The Rise Of The SaaS Business Model

The software-as-a-service industry has been one of the fastest-growing sectors since 2018, with the rise in accessibility and popularity mainly down to the monumental advancements made in private cloud computing technologies such as Google Cloud. 

Recent research has estimated that the SaaS market is growing at about 18% a year, with the trajectory only expected to quicken, and it’s no surprise. With around 16% of companies globally now operating with a fully remote workforce, the need for businesses to ensure that all business functions and resources are available via public cloud computing is essential.

Of all the leading cloud computing software, SaaS software continues to lead the way regarding spending forecasts, followed by Cloud System Infrastructure Services (IaaS) and Cloud Application Infrastructure Services (PaaS).

For new business owners, the concept of SaaS may be a little difficult to understand and trickier yet to master. And with so many SaaS products and providers in the market, how do you know which one will be right for you, and how can you be sure that you are getting your money’s worth?

Key takeaways:

• Learn exactly what a SaaS company is and the different stages of a SaaS model.
• Explore some of the pros and cons of creating a SaaS software company.
• Provide a rundown of the key SaaS metrics, plus cover some of the biggest success stories in the SaaS industry.

What is a SaaS company?

The days of buying an external piece of traditional software and storing relevant data on local hard drives are slowly becoming a thing of the past. Instead, a SaaS company acts as a software provider, so the software solution is hosted, delivered, and maintained via cloud computing services.

Source: Clouded Judgement

Rather than owning the software licensing outright, the user pays a monthly subscription fee to access the product or service via the internet. This can allow users to access the service and their data from any device with an internet connection, no matter the user’s location. 

Subscription plans vary from company to company, with many offering freemium pricing and additional features to acquire new customers and retain them in a highly competitive market.  

There are two primary forms of SaaS providers:

• Business-to-business (B2B) SaaS: The first type of SaaS company sells its products and services to other businesses. Companies that fall into this category will have developed products or services to streamline business processes and maximize efficiency. Sales, marketing, and customer services are some of the main areas where a company will likely use B2B SaaS services.
• Business-to-consumer (B2C) SaaS: The second type of SaaS company sells its products and services directly to consumers. Companies that fall into this category will have developed products and services that consumers can use and access for areas of their daily lives, such as work and entertainment. Online gaming and antivirus software are good examples of B2C products.

How does a SaaS business model work?

There is no definitive pathway for a SaaS company to follow to take its place in the echelons of the SaaS market. 

It depends on the market sector or industry you are trying to infiltrate, as the process may take longer with less scope for risk and broader challenges. Nevertheless, there are three prominent stages most successful SaaS businesses will go through.

Pre-startup stage

Successful SaaS business models often start with one question; what problems can my business idea offer solutions for?

Source: Growth Hackers

Before setting out on any business journey, you need to determine whether there is an actual need for your product or service; otherwise, you could be in for a costly waste of time. You should conduct considerable market research to evaluate whether there is a gap in the market for your prospective software and whether there are any notable rivals.

Once you have determined a need for your product or service, you will need to: 

• Develop a minimum viable product (MVP) — a prototype that contains the bare minimum features to test your product or service.
• Establish the key features and functions you will need to work on to satisfy and develop customer relationships. 
• Attract talent — cofounders to help you execute on your vision.
• You may also want to consider creating a business plan and a go-to market strategy.

During the early stages, you may want to explore funding options for the company. Seed funding is usually the first form of investment a startup receives and this usually comes from friends, family members, and initial founders.

There is also the option to secure funding from angel investors. These privately wealthy individuals will look to invest their own money in exchange for equity or a controlling stake within the company.  

Some valuable resources for early-stage startup founders include:

• Places for you to attract early adopters to your product, such as BetaList, Product Hunt, and AppSumo.
• Sam Altman, the former president of Y Combinator, has an excellent knowledge repository of startup lectures on How to Start a Startup.
• Essays by Paul Graham. You may want to check out his essay on “Do things that don’t scale.”
• Essays by Andrew Chen, a general partner of the VC firm at Andreessen Horowitz.
• Sequoia Capital’s guide to creating a pitch deck or business plan.
• Strategyzer’s business model canvas.
• Read Flippa’s article on, “How to grow your SaaS Busines.”

Growth stage

You are now at the stage where you have a robust and multi-faceted business plan. You have a viable product or service that has been thoroughly tested and subject to several rounds of customer feedback to refine the functionality and features. You have also secured your initial rounds of funding.

Source: Andrew Chen

As you move into the growth stage, your main objective will be revenue growth and customer acquisition. Your marketing strategy and revenue model needs to focus on building an active user customer base that is pleased with your product or service and ready and willing to ascribe to your subscription models.

To earn customer retention and monthly recurring revenue that is synonymous with SaaS providers, you must continue to refine and improve your product to develop customer lifetime value. You want to be in a position where your customers feel no inclination to go elsewhere as your product or service fully serves their needs.

Some useful resources for startup founders in the growth stage include:

• Essays by Michael Seibel, which covers both the pre-startup stage and growth stages.
• Growth Hackers, a community founded by Sean Ellis who coined the term growth hacking.
• Brian Balfour, founder of Reforge, previously VP of Growth at Hubspots essay on “The Road to a $100M company doesn’t start with product.”
• Read Flippa’s article about “6 profitable SaaS marketing strategies you need to try.”

Maturity

Your SaaS business will have acquired a loyal customer base over an extended period. As the business grows, churn rates are consistently low, and your monthly and annual recurring revenues are both looking healthy.

At this point, you should look to maximize the efficiency across the business, as it is unlikely you will need to invest in any additional overhead costs such as infrastructure and data storage. Marketing automation tools and streamlined management systems can contribute to this. 

Source: BaseTemplates

You should still carefully monitor growth, though, and keep in mind there will always be new and hungry startups looking to infiltrate the market and tap into the customer base you’ve worked so hard to build. The user should not feel that their experience has diminished in any way.

Source: Flippa

If your business continues to experience success and growth, you may eventually wish to look at sale options so you can net a tidy profit from all your hard work.

Some useful resources for startup founders in the maturity stage include:

• Marc Andreessen’s article about “The Moby Dick theory of big companies.” 
• Jason Lemkin, founder of SaaStr’s article, ”The only exit strategy Is IPO.”
• The market curve, by Mike Vernal, a venture capitalist at Sequoia Capital.

What are the key SaaS metrics?

You need to regularly engage with your SaaS metrics throughout the lifetime of your business. These are key parameters and data points to help you determine how well your business is doing. The following are vital metrics you will need to monitor carefully to enable you to gauge SaaS growth and customer data. 

Source: APIFuse

1. Active customers

These customers actively pay for your product or service rather than simply using it. Other users may be on a temporary freemium model or trial period and, as such, not be contributing toward Saas revenue. This is why it is always more prudent to track active customers than total users.

2. Annual recurring revenue (ARR) 

ARR is the total recurring income you expect to make over twelve months. While it is not an exact science, you can use it to forecast growth when used in conjunction with other vital metrics. For example, it can help to determine marketing and recruitment budgets.

3. Average revenue per user (ARPU) 

ARPU is the average revenue generated from your active users every month. This metric (when used in conjunction with retention strategies) will determine if you are gaining maximum value from your customer base and whether there is scope for tier pricing, scalability, and active user pricing charges.

4. Churn rate

The churn rate is a running calculation (usually monthly) of the percentage of customers and revenue lost during a given period. Churn rates are essential SaaS data that can look for trends and correlations in performance.

Customer churn refers to the percentage of active monthly users who have canceled outright out of the total number of the active user base. Revenue churn refers to the percentage of revenue lost from SaaS pricing and canceled subscriptions (or downgrades if tier pricing strategies are used).

Source: ChartMogul

SaaS businesses rely on a subscription economy, I.e., they only function and grow if subscription numbers increase and retention rates remain high over an extended period. So, if churn rates increase each month, it is often a clear indicator of something amiss with the user experience or pricing strategy. A healthy churn rate is around 5%.

5. Monthly recurring revenue (MRR)

MRR is another metric you need to monitor, as these figures can indicate further issues. For example, a decrease in MRR refers to lost revenue from existing, paying customers, usually through downgrades.

Downgrades are often a sign of dissatisfaction with an aspect of the service rather than the full service. Customers may not be happy with the pricing model concerning a higher pricing tier or additional costs and may not feel they are getting value for money. In this case, business owners can use MRR to invest in new and improved features and functionality.

Source: User IQ

So many successful SaaS business models involve developing new products and services throughout the business’s lifespan. The expansion of MRR often means that a SaaS company can place less emphasis and importance on acquiring new customers. In contrast, an expansion of MRR could drive the purchasing of add-on products or upgrades to a higher tier pricing level. 

6. Customer acquisition cost (CAC)

CAC is the average amount of money needed to acquire a new customer. It is used in conjunction with the monthly recurring revenue to determine if new customers typically cost more to gain than the revenue they bring into the business. If this is the case, the business is not making any money.

Focusing on inbound marketing tactics such as word-of-mouth and high search engine optimization (SEO) can often lower this cost. Review your paid advertising to determine if you can reduce these overheads. If there is evidence to suggest your customers are enjoying a positive user experience (low churn rates), you may be able to alter user pricing to lower these costs further.

7. Daily active users (DAU)

A SaaS business can use this metric to gauge how its users engage with the product or service on a given day. Time spent using the software or the number of interactions within the software are parameters a business owner can use to determine the quality of the user.

For example, suppose a user still pays for the product or service but shows no interaction with the software. In that case, it could be an early indication of a weak user experience and a predicted increase in the customer churn rate.  

The benefits of SaaS business models

With the SaaS market as competitive as it is, many prospective software companies and business owners may feel the road to success is tricky. However, those committed to securing SaaS customers and building something great can benefit from the following:

Reduced infrastructure costs 

The core of SaaS software development is based on cloud computing technology. So, businesses do not have to rely on hardware or extensive data centers that need to be maintained at the company’s expense.

Deeply entrenched products 

Many businesses will build their infrastructure around SaaS software, mainly for SaaS companies that focus on SaaS B2B products. If your business can provide this and it proves successful, the company in question is unlikely to uproot its entire infrastructure even if something new comes along. You have therefore created a customer with high lifetime value (LTV).

Source: Unstack

Flexible payment options

A SaaS company that is just starting can offer its services at a lower cost to secure its initial customer base. Continued customer success in terms of user experience and satisfaction can result in vertical SaaS potential and enable a company to offer higher-tiered prices for premium features, increasing ARPU without focusing on CAC.

High potential scalability

Some SaaS companies go through a stage known as ‘hypergrowth.’ This is where a piece of software quickly becomes a market leader for a given sector, resulting in rapid growth. 

As long as the company has taken the time to ensure its infrastructure, data security, and other technicalities are robust, it should be able to handle this rise in usage and bring in considerable revenue.

Steady revenue

Once a business establishes a loyal customer base, there is a high chance that it will be able to bring in a steady MRR. While a company should never neglect to monitor this revenue, its passive nature means that a company can focus the majority of its attention on market capitalization and diversifying revenue streams.

Mobility and accessibility

SaaS customers can access the software and services from anywhere with a mobile connection, and so too can company employees. Web development teams and project managers can access the infrastructure remotely. There is no need for expensive office space.

The cons of a SaaS business model

Despite the many benefits, there are also several challenges and risks for a SaaS company looking to grow or an established SaaS business. These disadvantages include:

High initial costs

A SaaS application is often complex in its design and development. Unless you are a skilled coder or programmer, you will need to hire experienced developers to create the software initially. 

A highly competitive industry

The SaaS market industry is rapidly expanding, with new and exciting products and services flooding the market every year. The competition will make it harder for your product or service to penetrate the market and gain a footing.

Customer trust

In January 2021, Slack suffered a huge outage resulting in a loss of service for thousands of companies. Ultimately, if your company is on the end of service disruption or issues with your operating system, it may damage customer trust. This could result in high churn rates and a reduction in MRR.

Data protection 

Cloud and hosted services have often been cited as having inconsistent data security. 

Difficulty switching vendors

All SaaS software is dependent on cloud software. If a SaaS business wishes to change vendors, this can often be difficult as some vendors have unique data types that are hard to transfer to new providers. As a result, SaaS companies can often find themselves stuck with a specific vendor.

What are some examples of SaaS business models?

As with any business startup, setting up a SaaS company is no guarantee of success, with 92% of SaaS ventures expected to fail within three years of conception. However, the market would not be in such a healthy position without several success stories. 

Source: Gary Fox

Salesforce

Often considered one of the first businesses to implement a SaaS-type model for their business, Salesforce initially achieved success by connecting businesses with their customers through innovative cloud technologies. It has since developed its products and acquired a vast portfolio of additional products and services, which has taken them into new sectors and markets.

Slack

Slack is a well-known messaging service that provides in-office communication through chat channels and private messaging. It has recently become indispensable for many companies due to the rapid rise in remote and virtual workforces. Its versatility makes it an ideal choice for all forms of business.

Source: Slack

Zoom

In much the same way as Slack, Zoom has been able to take advantage of the move to remote working by offering multi-faceted video conferencing software in place of in-person meetings. Zoom has been able to maximize the capabilities of freemium pricing strategies by providing easy-to-use, reliable free access that encourages businesses and individuals to invest further.

Source: Zoom

Adobe Creative Cloud

Initially hosted on Amazon Web Services, Adobe decided to move from individual product sales with perpetual software licenses to a subscription business using the SaaS business model. As a result, they offer a vast range of creative production and audio software often recognized as industry-standard, reflected in the high prices they can command.

Source: Adobe

Google Workspace

The days of Google being a simple search engine are long gone, and they now reach across a multitude of industries and sectors, including the SaaS market. Many products within Workspace (such as Gmail and Calendar) are still free, though they have now been bundled together and equipped with additional features and functionality for a subscription fee.

Source: Google Workspace

Summing up

The SaaS market shows no signs of slowing down. As businesses continue to move to cloud computing infrastructure, the demand for products and services that capitalize on this versatile and powerful technology will only increase. There has never been a better time to explore your SaaS potential.

If you find yourself in ownership of a SaaS company that you feel you have taken as far as possible, look no further than Flippa. As the world’s leading online marketplace for buyers and sellers of small businesses, you will find no better place to advertise and sell your SaaS business and reap the subsequent rewards. If you believe you are ready to sell your SaaS business, contact us today, and let’s get started.

Read our guide to buying a SaaS business here.

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Frequently asked questions

What is enterprise software?

Enterprise software refers to an arm of a SaaS business model, whereby a SaaS company will offer a specific pricing tier to cater to enterprise customers.

What is intelligence software?

Generally speaking, intelligence software refers to “business intelligence” (BI) which provides analytical solutions and market insights for small to large enterprises.

Why are SaaS companies killing it?

SaaS companies are performing exceptionally well due to their business model that offers software as a service, whereby businesses pay to use their software on a monthly basis. 

When their products become sticky (I.e. customers cannot live without them) then their SaaS platform takes off like a rocket ship. That’s why, for SaaS companies, in particular, finding product-market fit is key because it drives MRR growth.