Contracts serve a pivotal role in business transactions, formalizing agreements and providing a secure framework for a company’s growth.
In this article, we consider the particular importance of contract value — a critical concept for all parties involved in the agreement.
We’ll explain what a contract is, its value and the importance of understanding it, and how to determine this value.
- The value of a contract equates to the amount that will be earned once it has been fully executed.
- It encompasses all costs in the agreement—upfront and ongoing.
- This is particularly important in agreements where a service is being provided over a period of time.
- Calculating a total contract value (TCV) is crucial in business.
What is a contract?
To begin, it’s essential to establish why contracts are important.
A contract is a legally binding agreement between two or more parties. It establishes the rights, obligations, and expectations of the parties involved.
In doing so, it specifies the terms and conditions under which the parties will engage.
Not least, that includes payment terms (e.g., how much needs to be paid and when).
Whenever there’s an agreement to work with or for a third party, it’s advisable for businesses to formalize the arrangement with a written contract.
Doing so clarifies the terms of engagement, minimizes ambiguity, and provides suitable legal protection.
Good contracts strengthen agreements and help prevent conflict and disputes further down the road.
The security a contract profers is particularly essential for businesses that offer a service.
For example, in an agreement to provide software as a service (SaaS), parties need clarity regarding upfront and ongoing costs and other terms such as subscription length.
In short, knowing how to create a contract and efficiently manage it is an integral part of running a robust business.
What exactly is the “value of a contract”?
The “value of a contract” refers to the total monetary worth of a contract from beginning to completion.
It’s a specific metric for the amount that will be earned from the contract once it’s been “fully executed,” e.g., after all the obligations in the agreement are satisfied.
It encompasses all the costs in the agreement, including upfront and ongoing committed costs.
The importance of understanding the value of a contract
“Value of contract” is a crucial metric for businesses to monitor.
For a start, it allows companies to track how much revenue each customer generates.
It also facilitates accurate forecasting of income accruing from all such agreements collectively over time.
As such, businesses should utilize this metric in their strategic decision-making.
It’s particularly salient in situations where contracts cover an ongoing service provision — for example, software as a service (SaaS).
Let’s consider an example. Imagine a B2B software company has secured a new customer. A contract is agreed to specify:
- Any upfront costs for the customer to pay (e.g., for training, professional support, or hardware purchases)
- Any ongoing subscription fees (e.g., a monthly cost)
- The contract length (e.g., a year)
In this context, the “value of the contract” would be the total amount the customer pays the business for the service across the agreed period.
This includes both upfront and ongoing fees across the contract lifespan.
Of course, the customer may subsequently choose to retain the service.
In this case, a new contract will generally be prepared for renewal with its own additional contract value for the business.
But that future potential revenue is not, of course, part of this particular total contract value (TCV).
Knowing the TCV of a contract allows a business to assess the return on investment for each customer based on accurate real-life data.
For example, they could calculate the return on investment to secure the sale (e.g., the cost of product development, sales, and marketing).
This can inform future strategic planning.
Accurate knowledge of TCVs is essential for forecasting future revenue for the business.
You may also have heard of “customer lifetime value” (LTV).
Remember, however, that this is not the same as TCV. Instead, it’s an additional useful metric for businesses to consider.
It predicts the total amount a customer is likely to spend on your product or service across the lifetime of their relationship with you.
Ergo, it’s more of a longer-term projection.
Where TCV only captures the value of the existing contract with the customer, LTV takes a broader view. Is the customer a newcomer or a renewal? How likely are they to renew on a year-by-year basis?
A business’s LTV predictions are only as good as the modeling that underpins them.
Where TCV is a firm, contractually agreed figure, LTV is not. It’s a prediction based on your understanding of the market and customer behavior.
Existing TCV figures can play an essential role in predicting LTV, but this must also be informed by solid modeling of churn and retention.
With this difference understood, let’s get back to total contract value (TCV).
How to determine total contract value (TCV)
The total contract value (TCV) involves calculating the total amount payable to the business, according to the contract, across the agreement’s lifespan.
There’s a simple formula for this:
There are three variables to consider:
- Monthly recurring revenue (MRR). How much will the customer pay on a monthly basis for the service?
- Contract term length. How long has the customer agreed to pay for the service? How many months have they committed to paying for?
- One-off fees. This may be to cover initial set-up costs, training, hardware, or further professional services.
The best way to illustrate the TCV formula is with an example.
Imagine Company A provides a SaaS product to other businesses. They offer two pricing plans.
- Plan 1 is aimed at small enterprises and costs £100 per month for a one-year contract length, plus an additional £200 in one-off fees.
- Plan 2 is aimed at larger enterprises and costs £500 per month for a one-year contract period, plus an additional £1,000 in one-off fees.
What’s the total contract value (TCV) of each of these plans? Just plug the numbers into the formula to find out.
- Plan 1 TCV = (£100 x 12) + £200 = £1,400
- Plan 2 TCV = (£500 x 12) + £1,000 = £7,000
As you would expect, the TCV of Plan 2 is much higher than that of Plan 1.
Businesses can then model the impact of seemingly small changes using this metric.
For example, what would happen if your team agrees to a cheaper MMR of £410 for Plan 2?
That discount would reduce the TCV to £5,920, causing a significant reduction in business profits!
Understanding total contract value can help you focus your strategy and sharpen your tactics.
For example, while discounts can seem tempting to get deals over the finish line, awareness of TCV shows your team the potential long-term impact of such decisions.
Ensure a flawless contract creation process with PandaDoc
Getting great contracts in place isn’t always easy.
Drafting an agreement requires a certain degree of expertise, e.g., knowing what makes a contract valid.
PandaDoc is a comprehensive document creation platform that simplifies the entire contract lifecycle.
It offers a range of features designed to enhance efficiency, ensure accuracy, and improve collaboration during contract creation and negotiation.
If you’re wondering what to include in a contract, PandaDoc has you covered.
We provide a library of professionally designed, customizable contract templates and offer electronic signature functionality.
Moreover, our powerful tracking and analytics features offer support throughout the entire contract management process.
PandaDoc’s document value feature also allows you to see or adjust the total value of your document.
Our software can simplify contact management for your business and shorten its sales cycles by providing robust support through extensive features and capabilities that facilitate accuracy, efficiency, and collaboration.