In 2011, venture capital investor Marc Andreessen published his famous article “Why Software Is Eating the World”. He boldly predicted that software will become an essential part of our daily lives.
Over 8 years later, his predication became reality. Nowadays, software companies such as Google or Microsoft, are some of the most profitable and valuable companies in the world.
Beneath many of those applications lies the concept of Software as a Service (SaaS), which is the commercial engine driving the growth of these companies.
In a survey conducted by BetterCloud, 73 percent of firms who responded stated that by 2020 over 80% of the applications they use will be SaaS based.
The following article will examine how software came to eat the world and what makes the SaaS business model so valuable.
SaaS is a model in which software is licensed on a subscription basis. The software is hosted in a central cloud infrastructure and made available on the internet, either from a desktop or website application.
In the SaaS model, the vendor hosts and maintains the servers, code infrastructure, and databases. This is a significant switch from the on-premise software delivery present in the 90’s and early 2000’s. With on-premise, customers usually pay a one-time fee to install the software on their local hardware and between 15 – 20 percent in service and maintenance per annum.
With SaaS, customers pay a monthly or yearly subscription fee. In some cases, SaaS businesses offer a freemium portion of the application with limited access. This allows customers to test before financially committing to the product. Another possibility includes a free testing period of the whole product (similar to what Netflix does).
Oftentimes, SaaS products focus on providing software applications for either private consumers (B2C) or other businesses (B2B). When SaaS companies become more mature (that is greater financial resources and manpower), they tend to branch out into new customer segments and industries.
SaaS Business Model – Pros and Cons
SaaS Business Model – Advantages
Continuous & Recurring Revenue. One of the main advantages of the SaaS business model is that revenue is highly predictable as customers tend to rarely cancel their subscriptions. According to leading startup investor Bessemer, less than 5 percent of all customers cancel their subscription over the course of one year.
Close Customer Relationship. SaaS customers tend to visit and use the application on a frequent basis. This allows SaaS businesses to not only assess how their users interact with the product, but also to analyze what has to improve.
Less Friction. Many SaaS offerings come at a flat monthly or yearly fee, which is easy to comprehend for customers (as they are used to this pricing model from subscription businesses such as Netflix or Spotify). Furthermore, as there is no hidden cost involved, it’s often easier to convert customers to subscribe.
Customer Lock-In. This especially applies to B2B SaaS companies, where a company’s processes are executed through the application. Switching to manual labor would likely cost too much, while the SaaS software adds additional time and cost savings. Hence, organizations create their processes based on the SaaS, essentially creating a lock-in effect.
Easy Expansion. As the SaaS model does not require any physical movement of goods, it allows for rapid expansion into new markets and countries. Thereby, expanding SaaS companies can commit their financial resources towards various marketing efforts and eventually local country representatives.
No Piracy. As SaaS products are often delivered in the form of web applications, illegally distributing them becomes redundant.
SaaS Business Model – Disadvantages
High Set-Up Cost. Customers won’t subscribe to a semi-finished product, hence SaaS companies have to invest enough (monetary) resources to build up their offering. According to an estimation by SaaS Developers, I’d roughly take $100,000 to build up the first version of your SaaS.
Easy To Copy. Since SaaS can easily be easily distributed worldwide, potential competitors can get a first-hand look at the software and copy its features instantly. Hence, SaaS companies have to consistently innovate and find new means of customer acquisition to remain relevant.
Easy To Cancel. Whereas B2B SaaS companies often benefit from great customer lock-in effects, B2C suffer from the easiness of cancelling SaaS subscriptions (one of the biggest selling points given to customers).
Security. Just like any business operating within the realms of the internet, SaaS business are not immune to malicious infiltrations and data loss. As such, SaaS companies have to heavily invest in keeping their application and customer data secure at all times.
SaaS vs. IaaS vs. PaaS
Next to SaaS, there are two other main categories in the cloud computing space: Infrastructure as a Service (IaaS) and Platform as a Service (PaaS).
Infrastructure as a Service is a service delivery model, which offers computing infrastructure through a virtual network (as opposed to onsite servers). It allows companies to virtually build and run their storage, network, and operating systems.
Previously, companies had to operate their own local servers, workstations, and data centers. Nowadays, these resources are delivered by cloud service providers (CSP).
Some of the major advantages of IaaS are:
- Reliability: IaaS providers making sure that systems don’t experience major outages (i.e. by having back-up datacenters)
- Scalability: Customers can easily increase computing power when expecting major network increases (i.e. e-commerce companies during holiday season)
- Cost Savings: Companies don’t have to invest in the hardware and personnel to build up physical datacenters. Furthermore, as computing power can be flexibly adjusted, companies do not have to pay a standard rate and can lower their volume during less frequented times
- Security: IaaS providers invest billions of dollars to keep their systems safe, which removes the burden for companies to build up these skills internally
Examples of IaaS providers include Amazon Web Services (AWS), Microsoft Azure or the Google Cloud.
With Platform as a Service, customers are provided with a computing platform to create and operate their own custom applications. It thereby allows developers to collaborate through those applications, removing the need for onsite presence.
Advantages of the PaaS model include:
- Simplicity and Convenience: Developers do not have to create a platform for collaboration and can find all the necessary tools within the application
- Faster Development Cycles: As these platforms are optimized for collaboration, application development occurs much faster and with fewer roadblocks
- Cost Savings: by eliminating the need to build an internal development tool, PaaS applications can create major cost savings
- Continuous Upgrades: PaaS vendors continuously upgrade their platforms to accommodate for new standards and frameworks in application development
Essential Metrics & KPIs
Similar to subscription models, there are three key activities to be successful in the SaaS space:
- Acquiring Customers
- Retaining Customers
- Monetizing Customers
In order to maximize our efforts and resources within these activities, we need to track how successful we are at each and every step.
Nevertheless, SaaS companies (or any other type of business for that matter) have to adopt some level of frugality when it comes to metrics. KPI Overload, the act of tracking too many metrics, can deteriorate your focus and thus stall growth.
In order to keep things simple, we will focus on various key metrics for each activity. If you want to dig deeper into other KPIs, I can only recommend Ryan Law’s extensive guide on SaaS metrics.
According to The Software Report, there are over 10,000 SaaS companies registered worldwide. In such a crowded space, it can become very costly to acquire new users.
For instance, Slack alone spent a whopping $230 million on acquiring new users for the fiscal year 2019.
To keep your cost on a sane level, we have to track the effectiveness of your sales and marketing campaigns. The following metrics help us doing that.
Customer Acquisition Cost (CAC)
Customer acquisition cost indicates how much money you spend to acquire a new customer. According to David Skok, CAC is often a startup killer as many businesses fail to find ways to acquire customers at low cost.
Understanding how much it cost to acquire new customers and finding the most profitable marketing channels is therefore key in becoming profitable.
To calculate CAC, you have to divide your total marketing and sales cost by the amount of customers your business acquired over a given period.
CAC = (Sales and marketing) costs ÷ new customers
Conversion Rate (CR)
In layman terms, conversion rates indicate how many people completed a certain process after starting it. When thinking about customer acquisition, we use CR to assess how effective each marketing campaign is.
Hence, CR is calculated as follows:
CR = Number Of People Finishing An Action ÷ Number Of People Starting An Action
The reason this sounds so ambiguous is that conversion rates can be used on any part of the user flow. Take, for instance, an ad on LinkedIn promoting your product.
Over the period of running that ad, 1,000 people see your product in their feed. Off of those 1,000 users, 150 click on your ad and 10 people end up registering for your product. Depending on what you measure, the result would yield different conversion rates. For instance, your ad conversion rate (or Click Through Rate) would be 150 ÷ 1,000 = 15 percent. Conversely, your ad to sign-up CR would be 10 ÷ 1,000 = 1 percent.
Conversion rates can allow you to experiment with different marketing tactics. For instance, you can run your ads at different times, regions or platforms to test which channels are the most cost effective.
Lastly, it has to be noted that there is no “good” or benchmark conversion rate. Rather, you should try to constantly improve on the metric.
Customer Acquisition Rate (CAR)
Next to assessing how effective and costly your sales and marketing campaigns are, it is important to know how fast you are acquiring new customers. To do that, you need to calculate your customer acquisition rate.
CAR gives you a birds eye view into how well all of your acquisition efforts are performing in a given time period. It is calculated by dividing the number of acquired users by the length of a chosen time period.
CAR = Number Of Acquired Users ÷ Length Of Period
So if you acquired 1200 new customers over a six month period, your CAR is 1200 ÷ 6 = 200 users per month.
The beauty of CAR is that you can compare it across the timeline of your business. It thereby allows you to assess all your undertaken acquisition initiatives on a holistic scale.
As SaaS customers often tend to yield high lifetime monetary value (more on that later), maximizing your CAR is the most important objective your business should have.
Product Qualified Leads (PQL)
Product qualified leads are potentially interested customers, who previously used your product in a meaningful way. PQL’s are especially important to track when your SaaS business has a freemium component to it.
When you reach out to a PQL (to convert him to a paid user), that person already used your product extensively and as such does not require any marketing or promotional tactics.
PQL’s can be identified by looking at users who previously converted to a paid plan. Depending on the type of features and products, PQL’s are assessed differently.
For instance, data consolidation platform databox uses criteria such as time spent within the product, amount of features used and number of log-ins. For Drift, a PQL is someone who had over 100 conversations in their tool.
Example product behavior to identify a PQL can be as the following:
- Features used
- Spending and usage patterns
- Velocity, that is how fast an individual or team is adopting your product
- Product interest, i.e. through social shares or interactions with other users
As previously discussed, it can be very costly to acquire SaaS customers. Therefore, you want to keep them signed up as long as possible.
The following metrics help you assess how long customers are staying, what makes them leave, and what you could potentially do about it.
Understanding and measuring your churn rate is one of the most essential metrics for any SaaS business. When it comes to churn, we often differentiate between two key metrics: customer churn and revenue churn.
Customer churn measures the percentage of users that leave your service in a given time period. Conversely, revenue churn refers to the rate at which you lose revenue on a periodic scale.
Oftentimes, SaaS founders look at those two metrics on both a monthly and yearly period.
Customer churn would be calculated as follows:
Customer Churn = (Customers Beginning Of Period – Customers End Of Period) ÷ Customers Beginning Of Period
So if your business had 500 customers at the beginning of the month and 480 at the end of it, your customer churn would be (500 – 480) ÷ 500 = 4 percent. For revenue churn, the same formula would be applied on your monthly recurring revenue (MRR) instead of the customer count.
Churn rates are especially important for larger SaaS businesses. If you have 100 customers, replacing two or three isn’t that big of a challenge (equal to a 3 percent churn rate). But a business with a million customers would end up losing 30,000 customers a month. Replacing that many customers every month would be extremely costly.
Furthermore, churn rates can compound over time. A 3 percent monthly churn equals a 31 percent annual rate. You’d end up having to replace almost a third of your customer base just to maintain your user base. So the more customers you have, the more you need to invest in keeping them happy.
Net Promoter Score (NPS)
So how do you know your customers are satisfied with your product? Well, one indicator could be your product’s Net Promoter Score. It acts as a direct measurement of how much value your customers are getting from your product.
NPS gives you the likelihood at which your customer would recommend your company or product to someone else. It operates on a scale from 0 – 10, where 0 means they wouldn’t recommend your product and 10 means they absolutely would.
Normally, NPS is separated into three distinctive categories, namely being:
- Detractors (customers giving a score of 0 – 6)
- Passives (customers giving a score of 7 or 8)
- Promoters (customers giving a score of 9 or 10)
NPS is calculated by subtracting the percentage of detractors from the percentage of promoters.
NPS = % Promoters – % Detractors
The result should yield a measure between -100 and +100. For instance, if you have 70 percent promoters, 15 percent passives and detractors respectively, then your NPS would be equal to 70% – 15% = 55.
Now this is somehow of an ambiguous term because every SaaS company has different features and tools their customers utilize. So what you’d want to do is defining those key features and creating metrics around them.
For instance, a company like Dropbox would probably look at how much files their users upload and how those are stored. Video platform Zoom could look at the average session length per video call and the call’s respective video and sound quality. Lastly, Slack might consider the amount of content shared and Slack groups created.
Point being, identify the key features essential to your product experience and build measures around them. Only if you track how customers are engaging with them can you truly improve on offering a better user experience.
We got ourselves all those customers now, so what’s next? Preferably, you’d want to monetize them in some sort of way.
Let’s look at a couple of metrics which allow us to look at how much we earn from each customer and how we can maximize our revenue.
Monthly Recurring Revenue (MRR)
Recurring revenue is the backbone of every SaaS business. Therefore, it is essential to know how much you can expect to earn in a given month (or year for that matter). MRR tells you just that.
MRR is easily calculated by summarizing all the revenue your business earns from its paying customers in a given month. Alternatively, if you know your average revenue per account (ARPA), then MRR can be calculated by multiplying ARPU with the total number of customers you have.
Recurring revenue is what makes SaaS business so appealing. As long as you keep delivering good service, customers are highly unlikely to churn.
Some strategies to increase your MRR are:
- Simply charging more for your product
- Upselling through different pricing plans or add-on features
- Removing an existing price limit
- Removing your free plan to only attract financially potent customers
Whether or not these are applicable to your business is a matter of testing different pricing models.
Average Revenue Per Account (ARPA)
Average revenue per account (also known as average revenue per user or unit) measures the revenue generated by an average account. ARPA is usually measured on a monthly basis. Depending on your billing period, ARPA can also be calculated on a quarterly or yearly basis.
ARPA is calculated by taking the sum of your MRR and divide that by the total amount of customers you have at that month.
ARPA = MRR ÷ Total Number Of Customers
If you have an MRR of $100,000 and 5,000 customers, then your ARPA is equal to $100,000 ÷ 5,000 = 200 $/account.
ARPA can be especially useful when calculating it for different customer groups. As such, you can identify which of your customers yield the highest revenue and focus your acquisition strategies towards this group.
Customer Lifetime Value (CLV)
Customer lifetime value tells you how much your users are spending on your service over the course of their membership. The longer customers keep using your service or the more they spend, the higher their lifetime value will be.
Knowing how much you earn from a customer can help you assess how much money you can spend to acquire them. Furthermore, you can separate your LTV into different customer groups, which allows you to target them more specifically.
To calculate CLV, you first need to determine your customer churn rate and your average revenue per account (ARPA). Then, you divide your ARPA by your customer churn.
CLV = ARPA ÷ Customer Churn Rate
For instance, with an average revenue per account of $500 and a 5 percent customer churn rate, we’d generate a CLV of $500 ÷ 5 percent = 10,000$.
It has to be noted that calculating LTV only makes sense with businesses having a lot of customers. Small businesses (often B2B focused) generally incur greater fluctuations in their customer spend, which makes LTV hard to predict.
The Size Of The Global SaaS Market
According to Gartner, the global cloud computing market (as represented through SaaS, IaaS, and PaaS and others) is set to grow by over 17 percent in 2019; totaling $214.3 billion in customer spend.
That number is supposed to increase by over 50 percent to a whopping $331.2 billion in 2022. SaaS is accounting for $143.7 billion (or 43 percent) of that expected revenue. As of 2019, SaaS is a market worth close to $95 billion.
In 2018 alone, SaaS companies have collectively raised $38.2 billion through their IPO’s. This is partly driven by a more frequent adoption of SaaS software in modern organizations. Research by Blissfully suggests that companies with more than 250 employees use over 100 SaaS products. Smaller firms (up to 50 employees) tend to use between 25 to 50 applications on average.
In the Enterprise (B2B) space, Microsoft is leading the race in regards to customer spend. They are followed by Salesforce, Adobe, SAP and Oracle.
SaaS Marketing & Lead Generation Channels
Tomasz Tunguz, partner at early stage VC Redpoint Ventures, defines five key marketing and customer acquisition channels “great SaaS companies” utilize. These include:
- Referral Marketing. SaaS businesses can receive new customers through recommendations and referral programs. Oftentimes, existing users refer people in their immediate circle and receive some sort of compensation in return (e.g. discount codes, cash).
- Content Marketing. The SaaS business publishes text, audio, or video content within its niche. Content tends to be informative in nature, but also includes hints about the own product. HubSpot, for instance, heavily utilizes content marketing through its famous HubSpot blog.
- Advertising. While classic advertising (i.e. TV or billboards) might not be the most efficient marketing channels for SaaS businesses, they certainly can and should leverage modern day solutions. Depending on your niche, potential channels can include YouTube, Facebook, LinkedIn, Reddit or Google ads. Check out this Grammarly ad for an example!
- Events. Event marketing, whether as part of a bigger event or organized by yourself, can allow you to get in contact with new customers, show off the product and spread the brand message. For instance, Salesforce hosts an annual conference called Dreamforce, which attracted over 170,000 people in 2019. For an exclusive list of SaaS events and conferences, check out this blog post.
- Channels. Some SaaS providers offer their software through different channels such as the Google PlayStore or Apple’s AppStore. While your business operates at Apple’s and Google’s mercy, there are certain tactics you can use to positively affect your rankings. Examples include appropriate and concise descriptions, explanatory product images and videos, and localized country versions of your app.
SaaS businesses can furthermore utilize freemium as part of their customer acquisition strategy. Two types of approaches exist:
- Limited Product Trial. Users get access to a limited set of features or functionality without an expiration date. One example is Dropbox’s free trial, which allows customers to use all the features of the platform. Limitation occurs through a maximum upload volume (in this case 1GB).
- Timed Product Trial. Customers are given full access to the platform for a limited time. This can vary between one week to one month. For an in-depth analysis of the best trial length, check out Lincoln Murphy’s blog post.