SAAS Business Model – What is SAAS & how it works?

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saas business model

Details & Examples of SAAS Business Model

Know the insights of SAAS Business Model

SAAS stands for Software-as-a-Service i.e. software is sold to its users not as a product but as a service. Let’s understand what it means.

How SAAS (Software as a Service) Works?

Suppose a company is in need of software for meeting its operational requirements.  The company identifies two types of vendors who supply the software.

The first one sells the software to the company as a license that needs to be hosted by the company itself (on the company’s machine/system) and charges X amount of money upfront. This vendor is selling software as a product.

While the second one, instead of selling as a license, provides access to the software over the internet. The software is hosted on a server and any file created by the users is stored in the cloud which can be accessed anytime by the user. The vendor charges Y amount on a time-bound basis (monthly or yearly subscription). This vendor is providing a SAAS based solution or software as a service to the company.

Image Source: droitthemes.com

When the company compares X with Y, it turns out that Y is way smaller than X.  The owners of the company decide to make a comparison between the two options:

Thus, any vendor or company that provides (leases) its software through a cloud-based system is a SAAS company.

Under a cloud-based system, services related to storage, servers, networking, database, analytics, etc. are provided and the companies charge a fee for providing these services to its customers.

From the above comparative chart, it’s clear that SAAS provides a number of benefits to its customers and overcomes the limitations of the Software as a Product. 

Benefits of SAAS can be put below:

  • Customers don’t have to maintain the servers to use the software.
  • No upfront expenditure for purchasing the license
  • Eliminates the need for any IT infrastructure on the customer’s end. The only requirement is an internet connection.
  • SAAS lets the customers use the updated version of the software without the need to download the updates. Software Updation is the responsibility of the service provider or developer.
  • Apart from customers, it also benefits the SAAS providers. Since everything is hosted on the cloud, SAAS business model is highly scalable. Service providers can offer their services all across the world without geographical limitations.

Metrics in SAAS Business Model

SAAS business model is a bit complex model due to the involvement of many key metrics that a startup or a company needs to take care of.

These key metrics are the indicators of success of the business. Let’s understand each metric one by one:

Churn Rate

Churn rate indicates the number of customers that left or unsubscribed the service in a particular period. Ideally, businesses wish to have a zero churn rate but practically it does not happen. The needs of the customers evolve over time, so do the products. Hence the users leave one company and switch to another for the better services they receive.

The churn rate tells the satisfaction level of the users. A constant increase in the churn rate is harmful to any business.

Mathematically,

Customer Acquisition Cost (CAC)

CAC is the total cost of acquiring one customer. Following is the formula for calculating CAC.

Customer Life Time Value (CLTV)

It indicates the total revenue a business can expect to earn from a single customer during the period he/she is subscribed to the service. The longer the customer continues to buy from the company, the greater the lifetime value becomes.

Businesses use this metric for identifying their most valuable customer segments. To calculate CLTV, you may follow the following steps as suggested by Hubspot:

  • Calculate the average purchase value (APV)

APV = Total Revenue in a given period/ Total number of orders in that period

Here the average purchase value is calculated for each customer and then averaged out based on the number of customers surveyed. For example, if you as a customer place order at a shop 5 times and spends $100 in total, your APV is $20.

  • Calculate Average purchase frequency rate (APFR)

APFR = Number of purchases/ number of customers

It indicates the number of purchases from each customer in a given period.

  • Calculate the customer value (CV)

CV = APV x APFR

It indicates the amount of revenue earned from each customer in a given period.

  • Calculate the average customer’s lifespan (ACL)

ACL = Sum of customer life spans/ Number of customers

It indicates the amount of time for which each customer used your service.

  • Calculate the customer’s lifetime value (CLTV)

Monthly Recurring revenue (MRR)

It is the amount of expected revenue of the business per month. Using this, businesses predict the revenue that they expect to earn each month.

Understanding the Economics

We already know that the SAAS business model unlike SAAP (Software as a Product) is a subscription-based business model where the revenue is not generated in one go by selling a product but comes over a period of time.

However, the SAAS providers have to incur expenses from day one. Expenses are in the form of:

  • Cost of software development (including the cost of hiring designers and developers)
  • Cost of Sales & Marketing
  • Cost to maintain data storage capabilities, security, maintenance, etc.
  • Costs of Research & Development

Cash Flow Perspective:

Image Source: Slideshare

From the image above, it’s clear that in a SAAS based model; CAC is quite high as compared to the revenue that comes on a monthly basis from the subscription fee. The image above shows the case of a single customer.

Image Source: slideshare

CAC increases with the acquired number of customers (see the image above) and results in negative cash flow. After a few initial months, the subscription payments take over the CAC and the cash flow becomes positive.

Unit Economics Perspective:

SAAS business model is viable when the cost of acquiring a customer (CAC) is less than the customer’s lifetime value (CLTV) i.e.

CAC   <   CLTV

As customers start to leave, the churn rate increases. This reduces the lifetime Value of the customer (CLTV).  With a very high churn rate, CLTV may fall below CAC making the business model unviable.

To avoid this, companies that operate on the SAAS business model try new ways to increase revenue collection from the existing customers and find methods to attract more customers & retain existing ones.

The following sales funnel adopted by SAAS businesses is shown below:

Callstartup

Over time, up-selling and cross-selling help to increase revenue per customer which ultimately leads to a negative churn.

Negative churn means that the additional spending of your existing customers on the new services, add-ons, and upgrades that you provide exceeds the revenue lost due to cancellation or downgrading by current customers.

Types of SAAS services

Following are few of the popular types of SAAS services:

  • Enterprise Resource Planning (ERP)
  • Customer Resource Management (CRM)
  • Accounting and Invoicing
  • E-Commerce  & Web Hosting
  • Data Management
  • Project Management
  • Human Resources

Examples of SAAS Business Model

Zoom

Zoom provides a cloud-based video conferencing services to its customers. It works on a freemium model and offers 4 subscription plans to its customers; one of them being a free plan. You may read our article on Zoom Business Model to get more insights.

Amazon Web Service

AWS is another example of the SAAS business model that provides cloud-based services to its clients like analytics, cost management, etc.


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