Loss Aversion and Contracts

In 2002, Daniel Kahneman, a psychologist, won the Nobel Prize for economics for a body of research which showed how people make decisions. When taking a decision, people weigh up the gains and losses (as you would expect) but what Kahneman discovered is what became known as Loss Aversion.  People assign at least twice as much weight to losses as they do to gains.

 

Here’s the classic test. Imagine the toss of a coin where you could lose £100, but you could win £X. How much does £X have to be for you to take the bet? For most people, it’s at least £200. That’s Loss Aversion.

How does Loss Aversion work in contracts? There’s a number of ways, but one important element is the duration of the contract. Most sellers would like to tie up their customers for a long period, say 5 years. But the longer the period that a customer is locked in, the greater (more than x2) the corresponding gain that you have to demonstrate to get the customer to commit.

If the onboarding cost of each new customer is minimal (which is typically the case in SaaS contracts) and you don’t need a long contract duration to protect your break-even, then all you are doing is inviting Loss Aversion to kick in.

You might be better off by reducing your requirement for contract duration (or even letting customers walk away when they feel like it), and just making sure that your product is really sticky.

...the longer the period that a customer is locked in, the greater (more than x2) the corresponding gain that you have to demonstrate to get the customer to commit.