SaaS Business Model [ Explained Simply ]

According to the Gartner report, the worldwide public cloud service is expected to make an astronomical $266.4 billion in 2020, with SaaS-based businesses forecasted to make $116 billion, accounting for 43.54% of the cloud market.

Broadly speaking, cloud-based services can be divided into three categories: Software as a Service (SaaS), Platform as a Service (PaaS) & and Infrastructure as a Service (IaaS).

But today, we will specifically be talking about SaaS businesses — covering how they work, the metrics used to evaluate them and have a brief look at some notable SaaS companies

And by the way, if you’re unaware, the cloud is just a fancy term used for services delivered through the internet, which the end-user can access through a web browser.

What is the SaaS business model and how does it work?

Before we got to the Software as a Service (SaaS) era, we had what was called the Software as a Product (SaaP) model.

And to understand the beauty of the SaaS model, we first need to understand how SaaP functioned.

The idea behind SaaP was simple — an IT company like Microsoft would build a software like Microsoft Office and license it to users or firms who would then install the file package on their systems.

The problem with SaaP was that the companies buying the software also had to build their infrastructure ( buy servers ), install and configure the applications and employ an IT department to maintain it all.

What SaaS did was that it removed all the hassle companies traditionally had to go through. 

With SaaS being a cloud-based service, all companies now need to do is go to the Microsoft website and buy the Microsoft 365 solution that fits their needs. 

The apps ( Excel, Powerpoint, Word etc ) are hosted on Microsoft’s server and all customers need to do is to pay a fixed recurring fee to use them.

Not only does Saas reduce the hassle, but it also helps save cost, in most cases.

Let’s say that you start a startup that provides analytical and engagement capabilities to mobile apps. 

To make sure that your company operates efficiently, you will need an internal communication tool, a sales management software for your sales team, a marketing automation tool for your marketing team and customer support software to serve your customers.

In that scenario, you can do either of the two things: build all the tools yourself or buy a subscription for Slack, Salesforce, Hubspot & Zendesk, all of which are SaaS products.

The answer is, of course, a no brainer. 

You subscribe to the already existing SaaS products, saving both precious resource time & money.

In the aforementioned example, we looked at the use case of a startup.

But even we, individual users, use SaaS products regularly, without realizing it most of the time.

Google Drive, which falls under the G Suite umbrella, is a great example of a user-facing SaaS Product.

Many of us use Google Drive to store data for free, but when we cross the free 15 GB storage limit, we have to pay for further usage.

Until now, we’ve looked at SaaS businesses from the perspective of the buyer.

Now, let’s have a look at from the lens of the seller.

While SaaS businesses can become highly profitable businesses in the long-term, they usually require major upfront investments.

To build and grow the product, founders need to invest in hiring developers, project managers, marketers & salespeople; depending on their growth stage.

Since the software and customer data is stored in the cloud, SaaS startups also need to invest in infrastructure. 

They can usually do either of the following: buy servers and develop data storage capabilities in-house or outsource it to infrastructure providers like Amazon Web Services.

In most cases, all the cash SaaS businesses need to burn in the beginning is borne by investor money taken from venture capital firms, who more often than not love SaaS because its a proven model.

Of course, there are exceptions to the rule. Not all successful SaaS businesses are funded by VCs. 

Many of them, like Basecamp and Wingify, were bootstrapped and become profitable SaaS businesses.

Taking VC investment to build and grow a SaaS product is like trading partial control of product and strategy in exchange for being able to grow fast and capture the market quickly.

But both taking VC money and bootstrapping can work for a SaaS-based business. 

Before deciding the path they want to choose, founders often consider variables like the length of the opportunity window, the maturity of the market, types of growth challenges and limitation and uniqueness of product to name a few.

The Economics of Building a Successful SaaS Business 

The SaaS model or any other recurring revenue businesses are different because the revenue for the service comes over an extended period of time, which is quantified using the customer lifetime value metric.

If the customer is happy with the service, they stick around for a longer duration, meaning that the business can make way more profit. 

On the other hand, if the customer is unhappy with the service, they will churn quickly, meaning that the business will lose money they invested in acquiring the customer.

This nature of the business creates a dynamic where not one, but two objectives have to be met:

1. Acquiring the customer
2. Retaining the customer ( to maximize customer value )

A powerful tool, which can be used to evaluate whether a SaaS business is viable or not is ‘Unit Economics‘. 

Unit Economics help simplify the complex nature of businesses by measuring the profitability on per unit basis.

It attempts to answer the following question:

“Can the business make more profit from its customers than it costs to acquire them?”

Answering the question requires two metrics — the Lifetime Value of a typical customer (LTV ), the Cost to Acquire a typical Customer ( CAC ); and looking at the LTV to CAC ratio, or Payback period on CAC.

1. LTV to CAC ratio

3:1 is usually considered to be an ideal LTV to CAC ratio, wherein you make three times the value of acquisition from every customer.

Keeping a close eye on this ratio also helps decide what would be the right way forward for a SaaS company.

If the ratio is lower (1:1), then it’s a problem because you can only recover what it costs to acquire a customer throughout the lifetime of the customer using your product. 

In this case, you should be trying to optimize your acquisitions costs or change the pricing model.

If the ratio is higher (6:1), even then you have a problem, albeit a good one — you’re missing out on valuable opportunities because you’re making way more than the cost required to acquire a customer.

In this case, you should be investing more time and money in marketing & sales so that you can acquire more customers.

2. Payback period on CAC

Simply put, the Payback period on CAC measures the time it takes the company to recover the costs of acquiring a customer.

On average, startups have a payback time of 15 months based on gross margin.

But shorter the payback period, the better because less working capital is needed, which means companies can grow faster.

Ruben Gamez, the founder of Bidsketch, had the following thoughts on the unit economics approach we discussed,

“When it comes to profitability and whether a business model will work, I prefer to focus on payback period over LTV: CAC ratio. 

That means, how many months does it take for us to start making money from each customer. My target is typically 2 to 4 months. 

It’s still important to be aware of the ratio, but the faster you can put profit back to work into growth, the faster you can scale the business.

Early-stage companies often have higher churn and can have an especially hard time figuring out LTV as their product changes and different customer segments start to adopt the product. 

Zeroing in on the more profitable customers early and testing pricing (which is often the easiest growth lever) can make the difference between a business that thrives and one that doesn’t work.” 

3 Notable SaaS Businesses

SaaS companies can be categorized as Business-to-Business (B2B), Business-to-Customer (B2C) or both.

1.Salesforce ( Type: B2B )

Hailed as the pioneer of SaaS, Salesforce provides a CRM solution enabling businesses store information collected about leads, prospects and customers in a single platform. 

Salesforce claims to its tools boost customer sales by an average of 37 per cent & also helps in increasing client loyalty and satisfaction.

2. Shopify ( B2C primarily )

A no-code e-commerce solution, Shopify powers over 1,000,000 businesses worldwide. In three years ( 2016 to 2018 ) alone, Shopify powered businesses contributed $319 billion in economic activity worldwide.

3. Microsoft Office 365 ( Type: B2C & B2B )

With access to signature Microsoft applications like Word, Excel, PowerPoint and services like Skype, OneDrive included; Microsoft Office 365 offers customized solutions for home, business and enterprise use cases.

Thank you for taking the time to read the entire article.

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