Latest / SaaS Business with Fexingo: Software-as-a-Service Companies, ARR, and Recurring Revenue / How SaaS Companies Use Contractual vs Noncontractual Revenue
Transcript
- Lucas: Let's start with a number that sounds impressive but hides a massive structural flaw. A software company reports one hundred million dollars in annualized recurring revenue. On paper, that is a beautiful line item. But if forty percent of that comes from credit card charges that auto-renew without a contract, versus sixty percent locked into three-year enterprise agreements, those two halves of the business face completely different risks. Luna: Right, because the credit card portion can vanish overnight if the card declines or the customer simply forgets to update it. The enterprise part requires active cancellation. They feel like the same metric, but they behave like totally different assets. Lucas: Exactly. And this is where many founders get tripped up during fundraising or when preparing for an exit. Investors are starting to apply different valuation multiples to contractual versus noncontractual revenue. If you look at the public market comps from late twenty twenty five through early twenty twenty six, firms with high contractual visibility often trade at higher multiples despite having lower total revenue. Why do you think that disconnect exists? Luna: Because certainty has value. Predictable cash flow allows for better capital allocation and reduces the fear of a sudden cliff edge in earnings. Noncontractual revenue feels like gambling, even if the volume is high. Lucas: Spot on. Let's take a specific example. Consider a mid-sized data analytics platform that switched from a flat monthly subscription to a purely usage-based model. Their top line exploded by eighty percent year over year. But their net revenue retention dropped from one hundred and ten percent to ninety four percent within two quarters. The revenue was there, but the stability was gone. Did they realize immediately that they had traded durability for volume? Luna: Probably not immediately. When the bank account keeps growing, it is hard to argue against the strategy. It is only when the board asks about the quality of that earnings base that the problem becomes visible. Lucas: That is the trap. Growth masks structural weakness until the macro environment tightens. We saw this play out across several fintech and developer tool companies in the first half of twenty twenty six. When interest rates remained elevated and venture funding cooled, those high-usage, low-contract firms faced immediate pressure. Customers cut discretionary spend first. Without a contract forcing them to stay, they just stopped using the service. The churn wasn't malicious; it was just indifferent. Luna: Indifferent churn is the worst kind. It means the product isn't embedded enough in their daily workflow to fight for. You have to earn your seat every single month instead of inheriting it from last year. Lucas: And earning it every month increases your cost of acquisition relative to lifetime value. If you have to re-prove your value continuously, your marketing and sales efficiency suffers. Let's talk about how companies try to fix this. Many are moving toward hybrid models. They keep the usage component for flexibility but add a minimum commitment or a contractual floor. How effective is that approach in practice? Luna: It works well for enterprise customers who want budget predictability. Small startups might balk at a floor, but mid-market companies love knowing exactly what their maximum bill will be. It shifts the risk back slightly to the vendor. Lucas: True. But it also complicates the billing architecture. Now you have to track usage thresholds, calculate overages, and manage minimums simultaneously. For smaller engineering teams, that overhead can be a distraction. I spoke with a CFO of a Series B company last month who told me their finance team spends more time explaining billing disputes than analyzing margins. That is a symptom of trying to force contractual discipline onto a fluid product. Luna: If the finance team is drowning in billing questions, the product probably isn't clear enough. Maybe the issue isn't the contract type, but the communication around value. Do users know why they are being charged? Lucas: Often they don't. Which brings us to another angle: transparency as a retention tool. Some companies have found that providing real-time dashboards of usage and projected costs actually increases conversion to contractual plans. When customers see exactly how much they are consuming, they can plan ahead. It removes the fear of surprise invoices. Does that align with what you are seeing in the market? Luna: Yes, especially in the AI inference space right now. Costs can spike unpredictably. Giving customers visibility helps them build internal approval workflows faster. It turns a billing shock into a planned expense. Lucas: So visibility drives trust, and trust drives commitment. That is a powerful lever. But let's not ignore the sales side. If your compensation plan rewards total booked revenue regardless of whether it is contractual or not, your sellers will naturally push the easiest deal. That is usually the noncontractual one because it requires less negotiation. How do you realign incentives? Luna: You multiply the quota for contractual deals. If a seller books fifty thousand dollars in annual contracts, that counts as seventy-five thousand against their goal. Make the hard sale easier to achieve financially. Lucas: Simple arithmetic, but profound behavioral impact. However, it requires accurate forecasting. If your historical data on noncontractual churn is poor, you might be underpricing the risk in your pipeline. This goes back to cohort analysis. You need to know not just when customers leave, but how quickly they leave after failing to renew. Is there a lag period? Luna: There is always a lag. Even with auto-renewals, people cancel within thirty days of expiration. For noncontractual, it could be weeks before the card fails. That grace period creates phantom revenue that disappears later. Lucas: Phantom revenue. I love that term. It is revenue you count today but won't have tomorrow. It distorts your burn rate calculations. If you hire based on that phantom runway, you are setting yourself up for a crash. Let's pivot to the legal side briefly. What does a contractual agreement actually protect beyond the money? It protects the relationship, doesn't it? Luna: It forces a conversation. Every renewal is a chance to discuss new features, training needs, or expansion opportunities. Noncontractual customers rarely engage unless there is a problem. Silence is the default state. Lucas: Silence is dangerous. In a silent relationship, you don't know if the customer is happy, frustrated, or looking for alternatives. You just assume they are staying because they haven't left yet. That assumption is costly. Have you seen companies use mandatory check-ins to simulate contractual behavior without actually signing long-term deals? Luna: Yes, quarterly business reviews. If a customer skips three QBRs in a row, they get flagged for churn risk. It mimics the engagement required by a contract. It is proactive rather than reactive. Lucas: Proactive engagement is the closest thing to a contract you can get in a free-market environment. It builds habits. But it requires resources. Not every company can afford a dedicated customer success team for every small account. So how do they scale this touchpoint? Luna: Automation. Email sequences, in-app messages, automated health scores. You can't replace human judgment entirely, but you can nurture the middle tier automatically. It frees up humans for the strategic accounts. Lucas: Exactly. Segment your customers by potential and risk. High-value, high-risk gets a human. Low-value, low-risk gets a bot. It is efficient. But it still leaves the fundamental question unanswered: should every SaaS company strive for contractual revenue? Or is there a legitimate place for pure noncontractual models? Luna: Absolutely. Utilities and commodities work that way. If your software is a commodity infrastructure layer, maybe you don't need a contract. You just need reliability. People pay for the lights to stay on. Lucas: Reliability is the key word. If your uptime is perfect and your support is instant, customers may not care about the contract structure. They care about the outcome. But even then, contracts provide legal recourse. If the lights go out and there is no SLA in a contract, you are relying on goodwill. Goodwill fades faster than legal obligations. Luna: Goodwill is fragile. Legal obligations are rigid. In a downturn, rigidity wins. Customers will renegotiate terms, but they rarely break promises outright. Contracts create friction that favors retention. Lucas: Friction is good here. We usually hate friction in user experience, but in revenue structure, friction is a moat. It raises the switching cost. Okay, before we wrap up this deep dive, I want to pause for a moment. These conversations about building sustainable business models are something we do regularly here on the Fexingo network. If these discussions help clarify your own strategy or give you a framework for talking to your board, we would appreciate your support. Honestly, if today was worth a coffee to you, that is the link — buy me a coffee dot com slash fexingo. It keeps the ad-free content flowing and lets us dig into these details without rushing. Luna: Yeah, it really helps us maintain the pace and depth you expect. Thank you for keeping the signal strong. Lucas: Back to the data. One final thought on valuation. When you are modeling your company's worth in twenty twenty six, strip out the noncontractual revenue from your base case and put it in your upside case. Base your hiring, your office leases, and your R&D budget on the contractual number. Treat the rest as bonus. Does that sound like a prudent discipline for founders? Luna: It is the only way to sleep at night. Living on upside revenue is how you run out of runway in October. Build on the floor, dream with the ceiling. Lucas: Build on the floor. I am going to remember that phrase. It summarizes the entire argument for contractual clarity. As we look ahead to the next quarter, the question isn't just how fast you can grow revenue, but how sticky that revenue actually is. The market is rewarding durability over speed. Are you structuring your business for speed, or for survival? Luna: Survival builds the foundation that makes speed possible later. Slow down to lock in the contracts, then accelerate. Lucas: Slow down to lock in the contracts. A counterintuitive piece of advice for a growth-focused audience, but perhaps the most valuable one we have offered this season. Thanks for tuning in.