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Should you buy All, Partial, or No Upfront RIs?

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Chris Cochran   Chris Cochran, Co-Founder and Chief Executive Officer

The question of whether to purchase Reserved Instances (RIs) as No Upfront, Partial Upfront, or All Upfront is a common one. AWS provides these three payment options which you can learn more about here. RIs are fundamentally an exchange of a term commitment for a discount. These payment options determine whether you prepay none, some, or all of that commitment upfront in exchange for a marginally higher discount.

So when should you purchase No, Partial, or All Upfront RIs? Another way of asking that question is "Should I invest my capital to get a greater RI discount or use it for other investments that yield a higher return?" This is a common decision finance teams make when evaluating investment alternatives, but it may be a foreign concept to DevOps engineers who are making RI purchases.

For teams that have or are considering using their capital to purchase RIs, we find the drivers fall into one of two categories: (1) they have been allocated a capital budget that needs to be deployed or (2) they believe the ROI on the incremental discount from All or Partial RIs exceeds their cost of capital.

First things first, what is cost of capital? Aswath Damodaran from NYU's Stern School of Business (we highly recommend his research for the finance nerds out there) describes cost of capital as the "swiss army knife of finance". When it comes to prepaying RIs, cost of capital is the hurdle rate used to judge whether the investment is a good or bad one. In other words, to make economic sense, prepaying for RIs needs to yield a return greater than the cost of capital.

Cost of capital varies for each company. This begs the question "What is my company's cost of capital?" Your finance team knows the exact number, but to generalize we'll refer to David Skok's For Entrepreneurs blog where he summarizes the cost of capital/discount rate for different classes of SaaS companies:

  • 10% for public companies
  • 15% for private companies that are scaling predictably (above $10m in ARR, and growing greater than 40% year on year)
  • 20% for private companies that have not yet reached scale and predictable growth

This leads to the final question, "Does the return for prepaying RIs beat my company's cost of capital?" To answer that, let's look at an RI example for a t3.large Linux Convertible RI in us-east-1 (while this example is illustrative, each RI is different, so be sure to run the math):

Observations:

  • For both 1 and 3 year terms, the incremental discount of paying All vs. No Upfront is roughly 5% (see column F: 32.8% vs. 27.9% and 55.5% vs. 50.7%) with the majority of the discount coming from making a No Upfront commitment in the first place.
  • Using the upfront capital required (column C) and the incremental dollar savings of prepaying for Partial and All Upfront RIs (column H), we can calculate the annualized ROI of pre-paying for RIs (column I).
  • The 1 year term has a higher prepay ROI than the 3 year term!
  • The Partial Upfronts have a higher prepay ROI than the All Upfronts!
  • The 1 year Partial has the highest annualized prepay ROI of 10%, which barely meets the lowest SaaS cost of capital from Skok's analysis.

What does this mean in practice? If you're unsure whether the RI prepay ROI exceeds your cost of capital, stick with No Upfronts. If the RI prepay ROI exceeds your cost of capital, or if you have a capital budget to deploy, select the payment options that yield the highest aggregate prepay ROI.

If you find yourself asking "Why would I want to burn mental cycles calculating RI prepay ROIs?" we agree. ProsperOps completely removes this complexity from your plate, as well as other economic nuances of the RI... algorithms are just better suited to this tedious work. To learn more about how our algorithms will optimize your EC2 savings, please check out our site or email us at hello@prosperops.com.

 

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