service a month at a time, your ARR will be higher than your ACV. Alternatively, if you have multiple customers who pay for one or more years up front, your ACV will be higher than your ARR.
You know what that means? Depending on the business decisions you’ll need to make, one metric may be more important than the other. So, track both to ensure you’re making the most informed decision possible.
What about Total Contract Value?
Total contract value (TCV) is another metric that you can track as a subscription-based business. But the reason for doing so is different from why you’d track annual contract value.
TCV refers to the total value of one or more contracts customers have with your business. By tracking TCV, you’ll know exactly how much revenue you can expect to earn for the entire duration of a contract.
That being said, it’s important to keep in mind that total contract value is just a projection about how much you’ll earn from a contract.
For example, let’s say you have a customer who signs a $30,000 contract with your company for 5 years. In this case, the total contract value is $30,000. But what happens if the customer decides to cancel the contract after 2 years?
Unless you got all of the money upfront or have a strict no cancelation policy, your total contract value will drop significantly from the amount you were initially expecting. And, if you made business decisions based on that initial projection, you could find yourself in deep trouble!
So, would we recommend using this metric to make important, long-term decisions for your business? Not really. You’re better off focusing, instead, on annual contract value and annual recurring revenue since these metrics track revenue within the timeframe of a typical subscription.
Key Takeaways
Annual contract value is an important metric for subscription businesses that shows you the average amount of annual revenue you’re making from annual contracts. By tracking this metric, you’ll gain a better understanding of your business’s financial health and make better decisions to grow your business.
But ACV isn’t the only metric you need to care about. You should also track annual recurring revenue to make sure you’re getting a more complete picture of your business’s finances. You can also track total contract value, but it won’t be the most helpful metric for a typical subscription-based business.
For more tips on how to manage finances for your subscription business, check out our complete guide on The Fundamentals of Subscription Finance.
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