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SaaS Business Model: Everything You Need to Know

SaaS Business Model: Everything You Need to Know

Being young, innovative and trustworthy, cloud computing enjoys ever growing popularity in today’s global world. The very term “cloud computing” means availability of computer system resources, computing power, data storage on demand without any active management involved. This allows the businesses to minimize their IT infrastructure costs and concentrate directly on their business aims.

You may come across information about 3 types of cloud computing services:

  • IaaS (Infrastructure-as-a-service)
  • PaaS (Platform-as-a-service)
  • SaaS (Software-as-a-service)

In this article we’re going to focus on SaaS as a successful and promising business model. To get a better understanding of the SaaS business model let’s dive into the following aspects:

1. SaaS business model

2. A bit of history and statistics

3. Peculiar features of SaaS

4. SaaS stages

5. SaaS business model KPIs (metrics)

What is SaaS business model?

The term “SaaS” (Software-as-a-service) means distributing cloud-based and centrally hosted software to users on a subscription basis. However, this term is mostly used by professionals in the sphere of e-commerce and IT. Most people would also use such terms as “online software”, “web-based software”, “on-demand software”, which accurately describe its nature. Any company that maintains its software on a cloud and licenses it to users through a subscription plan, whether monthly or annual (those are the 2 most common options) can be called a SaaS company. SaaS business model substantially simplifies the process of using software. Instead of buying and installing specific hardware and software, renewing the software license, the users can simply buy a subscription and get all the benefits of using the application. This type of access to software obviously decreases IT spending for both individuals and companies.

A bit of history and statistics

While it may seem that the very idea of the SaaS business model is a bit over a decade and a half old, actually, the idea of centralized hosting of business software dates back to the 1960s. At that time banks and some other large organizations used to acquire computing power and database storage from computer provider data centers (IMB for example). Such services were called time-sharing or utility computing.

The 1990s saw a new kind of centralized computing-ASP (application service provider) due to Internet expansion. The main aim of ASPs was to provide businesses with hosting and managing third-party business applications, while SaaS companies today host and manage their own software. 

 Since the 2000s the SaaS business has experienced exponential growth with lots of startups emerging and significantly changing some business spheres.

The SaaS market reached $152 bn in 2021 and it‘s now estimated to reach $ 208 bn by 2023. The number certainly exceeds the projected ones that are mentioned in the graph below, which means that SaaS business is on the scale of expansion beyond expectations. If we look at the period of 10 years on the graph, we clearly spot a fivefold growth of the industry at the very least.

According to the Deloitte report “SaaS Industry Outlook: Time to ride the wave” dated November 2021, the global SaaS industry undergoes a rapid development phase accompanied by continuous innovation of products and business models. Over the past 10 years, the global SaaS market size registered a compound annual growth rate of 25%.

The following graph shows some of the most significant players in the SaaS business, where 1/3 of market share belongs to Amazon web Services.

Peculiar features of SaaS business model

SaaS companies boast the following peculiar features that distinguish them from others:

  • High customer retention
  • Consistent updates
  • Recurring payments

High customer retention

The SaaS business model is focused on building customer relationships and upselling simply because it’s the crux of keeping such businesses afloat.

Signing up new clients should be followed by turning them to loyal clients with the help of spotless customer service. Poor customer service, on the contrary, may discourage SaaS company clients even if the very service they provide is outstanding.

Consistent updates

One of the benefits of the SaaS business model for the clients is that SaaS companies invest a significant part of their resources in consistent updates of the software they sell. It’s quite obvious that updating the software you host in the cloud is much easier than delivering upgrades and new versions to the clients who have installed the software on their personal devices. SaaS companies understand the value of security of their clients’ data as well as the necessity to provide their clients with top-notch solutions. So frequent updates, new features and applications is the way SaaS businesses can keep their clients happy and satisfied.

Recurring payments

SaaS revenue model is based on licensing software with the help of subscription plans. Consequently, the clients of SaaS have to make sure they purchase a monthly or annual subscription as opposed to buying software once and installing it on your device. As a result, SaaS businesses get monthly recurring revenue (MRR) based on monthly subscription plans. It has to be noted though that a SaaS company normally gets paid upfront, and the notion of revenue is based on the concept of money earned. This means that a client may claim their payment back if dissatisfied with the service. Thus, revenue recognition might be a bit problematic for SaaS businesses. Taking that into consideration, a reliable SaaS accounting tool is one of the best investments in the business.

SaaS stages

Practically every SaaS company follows the same pattern or stages during its business life. It’s vital to understand what stage your company is at as it can help to avoid ungrounded decisions which can eventually lead to failure. This idea may sound even more convincing if we remember that 90% of all startups fail.  According to the specialists at Investopedia, this number can be further broken down to 21.5% of startups that fail in the first year, 30% in the second year, 50% in the fifth year, and 70% in their 10th year.

To get a better understanding of the process, let’s take a brief look at the main stages of the SaaS business model:

  • Pre-startup
  • Startup
  • Growth
  • Maturity

Pre-startup

According to the specialists at Chargify (the company that helps SaaS businesses manage their recurring revenue customers), pre-startup may be referred to as discovery or vision stage and characterized by:

  • trying to spot the problem and finding a viable software-driven solution 
  • looking for financial support from family and friends
  • studying and researching the problem
  • building relationships with potential clients, mentors, advisors
  • making up a business plan
  • joining an accelerator group
  • making a product (initial stage)

According to Andrew Armstrong, founder of KickStart Search, the common risks at this stage are:

  • “failure to design a business plan and strategy that will enable the company to become profitable 
  • a dependency on seed money to cover operational costs for a longer period than anticipated
  • a lack of funds to cover rising employee and infrastructure costs”.

Startup

Startup stage, also known as validation or product/market fit stage, has a name that speaks for itself. At this stage the SaaS business model focuses on:

  • honing the product and its key features
  • implementing analytics
  • proceeding with key hires
  • finding product/market fit
  • getting first customers
  • securing investments (angel/seed money)

The most common risks, according to Andrew Armstrong, at this stage would be:

  • inability to get the number of customers that can create the cash flow needed to fund operations 
  • failure to deliver the necessary volume of products or services
  • making hiring mistakes

Growth

According to the specialists at Chargify, at the growth stage some companies realize the necessity “to shift focus from revenue growth to profitability”. This stage is marked by the following activities:

  • increase of sales volume or revenue
  • expanding the market share and becoming profitable
  • refining the service based on market feedback
  • seeking new funding to support customer acquisition and scaling
  • hiring more professionals (including executives)

The major risks management should be aware of at this stage as defined by Andrew Armstrong are related to:

  • inability to keep the company stable and profitable
  • expanding into oversaturated markets
  • developing new products that turn to be unpopular at the cost of company’s reserves

Maturity

Maturity stage is also known under the name expansion stage. It’s explained by the fact that after reaching a certain desired proportion of the market, the company normally seeks new markets, possibly new products and channels of distribution.

At this stage the company may:

  • look for additional funding to support its expansion
  • develop new services
  • hire personnel to cater to new needs 
  • restructure some processes
  • go global
  • consider IPO opportunities

The biggest risks at this stage would be:

  • not accommodating the needs of the changing market
  • losing the competitive edge

In short, understanding the key demands and potential risks of the SaaS business model at every stage may help to prevent premature scaling and make the company successful.

SaaS business model KPIs (metrics)

When it comes to success, how exactly does one define whether a SaaS company is a successful one? And again, “successful” may mean a lot of things like “profitable”, “developing at a steady pace”, “well-known brand name”. That’s where good old KPIs come into play.

In his article on 7 important SaaS marketing KPIs, Chris Martin (the CMO of FlexMR, a hybrid research agency & tech firm that empowers brands with agile insight) argues that it’s vital to define which particular KPIs are worth tracking.

His idea is that too many KPIs might lead to “analysis paralysis”, while tracking just one KPI can hardly be of any great value for defining a company’s growth opportunities. Chris Martin believes that the following 7 key KPIs should give you a reliable picture of any SaaS business model health:

Net profit

Net profit can be defined as the sum of business performance and it’s calculated as revenue minus expenses. So implementation of strategies and techniques that help increase net profit is undoubtedly supported by the management.

Customer Acquisition Cost (CAC)

As it comes clear from the name, CAC equals the cost of getting a new customer. CAC is calculated by dividing total marketing and sales costs by the number of clients obtained over a certain period of time. It also measures the effectiveness of marketing technologies (advertising for example).

Customer Lifetime Value

Being one of the main metrics for any business, CLV helps to prioritize the most valuable clients, personalize campaigns and offers and analyze the value of customer acquisition channels. It’s calculated the following way: average customer value multiplied by average customer tenure. CLV-to-CAC ratio for a mature SaaS business model has to be between 2-to-1 and 8-to-1.

Monthly Recurring Revenue

MRR is calculated by multiplying average revenue per customer and total customers in a month. As SaaS revenue model is based on recurring fees from the customers, MRR analysis helps to track monthly cash flow, which can hardly be overestimated.

Funnel Conversion Rates

This indicator shows how many of the people who entered your funnel actually convert into customers. FCR is calculated by dividing total conversions by total leads in the funnel (then multiplied by 100). This percentage shows which funnel stages have leaks and need more attention.

Net Promoter Score

NPS score is sometimes referred to as the gold standard in measuring growth potential and shows customer loyalty and satisfaction with your service. Tracking NPS starts with asking one question: “How likely are you to recommend us to your friends?” The answers are scaled 0 to 10. NPS is the percentage of customers who will promote the service, also known as promoters (scored 9-10) minus the percentage of detractors (scored 0-6). Chris Martin suggests adding a follow-up “Why?” as well, because these answers will give real feedback from the clients and great opportunities for improvement when it comes to detractors.

Churn Rate

Churn rate is one more indicator of customer satisfaction. It’s actually the rate at which your company loses clients over a certain period of time. A successful SaaS business model is defined by churn rate that is lower than acquisition rate.  

Bottom line

The application of the SaaS business model is almost limitless. SaaS works for both B2B and B2C segments successfully. Among the most noted companies are Amazon web services, Google, Slack, Zoom, Netflix, Adobe Creative Cloud, Shopify, Hubspot, Microsoft, Zapier, Miro and the list goes on. While these companies provide different services in various spheres, convenience, cost-saving and higher security are the common features that attract their customers. From a business owner’s perspective, the SaaS business model stands out because of its rapid growth, increased revenue, simplicity of deployment and great scalability. Taking these benefits into account, as well as fast expansion of subscription-based economy over the last decade and a half, the prediction that SaaS is to thrive and flourish doesn’t come as a surprise.

Irina Seagull

Irina Seagull

Irina has a degree in Linguistics, 15 years of teaching experience and 3 years of experience in managing a team of 15 in a small business. Irina believes that a good structure and logic as well as in-depth research should be the attributes of every blog post.

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