The SaaS Business Model Explained
Software-as-a-Service (SaaS) is a relatively new business model and yet another model that literally could not exist without the internet.
What is the SaaS Model?
The premise of the software-as-a-service or SaaS model is that a piece of software is hosted on a cloud infrastructure (i.e., operated through a web browser), and businesses pay a monthly fee to get access to this software. It often takes a good amount of coding knowledge, combined with a good amount of user interface design skills, to really make a SaaS product worthwhile.
SaaS businesses in general are probably the most complex business models in our explainer series.
The main difference between SaaS businesses and software companies is that SaaS is hosted in the cloud. Basically, this gets rid of the need for an end user license to activate the software and any infrastructure to host the software. Instead, the SaaS company hosts their membership. The customer just has to log into their account and they get full access.
SaaS in Demand
As you can imagine, this is incredibly attractive as a service. Business owners that do not want to invest huge sums of capital in creating an IT infrastructure often use a SaaS solution, and that SaaS solution often becomes incredibly integral to their businesses – such as sales teams using SalesForce or customer service departments using Zendesk. The SaaS business eliminates this risk for the client that is using the service for their business, who usually only pays a small monthly membership fee.
Though there are many ways for a SaaS business to earn money, typically the bread and butter of a SaaS business is going to be its recurring membership revenue. Recurring revenue is most often set up in the form of annual and/or monthly recurring revenue (known as ARR or MRR). This membership fee is what gives the customer base access to the products and the features of the software.
When we get into growth strategies, we will dive a little bit deeper into other revenue streams a SaaS business owner can look at adding to their repertoire.
Before we do that though, it is important to make a note that valuing a SaaS business can be a little different than other business models that we’ve covered. This is because the huge reinvestment often needed to grow a SaaS business can eat through all the profits, causing many people to buy SaaS businesses based on their confidence in continued, stable growth.
The 3 Periods of a SaaS Business
For every SaaS business, there are three main phases that they are going to experience. Most people understand the Startup phase, and then everyone dreams about the Stable Golden Goose phase when the money is just rolling in. One of the phases that is often not talked about, though it is one of the major stress periods for a SaaS business when they either make it or break it, is known as Hypergrowth.
Let’s dive into the three phases:
- Startup – this includes getting everything going, programming a working product, and “going to market” with it to acquire your first few customers.
- Hypergrowth – if the market likes your product, you likely experience an immense amount of growth very quickly as businesses adopt your software. While this sounds great, this usually is going to cost you more money, because you need to rapidly expand in data, store, bandwidth and all sorts of technicalities to support the newly acquired customers. Remember how customers of SaaS products often love the product because they don’t need to create an IT infrastructure for their business? Well, the reason why they don’t need to create one is because your SaaS product is providing that backend for them through their membership.
- Stable Golden Goose – this is the stage when your SaaS business has leveled out. You are starting to turn a pretty healthy profit, and acquiring new customers at a rapid rate is not going to test your infrastructure limits, like it does in the hypergrowth phase. You will also become familiar with “churn”, which we are about to get into.
Many SaaS products are actually quite good, but the inability to manage hypergrowth is something that many businesses suffer from, which can cause many to fail as well. We will talk a bit on how to mitigate this somewhat in the Growth Strategies section of this explainer article.
Examples of Successful SaaS Businesses
SaaS businesses can be a range of software that covers many different things. However, SaaS businesses are most helpful to other businesses by allowing them to run more efficiently.
Let’s look at some of the big successes in the SaaS world.
Sales Force is one of the very first SaaS businesses, originally founded in 1999 as a software company. They have helped countless businesses manage their sales teams, process their prospects, and effectively help them follow up with their best potential clients. The product has been a huge success, and is a paragon of what most SaaS business owners wish to achieve with their own products.
Edgar is a social media automation SaaS product that can shave hundreds of hours off someone’s workload. It automatically fills up a social queue and also allows posts to be be recycled over time.
It operates on the premise that, since most social media posts will not be seen organically by those following someone’s Twitter feed or Facebook page, the content can be recycled and exposed to more of that business’s audience over time.
While certainly smaller than SalesForce.com, Edgar has become quite the heavy weight in the social media SaaS niche and is worth watching and modeling other SaaS businesses after.
Then there is this SaaS juggernaut. Zendesk is a customer service ticketing system famous for its usability by small, medium, and even large businesses to better take control of their customer service and ultimately give the end consumer a much better experience.
The Pros of the SaaS Business Model
The beauty of the SaaS business model is that your customers can become insanely loyal to your product. This is especially true if your SaaS product represents something that is integral to their businesses. After all, they are usually becoming “members” of your secret society.
For example, Zendesk offers software that helps businesses create an effective customer service solution. There might be a new ticketing software that comes out that blows Zendesk out of the water, but because Zendesk is so vital to a business’s success and so integral to that business’s process, the business is unlikely to change everything for the new and improved solution.
This loyalty can create a customer retention that last for years and years, adding to the burgeoning recurring income that makes SaaS products so profitable.
Obviously, that is the next big pro of a SaaS model. Every customer is technically only renting your software on a monthly basis, instead of outright owning it with a one-time purchase.
That means every month you are going to earn another bit of profit from that customer. Recurring revenue is often the dream for those who get involved with online businesses, and a SaaS business model has this idea of recurring income at its very core.
The Cons of the SaaS Model
While recurring income is extremely nice, the large sum of money to get your SaaS business going is not nearly as attractive.
There are all sorts of investments you will have to make in the beginning, such as hiring good developers and programmers and UI designers that will combine their skills to make your product as user friendly and efficient as possible.
Once you DO have a product off the ground, and have a handful of customers proving the model’s value, you are likely going have to reinvest all of your profits — plus some more capital — to scale the business. You are going to need to expand your data capabilities, security, storage, keep your team around to handle maintenance, and manage any unanticipated issues that likely will crop up during this hypergrowth phase.
The other negative side of SaaS, outside of the capital intensive business model, is that it is often not a simple product. While the model itself is easy to understand, maintaining the actually product effectively can be difficult even for people who understand all the coding involved.
This can make selling a SaaS product more difficult, as you are looking at a more narrow selection of prospective business buyers than, say, someone who is interested in an Amazon FBA or lead gen business.
What Buyers Need to Know
When it comes to buying a smaller SaaS business, it is only worthwhile if you actually understand the programming or the coding involved with the software. This is of course not the case if it is a bigger SaaS business — where the development team comes with the acquisition, and the seller has outlined all of their processes and systems so that if the team ever did leave, you could find another developer to take their place relatively easily.
You also want to make sure that the seller owns all the coding, intellectual property, and branding of the SaaS business. Make sure you are buying the entire deal, not just a portion of the SaaS business.
You will absolutely want to know what the churn rate is (the rate that customers drop off the monthly subscription to the software) as well as the Lifetime Value (LTV) and Cost Acquisition per Customer (CAC). These are important metrics because these are the life signs of the business. If your CAC is too high, with too low of a LTV because of high churn rates, the SaaS business is not going to be that attractive of a buy.
Unless you are quite adept at tweaking and growing various marketing funnels. In this case, the SaaS business might be a great undervalued purchase for you, if you know the product works well and you know exactly which parts of the marketing funnel or user interface needs to be fixed to remedy the situation.
Finally, when looking for a SaaS business to buy, it is better to buy one that has reached a consistent level of customer growth versus one that is explosively growing. As mentioned earlier, explosive growth can lead to quite a lot of problems in terms of scaling everything up appropriately.
It is better to buy a stable business (almost always) rather than one that is still going through a massive growth cycle. A stable business will allow you to more effectively tweak your marketing funnels and optimize the business. If you need more help to define your criteria, schedule a call with us, we’re happy to help.
You can also check our marketplace out for SaaS businesses for sale.
What Sellers Need to Know
The #1 thing a SaaS business seller can do is find ways to increase their LTV as much as possible.
We actually help SaaS entrepreneurs do this when they schedule an exit planning call with us.
If you’re curious what your business is worth, our SaaS valuation guide here might help you.
The higher the LTV number, the more attractive the business is going to look, since a SaaS business is all recurring income. This can be a huge deal maker if the LTV is high enough or is showing a trajectory increase.
Obviously, you will want to decrease your CAC and churn as well. This can be done by tweaking marketing funnels, or maybe even changing subscription pricing.
In addition to those two obvious metrics, you should have a good development team in place to hand off to the new owner. Or at the very least, a good amount of documentation and resources for the buyer to use to find new developers. The code used to create the software should be entirely owned by you, including everything else related to the business (the branding, marketing etc.).
Finally, train the buyer on your software. Offer a training manual of some kind for them to read to familiarize themselves with both the actual product and the business. In this training, you should really highlight any obstacles you are having, and where the growth potential sits, so the new buyer can start moving in that direction.
Don’t be afraid to talk about the negative aspects of your business. A lot of the times, a negative aspect is exactly what inspires the new buyer to actually purchase your SaaS business, because they see the solution to fix that problem.
Who Best Fits a SaaS Business Model?
As we mentioned above, the niche of people buying SaaS businesses are going to be more narrow than other business models, because of the inherent skills needed to grow and maintain this kind of business.
That being said, there are people who fit a variety of buyer personas, still very hungry to buy businesses like these—and for good reason.
A SaaS business makes total sense for someone like Strategic Sally, who is trying to corner a certain market or demographic. For example, if Strategic Sally also had an information product business doing effective customer relationship management, she might be on the lookout for a SaaS business that can be used as a CRM to upsell her info product customers on.
A SaaS business model would really appeal to someone that has the “do-it-yourself” attitude. These businesses are perfect for someone like a DIY Dave to deep dive into. They can deep dive from the programming and coding of the actual product, to learning how to drive down the Customer Acquisition Cost (CAC) ,while also tweaking marketing funnels to drive up the Lifetime Value (LTV) per customer.
SaaS businesses are a perfect place for an Investor Ivan to invest some of their capital. A SaaS business can have tremendous income potential, recurring income to boot, and since a SaaS business does take some capital to really get up and going, an Investor Ivan is likely to find a business partner a lot easier in this niche than an Adsense business model.
SaaS Growth Strategies
There are a lot of directions you can take when it comes to growing a SaaS business.
The growth strategies you choose really depend on your core competencies and what has moved the needle the most for you in the past. Regardless, here are some ideas you can use to grow a SaaS business to the next stage of income.
Increase Organic Traffic
It goes without saying that the best traffic that converts the highest is usually going to be organic search traffic from places like Google and Bing. One way you can see how to increase your organic search is by simply looking at where you are currently ranking using a tool like SEMRush.
This is actually a very easy strategy to implement and I discuss it more in detail on this article talking about the low hanging fruit for Adsense & Amazon businesses.
Introduce New Marketing Channels
When it comes to testing a new strategy, have some traction goals in place. Make sure you are going to invest enough in the new marketing channel that you can reach statistically significant numbers. Otherwise, there is no real point in investing in it.
A new marketing channel could be as simple as taking your best organic ranking, or most popular content, and converting that content into a Youtube video. It is, after all, the 2nd largest search engine in the world, so it is worthwhile to be found there.
Add Product Upsells
This is a fantastic option to offer to existing customers, as it serves them better and will earn you more. These upsells could be higher end packages where the customer pays more per month to receive extra features, benefits, data storage, or all the above. It could also be a one off upsell — perhaps an info product, such as a high impact webinar, on how to use the software to your best advantage. This is the idea of the “freemium” pricing model, where you entice customers with limited functionality for free, they get used to your product then become paying customers.
Whatever upsell you decide on, always make sure to consider the costs of offering that service, so you can factor it into the final pricing that your customers will have to pay for that upsold service.
Faster. Stronger. Cleaner.
One thing you can do to improve customer satisfaction and loyalty (and also reduce some infrastructure costs) is to make your software run faster by reducing bad code. Decluttering bad or wasteful code can make a huge different in upping the speed of your software, thus increasing your customers overall happiness with the product.
Make it lean, mean, and even more profitable.
Add an Affiliate Program
Adding an affiliate program can be a huge boon for your business. Especially if you offer a lucrative program that can attract skilled affiliates to promote your offer.
There are many routes you can go, but if you want the best way to attract affiliates, you might want to offer a residual income opportunity. This is often more appealing in a SaaS business model than a one off payment.
On the flipside, if you have your CAC and LTV numbers down pat, you might just offer a large, upfront, one-time payment to the affiliate — knowing that the average customer will stay around long enough to recoup the costs of paying the affiliate that money.
Some affiliates actually prefer this, since their marketing campaigns often are operating on razor thin margins.
Either way, an affiliate program can be an amazing way to increase your marketing power while also taking a lot of the actual marketing work off your plate.
Resources to Learn More
One of the first places you should check out to learn more about the SaaS business model is the Startups for the Rest of Us podcast by Rob Walling.
Here are some other helpful articles about creating a SaaS product:
- If you are brand new to SaaS, then this article on how someone built their SaaS business and got their first paying customer in just 60 days might appeal to you.
- Neil Patel has a good article on Forbes about the 11 Revenue Streams for SaaS Businesses that can be very useful when deciding on how you want to grow your SaaS business using upsells and different product offerings.
Interested in buying a SaaS business? Check out our marketplace for current listings.
Or maybe you have grown your SaaS business to the point of profit and you are ready for an amazing exit? If so, click here to sell your SaaS business.
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