Software-as-a-Service (SaaS)

Software as a service (SaaS; pronounced sæs) is a business-to-business delivery model in which software is licensed  and centrally hosted (vs. hosted by the customer). Also known as “on-demand software” SaaS is typically accessed by end users through a web browser or mobile app.

 

The shift in delivery model drove business model adaptation, as companies gained bigger margin advantages, and experimented with new forms of revenue streams such as subscription, freemium, and pay-per-use which are covered in our Business Model Library. However, investors and innovators will frequently refer to a “SaaS business model” – meaning the substantial margin advantage (< 70{4b0c188ae8604bf014d8bc27c7c65bbf455b55139b6ec077c9ec57d60479b1a7} gross margins) that can be attained in its purest form. So take note and go deeper to define how the benefits and challenge of SaaS delivery work for your model.

When it Works Well:

Delivered digitally, hosted for all

Before SaaS methods of delivery, software was sold as a perpetual license with an up-front cost. For example with Microsoft Office, customers paid an upfront licensing fee and bought a boxed set of floppy disks and uploaded the software to their personal computers.

Now, you have a choice for how to buy Microsoft Office – either as a one time fee for one personal computing device, or as Microsoft 365 – a set of licenses for PCs and other devices sold as a yearly subscription. The software resides on the host server from which all users access it.

Delivery via internet enables this method of subscription, and the proliferation of mobile and multiple devices increases the value of having the software available on multiple devices.

Low initial setup costs, lower maintenance costs for the customer

The initial setup cost for SaaS is typically lower than the equivalent software for both the customer and the Saas company. Companies typically price their software based usage, such as the number of users using the application, the number of devices, or the the volume of data being accessed. The low cost to set-up creates an opportunity for companies to offer a freemium model. Successful SaaS companies have been able to disrupt incumbents by pricing their total cost of ownership at a price substantially lower than “on-prem” or on-premises software, with demonstrated return on investment.

Naturally noisy user adoption

Many SaaS applications offer features that let its users collaborate and share information, thereby increasing the network effects and rate of user adoption. For example, project management applications delivered in the SaaS model such as Basecamp, Asana, and Slack offer collaboration features letting users comment on tasks and plans and share documents within and outside an organization.

Two-step value proposition

Tom Tunguz, a prolific Venture Capitalist scribe on the topic of SaaS, advocates for SaaS business targeting small and medium sized businesses to have a two step value proposition:

1/ An initial value proposition to the end user

2/ A longer term value proposition to a manager/decision maker

The proliferation of enterprise applications designed with the ease-of-use and addictive quality of consumer applications drives this point home – companies such as Slack, Evernote and Dropbox created free and easy-to-use versions of the software. When the manager of the early user adopter is made aware of the productivity advantages of whole department, or whole company adoption, the longer term value proposition kicks in.

Monthly recurring revenue (MRR)

In subscription-based SaaS models, customers tend to stick around for a while (the customer lifetime) and deliver steady streams of predictable revenue. Revenue is smoothed vs. lumpy, as the company does not have to worry about pushing for one-off sales and can better control marketing and sales costs. Instead, focus shifts to retaining customers, and reducing churn or loss of customers. Happy customers even increase their service and stay even longer as a customer, positively affecting the profit that can be made.

Challenges to the Subscription Model

Shape go-to-market to the size of the enterprise customer

If the SaaS company is not clear about the different economic models involved in serving different customer segments, profitable scale is difficult to attain.

Successful SaaS companies pick a target and stick with it: enterprise customers, SMBs (small to medium businesses, or SOHO (small office, home office). When targeting large enterprise customers, the SaaS company can afford a direct sales staff to hunt new business and an inside sales team to nurture, as long as they land large enough price points for their cost model to work. These same companies however may be  unprofitable for the first 12-24 months of a given customer’s life, and adding more customers in a growth curve may put further strains on profitability.

Companies targeting the smaller sized firms need to attract much higher rates of new customers through freemium and effective marketing strategies without relying on a salesforce as the primary acquisition channel. However the customer service team can function as effective inside sales – or sales made from a desk (vs. out in the field). The inside sales team’s job is to contact leads generated from the freemium side of the business and convert those users into paying customers..

Risk of becoming a professional services model

Another key risk for a new SaaS company is when founders lose discipline and never break out of a keep-the-customer-happy professional services business model. Customers often have unique needs when adopting software, and the growing SaaS company cannot respond to every request or need. The purpose of SaaS is to find the common denominator of need among a large customer base, and translate those pain points and needs into a common solution, delivered primarily through a software experience.

 SaaS companies often have a small consulting services arm to handle requests that are not solved in the software alone. For example, when professional social media management suddenly became a need in the workplace, companies like Radian6 and Buddy Media (both later acquired by Salesforce.com) built small consulting services groups to train customers on how to manage social media, and extract insights from data. But these companies were careful not to build large consulting arms, and kept the types of problems solved limited to those needs that arose in adopting and using the software.

Risk of not understanding unique customer needs

SaaS companies lose out to incumbent competitors when they are perceived to be out of touch with their customer needs, and unable to solve core IT and strategy problems.

Controlling cost of customer acquisition in growth phase

Successful SaaS companies often experience hyper-growth as they reach scale, but some struggle to maintain profitability through growth. The investor rule of thumb: customer lifetime value should be three times the value, or more, of acquiring a new customer.  A number of public SaaS companies have struggled to reign in cost of acquiring new customers while in growth phase, particularly in competitive sectors.

Data security

Because data is being stored on the SaaS company servers, data security becomes an issue. When SaaS applications require access a customer’s current data (such as an end users’ personal information), integrated on remotely hosted software can conflict with data governance. For example, healthcare organizations often have their own data governance policies that severely limit the integration of patient data into cloud-based software hosted off premises.

The Business Model Mechanisms to Test:

 

Mechanism to test Metrics to measure
Your ongoing revenue that shows up from your current customers MRR monthly recurring revenue or ARR annual recurring revenue
Margin advantage vs. incumbent Does the SaaS company have a substantial margin advantage (> 70 {4b0c188ae8604bf014d8bc27c7c65bbf455b55139b6ec077c9ec57d60479b1a7}?)
How many customers are cancelling Churn rate (make sure you pay attention to monthly vs. yearly)
Customer lifetime by customer type (cohort) Customer Lifetime Value (LTV) cohort analysis
Cost to acquire new customers CAC (cost of customer acquisition) by marketing channel, separating paid customer acquisition from earned
Effectiveness of your customer marketing and sales Measure each stage of the customer funnel, converting from visitors to free trial signups to paying customers to upsell, next sell, and referral
Referral rate: do your current customers love you so much they refer new customers to you Viral coefficient or lead velocity

Emerging Trends

SaaS Integration Platforms

Because there are so many fragmented SaaS providers, SaaS integration platforms (SIPs) are emerging. Subscribers are then able to access multiple SaaS applications through a common platform. For example, both Salesforce.com and Slack provide an Application Protocol Interface for SaaS developers to deliver on their platforms.

Consumerization of IT

An ongoing trend is the consumerization of IT. The proliferation of the iPhone and well designed apps within the app store for consumer experiences raised expectations for software in the workplace. Why was business software in systems like Microsoft Office, SAP, and Oracle so clunky and hard to use? This created a window for design-led products to tap into a growing demand for easier-to-use apps like Dropbox and Evernote that were designed to be adopted by individual users, first, before being adopted and paid for by the company’s IT department.

Shadow IT

As a result of the consumerization of IT and “bring your own device” trends, employees take matters in their own hands, tired of waiting for IT organizations to catch up, and use their own solutions to fill the void. This leaves C-Level execs, VPs and other managers unaware of how work is getting done and how data is being used inside their companies.

Data-as-a-Service

Data-as-a-service (DaaS) is a newer form of delivering the core utility of SaaS in the form of valuable data served via the cloud for a fraction of the cost (vs. hosted in company-owned data repositories).

Deeper Dives on the SaaS Model

The Business Model of “Software-As-A-Service” by Dan Ma, IEEE, 2007 (academic paywall)

Evaluating the Software as a Service Business Model: From CPU Time-Sharing to Online Innovation Sharing, by Markku Sääksjärvi, Aki Lassila, and Henry Nordström, IADIS International Conference e-Society, 2005 (PDF)

What’s in a Name? Distinguishing between SaaS and SOA, by Phillip A. Laplante, University, Jia Zhang and Jeffrey Voas, IT Professional, 2008 (academic paywall)

What the Second Time SaaS CEOs are All Doing, by Jason Lemkin at SaaStr, 2014.

Design Choices Underlying the Software as a Service (SaaS) Business Model from the User Perspective: Exploring the Fourth Wave of Outsourcing, by Anton Joha and Marijn Janssen, Journal of Universal Computer Science, 2012 (PDF)
SaaS Financial Plan 2.0 by Christoph Janz, Enterprise Irregulars, 2016

SaaS Metrics for Entrepreneurs by David Skok, For Entrepreneurs, 2013

The 8th Do for SaaS Startups: Stay on Your KPIs by Christoph Janz, The Angel VC, 2013

The Most Important Trends in SaaS by Bubba Page, Inc.com, 2016

The Unprofitable SaaS Business Model Trap, by Jason Cohen, VentureBeat, 2013

ADP vs. Zenefits and SaaS Business Models Edition, by y Jon Reed, Diginomica, 2015

Themes in SaaS in 2016, by Jason Lemkin, Enterprise Irregulars, 2016.

Is it SaaS? Is it ARR? by Jason Lemkin, Enterprise Irregulars, 2016

CAC Payback Period: The Most Confusing SaaS Metric, by Dave Kellogg, Enterprise Irregulars, 2016

 

We’ve had several requests to outline the SaaS business model, which defines how many new software-based businesses serve business customers. Do you have any opinions to add? Do you have company suggestions? Connect with us to share your ideas.

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