The world of Software as a Service (SaaS) is full of acronyms - from ARPU and LTV to CAC and Churn, it can be challenging to keep them all straight in your head. ACV is one of those startup KPIs, particularly because it is often (incorrectly) confused with ARR.
In this 3-part series we explain what ACV is and how it is different from ARR.
What is ACV?
ACV stands for Annual Contract Value, which is a KPI to track the revenue generated from a customer normalised for one year (hence, the name of annual contract value). This is a key metric, specifically for enterprise software companies that typically have multi-year contracts.
At company level, ACV is calculated as an average annual revenue generated from a group of customers normalised for a year.
How to calculate ACV?
The most prevalent formula to calculate is:
Let’s illustrate this with an example. Let’s say:
Customer A buys your product for £20,000 for 4 years
Customer B buys your product for £30,000 for 5 years
In these examples,
Total Contract Value (TCV) of customer A = £20,000
Total number of years of contract for customer A = 4 years
Therefore, ACV for customer A = £20,000 / 4 = £5,000
Similarly, for customer B:
Total Contract Value (TCV) = £30,000
Total number of years of contract = 5 years
Therefore, ACV for customer B = £30,000 / 5 = £6,000
For company’s ACV, calculate the average ACV as following:
(£5,000 + £6,000) / 2 = £5,500
In addition to this core approach to calculating ACV, following factors also impact ACV. However, there is no set-in-stone rule about whether to include or exclude them:
One-time fees/ set up fees that are usually charged upfront. Typically, these will be excluded from ACV. If included, it will result in a higher ACV for first year.
Adjusting for upgrades / downgrades to adjust TCV in subsequent years.
How to leverage ACV?
ACV is useful to baseline customers with different contract duration or different pricing tiers. It is best used in conjunction with other SaaS metrics, specially Customer Acquisition Cost (CAC). Together, they can inform your sales and marketing strategy.
Companies with low-ACVs (such as Netflix, Calm) will require a larger number of customers to hit a certain revenue target and will likely aim for a low CAC to manage their payback period.
In contrast, companies with high-ACV (such as SAP, Oracle) will require fewer customers to hit the same revenue target (because higher revenue is earned per customer). Typically, higher-ACV companies can also absorb higher CAC and still manage a healthy payback metric.
It is entirely possible (and not uncommon) to develop a business model that straddles both low and high ACV customer groups through tiered pricing.
Companies such as Zoom and HubSpot are examples of hybrid-ACV companies that serve individual customers, as well as large enterprises.
Once you determine where your company falls on the ACV spectrum, you can use the number to drive following 3 applications:
Identify Upsell Opportunities
Customers that are below your company’s average ACV are prime targets to upsell so as to bring them in line with your overall ACV. This is particularly effective when you have an engaged customer with good usage levels but with low-ACV numbers.
Assess Performance of Sales/Customer Success Reps
Some reps are more effective at making bigger sales or driving ACV higher via upsells. Tracking ACV per sales/customer success representative will enable you to baseline performance of your team.
In turn, this will enable upskilling those who have room to learn and sell more effectively.
Benchmarking and discount strategy
A tried and tested method to increase sales and close big clients is by offering pricing discounts. But knowing how much discount you should offer is not easy to pinpoint.
This is another scenario where tracking your company’s ACV can be beneficial. It will enable you to create a baseline from historical data and use that as a basis to determine how much discount to offer vis-a-vis the ACV spectrum you are operating within.
In summary, ACV is a core metric because when used appropriately in conjunction with CAC and other relevant metrics, it can be a really valuable tool to drive your sales, marketing and pricing strategies.
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