Posted: Mar 7, 2023 8:10 AM ET

Software-as-a-Service (SaaS) is a relatively new business model that literally could not exist without the internet.

The concept behind SaaS business models is that the software is hosted on a cloud infrastructure, and businesses pay a recurring fee to access it via a web browser. The primary difference between SaaS businesses and more traditional software companies is that SaaS is cloud-based. This eliminates the need for end-user licenses to activate the software and any infrastructure to host the software. Instead, the SaaS provider hosts the membership, and customers simply log in to access the software.

There are many famous SaaS companies that have become household names, such as:

1. Salesforce: A customer relationship management (CRM) platform that allows businesses to manage their sales, marketing, and customer support processes.

2. Dropbox: A cloud storage and file sharing platform that allows users to store and share files online.

3. Zoom: A video conferencing platform that allows people to host virtual meetings and webinars.

4. HubSpot: A marketing automation platform that helps businesses attract, engage, and delight customers.

5. Slack: A team communication and collaboration platform that allows them to communicate and work together more efficiently.

6. Shopify: An e-commerce platform that allows businesses to create and manage their online stores.

7. DocuSign: A digital signature and document management platform that allows people to sign and send documents securely.

In this article, we’ll explore why the SaaS business model is particularly attractive to companies and investors alike, its pros and cons, and what investors look for when valuing them.

The Secret Sauce of SaaS

As we’ve already highlighted, the SaaS business model is particularly attractive for companies who prefer not to invest large amounts of capital in creating their own IT infrastructure. And once integrated, SaaS solutions can become crucial to the business’s operations. By paying a small monthly fee, clients are able to use the service without having to take on the risk associated with developing it from scratch.

For SaaS businesses, the recurring revenue from customers is typically the primary source of income. This is often in the form of annual or monthly recurring revenue (ARR or MRR). 

It’s worth noting that valuing a SaaS business can be different from other business models given the significant reinvestment often required to continue growth. As a result, many investors value SaaS businesses based on their confidence in sustained, stable growth rather than profitability alone. We’ll explore some of the key metrics investors look at below. 

How to Build a SaaS Company

Building a successful SaaS business is not easy. It first requires a combination of coding skills and end user interface expertise to build a successful product. And then it requires finding customers to pay for the product. Here we’ll look at several growth strategies SaaS companies commonly use to expand their customer base and revenue.

One of the most important strategies for growing the business is customer acquisition. This can be accomplished through various channels such as social media marketing, paid advertising, search engine optimization (SEO), content marketing, referral programs, and partnerships with other companies.

Another key strategy is upselling and cross-selling, which involves increasing revenue by offering customers higher-priced plans or additional products and services. This can be achieved by identifying customers with a high potential for expansion and offering them targeted promotions or discounts.

Retaining existing customers is also critical, as it is generally easier and less expensive to retain an existing customer than to acquire a new one. SaaS companies improve customer retention by providing excellent customer service, releasing regular product updates, and offering incentives to customers who renew their contracts.

Referral marketing is another common approach to growth. By providing incentives to existing customers, new customers can be acquired in a cost-effective way compared to more traditional advertising or marketing methods.

And then finally, forming strategic partnerships with other companies. This is a popular method of growth for many business models. But in this context, for example, a SaaS company that provides project management software could partner with a software development company to offer a more complete solution to customers.

Advantages of the SaaS Model

Let’s take a look at some of the reasons for SaaS supremacy in the software space.

The SaaS business model has a distinct advantage over traditional software sales in terms of customer loyalty. When a SaaS product becomes integral to a company’s operations, it creates a level of dependency that is difficult to replicate with other types of software. This is because the SaaS product is typically hosted in the cloud and can be accessed from anywhere, making it convenient and easily scalable.

For example, Zendesk provides software that facilitates efficient customer service solutions. Even if a better ticketing software emerges, businesses are unlikely to switch from Zendesk because it is so essential to their operations and processes. By providing a reliable and valuable solution that meets the needs of its customers, Zendesk has created a sense of loyalty that is difficult to break.

This loyalty creates long-term customer retention, which is one of the primary reasons why the SaaS business model is so appealing. The recurring revenue generated by monthly or annual fees, as opposed to one-time purchases, is the ultimate goal for online businesses. And the SaaS business model revolves around this concept of recurring revenue. SaaS companies generate a steady stream of income, even during times of economic uncertainty.

This is why investors love SaaS companies so much. Because the recurring revenue model allows them to invest more in product development, customer service, and marketing, it creates what investors call a virtuous growth cycle. This is where loyal customers refer new customers, and the company can continue to scale and improve its offerings from its increasing customer base and revenue growth.

Disadvantages of the SaaS Model

With that said, launching a SaaS business can be challenging. One of the main obstacles is the significant upfront investment required to develop a user-friendly and efficient product. As we mentioned earlier, this involves hiring skilled developers, programmers, and UI designers to build a platform that meets the needs of the target audience.

And then even with a significant number of paying customers, profits must continuously be reinvested to keep scaling the business for rapid growth. This involves expanding data capabilities and security measures to protect sensitive customer data, hiring additional personnel to manage customer service inquiries, and investing in marketing and advertising campaigns to attract new customers.

Finally, scaling a SaaS business can also present unforeseen challenges that require quick action and additional investment. For example, a sudden surge in traffic or usage could cause technical issues that require immediate attention. And failure to address these issues could result in a loss of customers and revenue.

Metrics to Focus On

Up until now, we’ve mostly talked about why companies love working with SaaS businesses. And we’ve also mentioned why investors love investing in SaaS business models. So whether you’re trying to build the next great SaaS company or just looking to invest in one, here are a few of the essential metrics to know:

1. Monthly Recurring Revenue (MRR): This is the amount of revenue a SaaS company generates from its recurring monthly subscriptions. MRR is often used as the primary valuation metric for SaaS businesses, as it represents the company’s predictable, recurring revenue stream.

2. Annual Recurring Revenue (ARR): Similar to MRR, ARR is the amount of revenue a SaaS company generates from its recurring annual subscriptions. ARR is often used in conjunction with MRR to provide a more complete picture of the company’s recurring revenue stream.

3. Customer Acquisition Cost (CAC): This metric is the cost of acquiring a new customer. It includes all the marketing and sales expenses associated with the process. Lower CACs generally indicate a more efficient customer acquisition strategy.

4. Customer Lifetime Value (CLTV): This represents the total revenue a SaaS company can expect to earn from a single customer over the course of their relationship. CLTV takes into account factors such as customer retention rates and upselling opportunities, and is often used in conjunction with CAC to determine a company’s overall profitability.

5. Churn Rate: This is the percentage of customers that cancel their subscriptions during a given period. A high churn rate can be a sign of a product or service that is not meeting customers’ needs, and can lead to lower revenue and reduced profitability.

6. Gross Margins: Gross margins represent the amount of revenue a company retains after deducting the cost of goods sold. For SaaS companies, gross margins are typically high, as the cost of delivering software over the internet is relatively low.

By analyzing these key metrics, investors can gain a better understanding of a SaaS company’s growth potential, profitability, and overall value. And businesses can get a better sense of where to improve. 

Key Takeaways

As we’ve discussed, SaaS business models have proven to be an attractive option for businesses seeking to avoid large investments in IT infrastructure. With a focus on generating recurring revenue from customers, SaaS businesses benefit from the potential for customers to become incredibly loyal to their product, leading to long-term customer retention.

Despite the challenges of launching and maintaining a SaaS product, investors are also attracted to SaaS companies. Just keep in mind that, as we’ve mentioned above, they are often valued differently from traditional business models given the significant reinvestment required for continued growth.

So to sum up, the SaaS business model represents a unique and compelling opportunity for businesses and investors alike. It will be exciting to watch as this sector continues to grow and evolve in the years to come.

Quantum Growth Advisors provides data driven fundraising & dealflow automation services for startups, investors and service providers. To learn more about our software & services, book a consult.