What's the right duration for a contract?

If you are a seller, choosing the right duration for your contracts is more complicated than it looks.

 

Ex-ante, before the contract has been signed, a short contract duration (or the ability to exit early) is more likely to get buyers over the line. Buyers are wary of lock-in, and the longer they have to commit, the less likely they are to sign.

But ex-post, once the contract has been signed, most sellers want a long contract duration. The buyer is now locked in, the salesperson will generally get a bigger bonus, and the thought of annuity revenue makes investors happy.

This preference for annuity can be misleading. Yes, annuity means committed revenue, but what the annuity number doesn’t tell you is the revenue you are losing each year because customers balk at the contract duration.

Here are two more reasons why a smart seller might adopt the position of allowing customers to terminate for convenience.

The first reason will make sense to anyone who has ever worked in outsourcing. Assume a five year (60 month) contract. The first six months are the honeymoon. During the next 42 months, the supplier loses interest – the customer is locked in (so why try too hard?) and the supplier moves its best people on to chasing the next big win.

Service levels drop and the customer is given, not quite the cold shoulder, but isn’t feeling the love either.  Then, in the last 12 months of the contract, the supplier suddenly realises the customer might move on. The love tap is switched full on – but too late! The customer, once bitten but twice shy, will take its business elsewhere.

Locking in customers builds institutional complacency. But if you allow customers to walk away at any time (or, say, at the break-even point) you just might build a company that is constantly on its toes and really takes customer success seriously. That sounds like a company that is likely to be successful.

The second reason is that it’s a fabulous sales pitch! “Hi Mr Customer, unlike our competitors, we don’t lock you in – you can leave at any time. We believe that it’s up to us to provide so good a service that you will never want to leave”.

This preference for annuity can be misleading... what the annuity number doesn’t tell you is the revenue you are losing each year because customers balk at the contract duration.