Under what conditions are short-term contracts preferable to long-term contracts?

In dynamic markets where cost of components changes fast, buyers typically auction off regular short-term contracts to fully leverage supplier competition in each period to continuously source from the lowest-cost supplier. However, too much competition through short-term contracts does not incentivize the incumbent supplier to make relation-specific investments in reducing costs, as future business is not assured. We investigate this trade-off, between leveraging supplier competition in each period versus incentivizing incumbent’s investment, with a stylized two-period model in which the buyer decides whether to auction off short-term contracts in each period or auction off a single long-term contract spanning both periods. In both cases, we characterize the optimal incumbent supplier’s investment, the suppliers’ equilibrium bidding strategy and the buyer’s expected cost. Our analysis shows that the supplier always invests more in a long-term contract. However, the buyer’s cost depends on supply base size: it prefers short-term contracts for large supply base size, otherwise it prefers long-term contract. Moreover, we find that system cost is typically lower with short-term contracts and that the suppliers are always better off with short-term contracts. Finally, adding non-discriminatory or discriminatory reserve prices to our model does not fundamentally modify the trade-off, but we find that auctions with discriminatory reserve price are better at balancing this trade-off compared to long or short-term contracts. Full paper available at https://doi.org/10.1016/j.ijpe.2020.107652.

Keywords: Contract length, Relation-specific investment, Auctions, Supply base size

As an agency, you might think a long-term contract is the best way to keep revenue flowing into your business. Every agency wants to hear those magical words, “let’s sign a deal.” But a long-term contract isn’t always the best option.

The stable income that comes with a long-term contract can be exciting. But it also comes with downsides. If the relationship with a client falls flat, you’re stuck in a deal that isn’t good for your agency or the flexibility to replace the client.

On the flipside, there are many occasions where using a long-term contract makes complete sense from a financial and strategic point of view for an agency and your client.

The trick? Figuring out which contract is best to use each time you bring a client on board.

Let’s compare long-term vs. short-term contracts, and how to choose which one is best.

The difference between long-term and short-term contracts

Besides duration, there are more differences between long and short-term contracts.

A long-term contract is an agreement when an agency and a client have some serious projects to work on. We aren’t talking about making a new logo here.

We’re talking long-term social media and marketing strategies, SEO campaigns, and analytics that often require many months (even years) to figure out and capitalize on.

What’s a long-term contract in terms of a timescale? Anything that’s around 6 to 12-months:

These long-term plans are essential as many big-ticket items like SEO and content marketing campaigns need months to prepare and execute properly.

The benefits of a long-term contract

Long-term contracts can provide much-needed stability to an agency, especially if you’re just starting out. A long-term contract can help you take the financial guesswork out of your agency’s cash flow, and they offer a great opportunity for you to grow a meaningful relationship with your client.

But why else would you want to sign your agency’s life away?

You can truly master the strategies behind your client’s campaign

No matter how experienced and proficient your agency is, you need some time to get to know the ins and outs of your client’s company. It takes time to discover their pain points and what they’re looking to achieve long-term.

Their target audience, forecasts, and goals can’t be worked out overnight. Allowing your agency some time to figure these out will give you an intimate look into the company. It’s important to do this, as it’s these early stages in a contract’s lifetime that can give your agency key insights to help build highly profitable campaigns for your client down the line.

This also gives you time to figure out how many resources you should invest in the project to make it work. If you have a long-term contract in place, you can dedicate more of your agency’s resources into this crucial stage early.

You’ll actually get to know your client

When is the last time you developed a meaningful relationship with a short-term contract client?

A long-term contract allows you to provide your client with more direction and figure out a long-term plan to make sure the project is sustainable.

A shorter contract adds pressure as a client will want to see results immediately, and it may be difficult for them to see the bigger picture. A long-term contract can eliminate these issues as time can build a strong bond between your agency and your client.

Not to mention, one of the most important benefits from a good relationship with your client is them recommending your agency to their colleagues:

Building and maintaining a solid relationship with your clients will help you secure more clients in the future.

You can prepare a pitch with a lot of value and secure cash flow

Ever had a problem selling your client on a deal?

Marketing contracts are worth thousands of dollars. The more you promise, the higher the price tag, and the bigger the win for your agency. The big point to hammer home is your client’s ROI.

If you can map out how and when you’ll expect your client to receive their ROI, it’s easier for them to invest in your agency. No client will reject a long-term marketing contract at $10k per month if you can show them their ROI will be 10x that amount.

The downfalls of a long-term contract

It’s not all roses. If your agency enters into a long-term contract without identifying if you’re a good fit for the client, you could end up spending months investing resources on a bad client.

You don’t have much flexibility

Take a typical scenario: you’ve signed a client to a 12-month marketing contract to build their brand awareness through a range of strategies.

If one of those strategies is Instagram marketing, and you discover two months in that it’s not the best tactic for the company, you could be stuck utilizing a failing strategy or have to invest more of your resources to come up with a new tactic.

You could get stuck with a bad client

Not every client relationship is perfect, and sometimes you just have to pull the plug for the benefit of your business.

The bad news is if your relationship with your client goes south and you still have eight months remaining, you’ll have to stick it out.

A recent post by CodeinWP featured 32 agencies who talked about their worst type of client. Agency owners said a bad client sucked their time dry, haggled on prices, and expected more from their contracts than what they agreed on:

When you sign a long-term contract, you must realize you are making a massive commitment to your agency’s time in a deal that may prevent you from signing more clients.
If you don’t click with your client and work well together, longer contracts can be a brutal environment for your agency to spend months (or years) working in.

Deciding between long-term and short-term contracts

Even though you can’t be 100% sure that signing a client to one type of contract versus the other will be the best move, there are a few red and green flags to look for that will help make your decision easier:

Red flags: When a long term contract is a mistake

Want to spot a bad long-term contract before you sign the dotted line? Some obvious signs include:

• Your client is reluctant or skeptical of the contract, even during the proposal stage
• Clients attempt to cut your prices and negotiate you down from your first meeting
• They have a limited advertising budget but expect you to work miracles with
• Clients who don’t trust your agency and your abilities 100% from the start

Green flags: when a long-term contract is the right choice

Despite some of the potential downfalls, there are always clients who you should sign up to work with for the long haul. These clients have a clear vision of where they want their business to be and want you to help them get there.

Some of the green flags for signing longer deals include:

• Your client is used to spending money on advertising and sees the benefit of the investment
• They have a long-term project and require help with a range of services
• They have several ongoing needs for creative assets and deliverables
• They already have a content marketing plan or want to launch one with your agency
• They trust your abilities and respect your pricing strategy

What should long-term contracts include?

A typical long-term contract will focus on marketing goals that take several months.

If a client needs services like building brand awareness, increasing sales and conversions, or SEO, a long-term contract may be the best fit. If you find that a long-term contract is the best option, then your next step will be to draft the details. But what should you include?

Here are two key points to consider adding when drafting your contract:

Include a clear plan with milestones

If you’re considering a client for a long-term deal, you need a strategy that will keep you on track. You should clearly outline how and when your agency plans to meet certain milestones for a client:

If you plan to increase a client’s click-through-rate by 30% in the next six months, write it into your contract as a milestone. With milestones in place, your client will know when campaign goals should be met.

Have a payment trigger for each milestone

Every time you hit a milestone, make sure that you get paid.

One of the perks of signing a client up long-term is the guaranteed cash flow, but make sure you aren’t waiting too long to see the money. If you’ve planned to have a conversion strategy reach a certain point at the six-month mark, and it has, your agency should have a trigger payment setup to make sure you are compensated.

Alternatively, you could consider putting your client on a retainer so that you have income flowing in monthly. Additionally, retainers provide clients with expected costs which make budgeting easier:

Without clear milestones or a retainer in place, you could find yourself months into a long-term contract, lacking in finances and at the worst, having to draw on credit to keep your agency going.

Choosing the right contract is necessary

If you’re struggling to decide whether to sign a client on a short-term vs. long-term contract, you should weigh the pros and cons of your agency first. If a client doesn’t have a long-term vision for a strategy or trust your agency’s ability from the onset, you’re better off sticking them on a short-term contract, or not working with them at all.

Long-term contracts work best when your client is as invested in a strategy as you are. They know that results will take time, but they’re willing to invest long-term and work with your agency along the way.

Of course, figuring out the best contract to sign your clients to is only one component of building and growing a successful agency. Learn how to grow your agency with AdMap, 1:1 Personalization, built-in collaboration, pixel-perfect designs & more, no other solution can compare. Sign up for an Instapage Enterprise demo today.

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