The SaaS business model Detail Guide

Software as a service (SaaS) is a software billing and delivery model that is so superior to the traditional method of selling software licenses that it can reshape business around it. This has led SaaS businesses to form a distinct practice. Unfortunately, many entrepreneurs are discovering this practice the hard way, making mistakes that have been made before, rather than spending their budget on new and better mistakes.

This shouldn’t be the case for you either, so we’re going to give you a tour of the state of the SaaS business. You need to better understand the SaaS business model, be able to predict which model you’ll sell your product in – low-touch or high-touch, and (if you already have a SaaS business) be able to assess its state and start improving it.

If you are a software developer and not selling mobile apps (which have a separate billing model imposed by platform app stores), you need a deep understanding of the SaaS business. This will allow you to make more informed decisions about your product (and company), allow you to see business-threatening problems months or years before they become obvious, and help you in communicating with investors.

Why is SaaS taking over the world?

Customers love SaaS because it “just works.” You typically don’t have to install anything to get access. Hardware failures and operational errors, which are extremely common on machines not maintained by professionals, do not result in significant data loss. SaaS companies achieve availability metrics (e.g., the percentage of time that software is available and working properly) that far exceed what almost any IT department (and anyone, in general) can achieve.

In addition, SaaS typically turns out to be cheaper than software sold under other billing models, which is important for users who aren’t sure which software to choose in the long term, for example, or only need it for a short time.

Developers love SaaS primarily for the delivery model, not the billing model.

Most SaaS are continuously developed and run on the company’s infrastructure. (There are significant exceptions in enterprise SaaS, but the vast majority of SaaS sold outside the enterprise is available over the Internet from servers maintained by the developer).

Historically, software companies have not controlled the environments in which their code runs. This has historically been a major source of development friction and customer support problems. All software developed on customer hardware suffers from differences in system configurations, interactions with other installed software, and operator errors. This must be taken into account during development and customer support issues must be addressed. Companies that sell their software in both SaaS and deployable models often receive 10+ times more support requests than customers who install the software locally.

Businesses and investors love SaaS because the economics of SaaS are incredibly attractive compared to selling software licences. SaaS revenues tend to be recurring and predictable; this makes cash flows in SaaS businesses remarkably predictable, allowing companies to plan for them and (through investors) exchange future cash flows for status quo money. This allows them to (generously) fund ongoing growth. This has made SaaS companies some of the fastest growing companies in software history.

SaaS sales models

In general, there are two ways to sell SaaS.
The sales model dictates almost everything else about the SaaS company and product, and to an extent that is shocking to aspiring entrepreneurs. One of the classic mistakes in SaaS that can take years to fix is the mismatch between the product or market and the model chosen to sell it.
You will find that the sales model for SaaS defines the product (and the company) much more than other differences, such as whether the company sells to customers (B2C) or enterprises (B2B), whether it is bootstrapped or on the trajectory of a VC rocket ship, or what technology stack it is built on.

Low-contact SaaS sales

Customer support for low-touch offerings is generally handled primarily in a scalable manner, i.e., by optimizing the product to avoid incidents that require human intervention, creating educational resources that can be scaled to the entire customer base, and using personnel as a last resort.
That said, many low-touch companies also have excellent customer service teams. the economics of SaaS depend on long-term customer satisfaction, so even an offering that only receives a single ticket (a countably discrete interaction with a customer) every 20 months can invest a relatively large amount of money in its customer support teams.

Low-touch SaaS is typically sold on a monthly subscription basis, with price points around $10 for B2C applications and between $20 and $500 for B2B applications. This equates to an average contract value (ACV) of around $100,000 to $5,000 USD.
Low-touch SaaS companies don’t even use the term ACV very often – they usually describe themselves in terms of monthly pricing – but comparisons with high-touch SaaS applications are important.

If you ask a low touch SaaS entrepreneur what their most important metric is, they will tell you MRR – monthly recurring revenue.
Basecamp is a great example of a low-contact SaaS business, and Atlassian (which makes Jira, Trello, Confluence, and a few others) is probably the most successful company operating under this model.

High-contact SaaS sales

Some customers need help deciding how or whether to use certain products.

High-contact SaaS sales are based on the time-consuming process of convincing organizations to implement the software, operate it successfully, and continue to use it.

At the center of the organization is almost always the sales team, which is often divided into specialized roles:

sales development representatives (SDRs), who are responsible for finding new customers for the software;
account executives (AEs), who are responsible for the sales process for a specific customer;
account managers (AMs), who are responsible for the well-being and ongoing performance of an individual customer portfolio.

The sales team is usually supported by marketing managers, whose primary job is to ensure that the sales team has sufficient and necessary information to evaluate and close the deal.

There are a lot of really great products sold within the high-touch model, but at a first approximation, engineering and product are generally considered less important in a high-touch SaaS business than the sales mechanism.

The organization of customer support varies widely among high-contact SaaS companies; the common thread is that it is generally expected to be heavily used. The number of tickets per account per period is expected to be orders of magnitude higher than in low-contact SaaS.

Note that while it is in principle possible to sell to consumers (e.g. insurance has historically been sold mainly through authorised agents), in SaaS the vast majority of high contact companies sell to businesses (B2B).
In B2B there is a wide range of expected customer profiles, ACV (variously defined as average contract value or annual contract value) and transaction complexity.

Lowest Level hirarcy

At the lowest level, SaaS sold to small and medium-sized businesses (SMBs) under a multi-contact model typically has an ACV of $6,000 to $15,000, though it can be higher. The exact definition of an SME varies widely depending on who you ask; operationally, it’s “any business complex enough to successfully implement $10,000 worth of software,” which probably excludes your local flower store but includes a dental practice with two partners and four employees.

Higher Level hirarcy

The higher level is usually referred to as “enterprise” and is reserved for very large companies or governments. Real business deals start at six figures; there is no upper limit.

If you were to ask a SaaS entrepreneur with a lot of contacts what the most important metric is, they would say ARR – annual recurring revenue. (This is essentially the company’s total non-recurring revenue minus some one-time items like one-time setup costs, consulting and similar expenses. Since the SaaS economy is attractive because it grows over time, non-recurring revenues, especially those with relatively low margins, are not of particular interest to entrepreneurs and investors).

Salesforce is a prime example of a high-contact SaaS company that literally invented this model. Small high-contact SaaS companies abound, even if they are less visible than low-contact SaaS companies, primarily because visibility is a customer acquisition strategy for low-contact SaaS and not always optimal for high-contact SaaS. For example, there are many small SaaS companies that generate six- or seven-figure revenues annually by selling services to a narrowly defined industry.

Mixed Sales Approach

Some companies have successfully conducted both low-touch and high-touch business utilizing the same functional offerings. This is extremely rare compared to the SaaS business. Attempts to adopt both models often result in only one model gaining traction and (because these models are intertwined across all functions of the company) usually displacing the other.
A more common form of hybridization is the adoption of certain elements of another sales model.
For example, many low-touch SaaS companies have account teams that, if you look closely, almost resemble inside sales.
High-touch companies tend to borrow fewer tactics than low-touch companies; most commonly, they own products that the company (in fact) doesn’t sell, and they distribute them in a low-touch way to generate leads for the products the company does sell.
The SaaS model basically works by monetising software: instead of selling software as a product with a price, it is sold as a financial instrument with predictable cash flows.
There are more sophisticated ways to model the SaaS business, but versions that don’t require a master’s degree make only a few simple assumptions (such as ignoring the time value of money) and use high school math. If you’re only learning one thing about SaaS, learn this equation; it’s the Rosetta stone to understanding all the fundamentals of SaaS business.
The default is very simple: long-term revenue is the product of the number of customers and the average lifetime revenue per customer.
The number of customers is a function of two factors: acquisition (how well you can capture the attention of potential customers for a low-engagement SaaS, or identify and reach them for a high-engagement SaaS) multiplied by the conversion rate (the percentage of leads converted into paying customers).
Average revenue per lifetime customer (often called lifetime value [LTV]) is the amount paid by a customer for a given period (e.g. one month) multiplied by the number of times the customer continues to use the service.
Average revenue per user (ARPU) is simply the average revenue per account over a given period.
Churn is the percentage of customers who stop paying for services during a given period. For example, if you have 200 customers paying you in January, and only 190 of them pay you in February, the churn rate is 5%.
With some simplifying assumptions, the lifetime value of customers can be calculated as the sum of an infinite geometric series; it is simply the reciprocal of the churn rate. A product that loses 5% of its customers each month has an expected customer lifetime of 20 months; if it charges each customer $30 per month, it can expect to earn $600 for each new customer.

Implications of the SaaS business model

SaaS business improvements have multiple effects.

A 10 percent improvement in customer acquisition (e.g. through better marketing) and a 10 percent improvement in conversion (e.g. through product improvements or more effective sales techniques) results in a 21 percent improvement (1.1*1.1), not a 20 percent improvement.

SaaS business improvements are highly effective.

Because SaaS profit margins are so high, the long-term valuation of the SaaS business is effectively tied to a multiple of long-term revenue growth. So a 1% improvement in conversion rate not only means a 1% increase in revenue next month, or even in the long term, but also a 1% increase in business value.

Price plays major role in saas business accusation

Customer acquisition, conversion and churn often require major cross-functional improvement efforts. When you update your pricing model, you usually need to replace a small number with a larger one (there’s enough nuance here to write a guide to SaaS pricing).

SaaS companies will break even at some point.

At a fixed level of customer acquisition, conversion and churn, there will be a point at which your company reaches a revenue plateau. This can be predicted in advance: the number of customers at the peak point is equal to acquisition multiplied by conversion and divided by the churn rate.

A SaaS company that can no longer increase its acquisition, conversion or churn rate will almost mathematically stop growing. A SaaS company that stops growing before it can cover fixed costs (such as the salary of an engineering team) will die an ignominious death, even if the company has done everything right.

The development of SaaS businesses can be capital intensive.

SaaS businesses have high initial development costs, especially when they are aggressively deployed; marketing and sales dominate marginal cost per customer and, often, total company costs. The marketing and sales costs attributable to a particular customer occur very early in the customer lifecycle; the revenues that will eventually pay off these costs come later.

This means that SaaS companies that optimize for revenue growth almost always spend more money in a given period than they receive from customers. The money spent has to come from somewhere. Many SaaS companies choose to fund growth by selling company stock to investors. SaaS companies are very attractive to investors because the model is very well understood: Create a product, achieve some measure of product-market fit, spend a lot of money on marketing and sales according to relatively repeatable guidelines, and eventually sell your stake in the business to someone else (the public market, a buyer, or another investor looking for a risk-free business with good growth prospects).

At first glance, profit margins do not play a role.

Most companies are very interested in their cost of goods sold (COGS), which is the cost of satisfying a marginal customer.
While some enterprise platforms (e.g. AWS) have significant COGS, a typical SaaS company’s primary source of value is software and can be replicated with extremely low COGS. SaaS companies often spend less than 5-10% of their marginal revenue per customer on providing the underlying service.
This allows SaaS entrepreneurs to ignore almost every factor of their economic unit except customer acquisition cost (CAC – the marginal marketing and sales cost per customer added). If they are growing rapidly, the company can ignore all expenses that do not scale directly with the number of customers (e.g. technical costs, overhead and administration costs, etc.) on the assumption that growth with a reasonable CAC will outpace anything on the expense side.

SaaS companies take time to grow.

Although it is often talked about in the media about the so-called “hockey growth curve”, the experience that represents SaaS companies is that they take a very long time to adapt their product, marketing and sales approach before things really take off. This is often referred to as the long, slow road of SaaS death.

Growth expectations are very different in the SaaS industry.

SaaS companies that are still in their infancy (bootstrapping) often take 18 months to become profitable enough to compete with a decent salary for the founding team. Once this point is reached, there are various acceptable growth rates for bootstrapped companies. Revenue growth of 10-20% per year can provide very, very pleasing results for all parties involved.
Funded SaaS companies are designed to trade cash for growth, which means they lose a lot of money up front as they perfect their model; almost no funded SaaS company has ever failed in this goal.
Once you’ve perfected your SaaS revenue model, you scale it to typically generate more revenue, faster. This is a successful business outcome, contrary to the fears of many in the software industry. If the business can continue to grow, the accumulated deficit will eventually be paid off; if it can’t grow, the business will fail.
Many businesses are less stressed than SaaS companies that are managed for aggressive growth, which can be likened to driving a rocket ship that aggressively burns fuel for acceleration and then explodes when something goes wrong.
The rule of thumb for growth expectations for successful SaaS companies that are driven for aggressive growth is 3, 3, 3, 2, 2, 2: start from a substantial base level (e.g. $1 million or more in annual recurring revenue (ARR)), triple annual revenue for two consecutive years, and then double it for three consecutive years. A funded SaaS company that consistently grows 20% per year for the first few years is likely to be a failure in the eyes of investors.

What you need to know

One of the most common questions asked to SaaS startups is: “Are my numbers good?”.
This question is surprisingly difficult to answer, as there are differences between industries, business models, company stages, and founder goals. In general, however, experienced SaaS entrepreneurs have a few rules.
SaaS benchmarks that perform below average

Conversion rate:

Most low-profile SaaS solutions use a free trial, with registration requiring either minimal information or a credit card that will be charged if the user does not cancel the trial. This decision is determined by the type of free trial: Users who sign up for a trial period with relatively few restrictions may not have evaluated the software very seriously and will have to decide later whether to purchase it, while users who provide a credit card number have usually done more research beforehand and are essentially required to pay unless they indicate they are not satisfied with the product.

This leads to cosmically different conversion rates:

Conversion rates of low-touch SaaS trials that do not require a credit card:
1%: usually an indication of poor product-to-market fit
~1%: roughly the basic requirement for competent execution
2%+: extremely good
Conversion rates of SaaS trials with low contact and credit card required:
Well below 40%: usually indicative of poor product-market fit
40%: roughly the basis for good execution
60%: good

In general, requiring a credit card upfront increases the number of new paying customers (it increases the conversion rate from trial customers to paying customers more than it decreases the number of trials initiated). This factor reverses as a company improves its customer relationships and better supports free trial users (by making sure they use the software wisely), usually through better product experiences, lifecycle emails, and customer success teams.

Conversion rate (in test trials):

However, it is not the most applicable metric for your business and it is difficult to give a good indication of your expectations based on this figure.
The conversion rate in test trials largely depends on whether or not you are attracting quality visitors. Conversely, companies that do better marketing have lower conversion rates than companies that do worse.
Companies with better marketing attract many more potential customers, usually with a higher percentage and absolute number of potential customers who are not qualified for the offer. Companies with poorer marketing are only discovered by those who know their markets and who are usually disproportionately good customers; they are so dissatisfied with the status quo that they actively and often vigorously seek solutions and are willing to use an unknown company if it is potentially better than their current situation. The rest of the market may not be actively looking for a solution right now, may be satisfied with known providers or only those that appear at the top of Google, and may not be motivated to take the risk of working with a newer provider.

Customer churn rates:

Most customers are on monthly contracts, and churn rates are monthly. (Selling annual contracts is certainly a good idea too, both because of the money received upfront and the lower churn rate. However, when reporting on churn, the impact of these contracts is usually factored into a monthly amount).

2%: a very stable SaaS product with strong product-market fit and significant investment in reducing involuntary churn
5%: about where you want to start
7 %: Signs of low-hanging fruit to prevent involuntary churn, or sales in a difficult market
10 %+: Signs of very poor product fit in the market and an existential threat to the business
Some markets have a structurally higher termination rate than others: Sales to “pro-sumers” or informal businesses such as freelancers expose you to their high exit rate from the business, which significantly affects the termination rate. Established businesses are much less likely to go out of business and don’t have to optimize their cash flow down to the last $50.
Because higher prices preferentially attract better customers, price increases are even more effective than business owners expect: a 25% price increase can “accidentally” reduce the quit rate by 20% simply by changing the composition of customers buying the product. This factor leads many SaaS companies with low customer engagement to “go up” over time.

High-touch SaaS benchmarks

High-touch SaaS companies typically have much, much greater heterogeneity both in how they measure their conversion rates (largely due to differences in how they define “opportunity”) and in their realized conversion rates under similar definitions due to differences in their industry, sales process, etc.
However, contract termination rates are similar: approximately 10% annual contract termination is reasonable for companies in their early years, and 7% is an excellent termination rate. Note that mediocre high-touch SaaS companies have structurally significantly lower termination rates than even the best low-touch SaaS companies.
High-touch companies often measure so-called “logo” churn (one company counts as one logo regardless of how many units in that company use the software, how many locations they use, what they pay, etc.) and revenue churn. This is less important in low-touch SaaS, as these drop-off rates are usually quite similar.
Because high-touch SaaS companies price their offerings so that they can increase the amount of revenue over the lifetime of the customer by selling more seats or offering add-on

Product-market fit

SaaS is not just about metrics. The most difficult point to assess in the early stages of a SaaS company is “product-market fit”, a term coined by Marc Andreessen that informally means: “Have you found a group of people who love what you’ve created for them?”
Products that do not yet have product-market fit are characterized by relatively low conversion rates and high bounce rates. Products that achieve product-market fit often accelerate their growth rates significantly, have much higher conversion rates and are generally more fun to work with.
Serial SaaS entrepreneurs often struggle to describe product-market fit other than to say, “If you have it, you know you have it, and if you have doubts about whether you have it, you don’t” – that’s the difference between any sales pitch being a push up the hill and the customer practically ripping your arm off to get your software.
Many SaaS business models with product-market fit didn’t start out that way; sometimes it takes months or years of iterations to get there. The most important issue during iterations is to talk to many, many more customers than seems natural. Entrepreneurs with a low level of SaaS service can justify trying to talk to literally everyone.

Who are the “best” customers?

Typically, these customer segments (depending on industry, size, customer profile, etc.) have high conversion rates, low bounce rates, and (almost always) relatively high ACV. By far the most common shift in focus for low-touch SaaS companies is to start with a product that serves a wide range of users with broad needs, and then focus on one or two niches that serve the most in-demand users.