SaaS Business Model: Learn How It Works and How to Measure If It Does
mins to read
With more than 15,529 SaaS companies registered on Crunchbase and 12 times growth rate since 2010, it's okay to say that SaaS is a business model of the 21st century. As a SaaS design company, Eleken works with SaaS businesses every day. Over the past couple of years, we've seen an increasing number of entrepreneurs looking to adopt this business model. Why does everyone want to be a SaaS company?
We decided to cover the most important aspects of the SaaS business model so you could better understand how it works and whether you need to be looking into it for your next project.
What is SaaS?
SaaS (Software as a Service) is software hosted on the cloud. It can be accessed via an internet browser, mobile application, or desktop app. SaaS is provided to users on a subscription basis, which means they have to pay a recurring fee monthly or annually.
You know Zoom, right? It's a go-to app for group video chats today. You may hold an unlimited number of one-to-one and group meetings on Zoom as well as record these meetings, share screens, use boards, and have productive discussions without any annoying issues (hello Skype!). Zoom offers access to its video conferencing app using a subscription model.
SaaS revenue streams
SaaS companies typically have a few revenue streams in addition to subscription. Let's look at all of them.
Recurring payments are the main revenue-generating stream of SaaS businesses. This stream is fluctuating and varies from month to month (depending on your pricing model and customer satisfaction). People continue to use the app as long as it delivers value.
You can upsell to existing customers offering them more storage, more data, additional features, or more accounts. Going back to Zoom again (we do not promote it, but we do like it, especially in times of remote work), they have a couple of available add-ons: Audio plan and Additional Cloud Recording Storage. With the Audio plan, you can call out your participants (like in Skype) instead of just waiting for them to join in. If you need more storage to keep your conference recordings in the Zoom account, you can pay for additional space.
You may charge for software setup. This revenue stream not only adds to the profit of your SaaS but also enables a customer validation process. You need to approach setup fees carefully. It works better for enterprises (big clients) with a lot of data.
For example, a well-known customer relationship management platform, Salesforce, provides different integration and installation services from their in-house architects on request. They get pretty good financial returns from this offer. Salesforce has hundreds of apps and features which are useful for any business, but customers struggle to integrate them. Because the value dominates over the price, people pay for architects’ services.
You may apply additional charges for creating data-driven reports based on what service you provide to your customers. It may be a feature in one of your plans or just an additional service. Make sure that these reports add value to your customers and have ROI (return on investment). One more successful SaaS player, Hubspot, a platform for sales management, marketing automation, and customer service offers their customers to get Reporting Add-on and create Custom Reports to track various metrics.
You can develop different levels of customer support and charge for this service. Customer service is an important and expensive part of any business. And, we consider it to be part of the SaaS value proposition so it might also be included in the pricing model.
A prominent email-marketing automation SaaS, Mailchimp, offers different levels of support depending on the pricing plan. If you are signed up to the Free plan, you will only be able to use published tutorials, and email-support during the first 30 days. Standard and Essential plans will let you communicate with support representatives via live chat. And Premium Mailchimp plan users, in addition to the mentioned before support features, can get phone support and priority response.
Key metrics of SaaS Businesses
SaaS is a “metrics-based” model. If you want your business to succeed in the competitive SaaS environment and scale up, you have to keep an eye on the key metrics for your business.
One metric that matters (OMTM)
It is also called the Northstar metric. It helps you figure out whether your product is succeeding or not. Northstar metric is unique for every SaaS business and defines the goal for your entire product team. For example, Slack aims to 2K messages per user. Airbnb has bookings per night as OMTM.
Monthly Recurring Revenue (MRR)
MRR is the most important financial metric. As SaaS is a subscription-based business, you need to count how much money you get every month. This metric doesn’t include upsells or profit from additional revenue streams. You should only take into account the number of subscriptions.
Lifetime Value (LTV)
LTV is the amount of money you receive from your customer during the whole period of using your software. This number helps you predict profit and allocate resources wisely. Companies that have a good LTV focus on improving the user experience of their existing customers. It's cheaper to keep an old client that attracts a new one.
Customer Acquisition Cost (CAC)
CAC is a marketing metric that indicates how much money you spend to acquire new clients. Watching LTV and CAC of your SaaS will help you keep a healthy balance and growth.
Net Promoter Score (NPS)
NPS helps you identify how satisfied your users are with your product. NPS is based on a simple question: How likely are you to recommend our product to your colleague or friend from one to ten? This metric is related to the quality of product features, customer services, and user interface.
It is a percentage of clients you have lost during a defined period of time (week, month, quarter). SaaS businesses are based on a subscription model which means you have to keep track of current clients and make sure they continue to use your service from month to month. Trying to find the reasons of why they churn may help you improve your product.
Will every business evolve into a subscription business model?
According to a 2020 survey, the average growth rate for startups with less than $1M ARR is 144%. For companies with more than $5M ARR, the number decreases to 60%, which is still rather significant growth. The business model is lucrative and thus luring entrepreneurs to build new products. Still, there are dozens of other industries that generate the same or even bigger revenue. What do so many entrepreneurs want to build a SaaS?
We have been living in the “subscription economy” long time before SaaS became popular. We used to rent and lease housing, cars, offices, even outfits, and pay a monthly fee for using them. SaaS is another service that offers stuff "for rent," the only difference is that the stuff is digital.
Software as a Service business model is a win/win for customers and businesses. For businesses, SaaS scales fast, generates recurring revenue, and gets managed easily. For customers, it offers convenience and reduced investments.
Customer demand is changing. They are more willing to pay for access to the product or service in smaller amounts rather than paying lump sums up-front. Customers enjoy not only lower costs but also constant upgrades of the software and easy access to new features and cutting-edge technologies.
There is a luring opportunity for every business to evolve into a subscription business model. If you want to keep your product viable and generate constant profit, regardless of where you are, you should start considering this option.
The transition may be expensive at first, but you can reap benefits very fast as soon as you choose the right pricing model and set up your metrics.
Tien Tzuo, in his book “Subscribed: Why the Subscription Model Will Be Your Company’s Future—and What to Do About It” makes a point that the subscription business model is about freedom, easy access, cutting edge technologies, and easy financial management.