How Does A SaaS Business Model Work? A Detailed Explanation

Ever since the Software as a Service (SaaS) industry broke into the scene in the 2000s, it has experienced unprecedented growth as organizations worldwide continue adopting SaaS solutions for various business functions — HR, finance, marketing, or operations.

Research shows that the SaaS market is predicted to be worth approximately $172 billion in 2022, a staggering jump from $31.4 billion in 2015. Among the countries, the USA is expected to experience the largest increase in SaaS market share by 2025.

Defining the SaaS business model

Simply defined as delivering software over the internet, SaaS allows end-users to connect and use cloud-based solutions — as a service through desktops, mobile apps, and web interfaces — without the installation hassle. 

Common examples of SaaS include MailChimp (email), Skype (communication), Shopify (eCommerce), Salesforce (CRM), and Dropbox (file hosting). SaaS companies offer their products to customers based on a pay-as-you-go model or monthly/annual subscription.

Perhaps the biggest reason SaaS has become popular is that it saves customers from investing in other on-premise solutions upfront, which is a massive commitment. They can use a SaaS product instead — for as long as possible — at a much more reasonable cost and end the contract whenever they feel like it.

On the other hand, SaaS companies are responsible for continuously developing the software and running it on their infrastructure. They maintain servers, software, and databases, enabling the product to be available for use over the internet. 

Primary growth stages of a SaaS business

Starting, growing, and expanding a SaaS company is not easy. You face many challenges on a daily basis. But you can break down these problems into smaller, solvable pieces with the right knowledge. Here is a top-level view of what a life cycle typically looks like for SaaS companies:

1. Pre-startup

The beginning of every SaaS business starts with researching to determine the problem you want to solve and how your SaaS product can provide the solution. Think of it as a “problem-solution fit” phase where you speak to potential customers, establish business relationships, seek and secure financial backing, and produce a minimum viable product (MVP).

2. Startup

This is a “product-market fit” stage where your SaaS product offers a viable solution to the problem you first set out to solve. Channelize all your efforts to make key hires, identify and secure your first 100 customers, and refine the product and its core features.

3. Process and efficiency improvement

This stage aims to establish SaaS brand credibility by building a loyal user base by polishing your user onboarding and experience. Other critical tasks to be undertaken include:

• Identifying repeatable sales processes
• Optimizing the customer life cycle funnel
• Finding new channels to scale user acquisition

Keep a check on what you have accomplished so far. However, focus on keeping up with market changes so you can ensure stability and profitability for years to come.

4. Growth and scaling

During the growth stage of a SaaS business, you typically have a SaaS product and market fit that delivers results — in terms of high traffic and conversions. Use the stability that the phase offers you to raise additional funds to support scaling and customer acquisition. You might even have to deal with competitors who copied your business model. Pivot!

5. Maturity

Once you reach the maturity stage, your SaaS company’s growth will slow down but should not stop altogether. In this phase, your customers understand what you offer, and they know how it solves their problems.

Consider adding new products or services. Use the opportunity to invest in experimentation to secure additional growth. Think about holding an initial public offering (IPO). Do not lose your competitive edge.

What makes the SaaS business model unique?

Perhaps the fact you are not just selling a product but a full-blown service and that your customers are not a one-and-done affair is what makes a typical SaaS business model unique. 

In a nutshell, even if someone becomes your customer for the foreseeable future, you still have to continually improve your product and optimize how you market it and approach customer service. Mentioned below are three traits that set a SaaS business apart:

1. Greater focus on customer retention

It is user retention and not acquisition that forms the core of SaaS. The ultimate goal of your SaaS business is to keep customers around for the long haul. That means your product must go beyond meeting an initial customer pain point and become an integral part of life.

Think of SaaS platforms such as Gmail, Zoom, or Trello. These are a few tools one cannot do without despite there being any shortage of alternatives. Offering impeccable customer service can make all the difference in the world!

Periodically touching base with customers, collecting feedback, and taking action based on suggestions or complaints is vital. Offering self-help channels and speedy social support can make a massive difference to your customer base.

2. Constant acquisition of new customers

It costs five times more to attract a new customer than to retain an existing one. The foundation of the SaaS business model is based on this concept. However, this does not mean you stop acquiring new customers.

Let us say you have hit a milestone of 10,000 users. At this point, what is going to be your next point? Acquiring the next 10,000 users, right? If you want your Saas business to be successful in the long run, you have to keep introducing new users to the funnel.

Your business depends on a constant influx of new users. You also need to understand that many SaaS companies operate on a free or freemium pricing model. That means not every user will be a paying one or even convert.

Moreover, some of your customers may stop using your service on a monthly basis, whether it is due to their budgets or because they switched to a competing product on the market. That is why you always have to think about acquiring new users.

3. Reliance on data for decision-making

Businesses of all shapes and sizes should have their pulse on KPIs and metrics. SaaS is no exception. The only difference is you have the chance to keep a closer eye on your customers’ behavior because of the subscription model compared to in the case of a one-off transaction. There are many SaaS metrics you must monitor:

• Monthly Recurring Revenue or MRR to check how much revenue your business generates every month.
• Average Revenue Per User or ARPU to check revenue generation per active customer.
• Churn to understand the rate at which people stop using your service.

With the help of tools such as Baremetrics, you can keep track of such metrics, identify trends and improvise your areas of concern.

Pros of the SaaS business model

Choosing SaaS has become a no-brainer for businesses and end-users as the tech wheels turn. The traditional on-premise software model is quickly becoming a thing of the past. So, what advantages does SaaS bring to the table? Let us have a look:

• As SaaS is hosted on the cloud, updates need to be rolled out from the provider’s end. End-users do not need to worry about that!
• SaaS enables the use of varied marketing strategies that are low-cost and effective, including affiliate marketing and social media promotions.
• The business model reduces customer fiction because what your end-users pay is what they get. There is greater transparency.
• SaaS platforms can be made scalable to handle high-volume data transactions and increased swells of activity such as month-end closures and payroll processing.
• The SaaS subscription model is more accommodating to the customer’s needs and offers adaptability that traditional software platforms cannot provide. The flexibility fosters customer loyalty and stickiness.

Cons of the SaaS business model

Although there are several attractive pros of SaaS, you need to consider its apparent downsides.

• The road to turning free or freemium end-users into paying customers involves a longer sales cycle that could span months or even years. A lot of money first needs to be spent upfront before you can even think about moving towards making profits.
• It is easy for competitors to copy your successful SaaS business model, thus bringing down your USP. Plus, if your customer is dissatisfied with your product, they can easily move on with a competitor.
• Business and marketing analytics for the SaaS model is complicated because the data is sourced from multiple directions.

Different types of SaaS business models

By now, it is clear that having actionable plans to drive growth is a must. Your customers are not simply going to appear out of the blue, and you need to bolster your marketing and sales efforts to reach your intended audience in creative ways proactively.

However, picking the right customer acquisition strategy in such a crowded market is a challenge, but it is not something you cannot overcome. Sure, free trials can help spark interest, but they are not enough to push the customer to become a paying one.

Here are four of the various SaaS business model growth strategies that will help you improve your sales process, acquire more users consistently and build a stronger brand:

1. Low-touch SaaS

Companies following this model rely on sending the potential customer to check out their SaaS website content. In such a scenario, they would be enticed with a free trial. The goal is then to have the free trial user love your product so much that they decide to purchase a subscription.

Email marketing platform Mailchimp attracts many users through inbound and outreach marketing initiatives. They offer a free version so people can try the software once before finally upgrading to the paid version.

2. Freemiums

Speaking of “trial before use,” the freemium model gives customers access to a limited version of a product indefinitely. However, they have to upgrade and pay to go beyond the restrictions. This option offers a quick way to generate revenue.

It delivers a conversion rate between 8% and 10% for SaaS, compared to a meager 1%-2% for eCommerce stores. You see, everyone loves a good discount.

However, if you have the liberty to use specific features of an application for free for an unlimited period, you will bank on the opportunity. For instance, Canva follows the freemium model and allows its users to leverage a significant chunk of its features for free.

The “try-before-you-buy” option lets you get a handle on the product before making the call to upgrade or pay for it. The freemium model eliminates the need to take a leap of faith. 

Trello, a project management tool, takes a slightly different approach to offering a freemium service to its customers. Rather than limiting the number of times you can use the platform, Trello restricts the number of apps you can integrate it with.

Free Trello users enjoy almost total access. But if third-party integrations are necessary for them to do their job, they have to upgrade to the premium version.

3. High-touch SaaS

Companies following this model do everything the opposite way. Instead of sending the potential customer to the website to explore on their own, they rely on making direct sales to more prominent end-users (e.g., enterprises) that want to and can spend a lot of money on the software.

These enterprises could use your product to manage a process or function or offer the software to an existing user base, i.e., their employees. Since high-touch SaaS companies deal with enterprise-level SaaS customers, their specific requirements must be met.

More resources are put towards building customer relationships in high-touch SaaS. It also means customer support has to be more personal, and the team’s job evolves into managing the account.

4. Customer referrals

Capitalizing on user success stories through marketing, speaking events, and referrals is a smart way to grow your SaaS business authentically.

Referrals, especially, can result in better conversations with prospects or even help the sales team break into accounts that have been historically a hard sell.

Research shows that customers acquired via referrals have a 37% higher retention rate and 18% lower churn than those customers acquired through other means. Dropbox is a fantastic example in this context. Their concept was simple.

Since the SaaS company offered storage space in the cloud, they rewarded customers with more free space if they referred other people. The condition for availing more storage space was that those referred to should accept the invitation and create an account on Dropbox.

Dropbox also marketed the referral scheme in creative ways. It integrated the program in the final step of the onboarding process. New customers had a clear view of the rewards and benefits. Instead of saying “Invite your friends,” Dropbox attracted attention with this phrase instead “Get more space.” Moreover, the invitation process was easy.

Customers could do so via social media sharing or just share their unique referral link in their circle – via email, SMS, or messenger apps! Dropbox grew 3900% via referrals in 15 months.

Key SaaS business metrics to track

SaaS companies are powered by data, and how well you track, optimize and leverage critical metrics that define the success of your business. Here are the top five metrics most valued in a SaaS business model:

1. Customer Acquisition Cost (CAC)

The total cost of marketing and sales initiatives is needed to acquire a customer.

Being too conservative about how much you can openly spend on CAC can result in missed opportunities for revenue from new customers.

On the other hand, being too reckless can cause critically low profitability.

Organic marketing channels like SEO enables free inbound marketing for your brand.

Finding an experienced SaaS SEO agency is a good start towards developing a robust SEO strategy and executing it to attain pocket-friendly CAC.

2. Lifetime Value (LTV)

It is the total amount a customer may spend on your product or service throughout the course of their association with you.

This is a crucial metric for any SaaS business because it gives you a precise understanding of how much revenue existing customers bring in every month.

LTV can help you move from transaction-based thinking to focusing on the long-term value of repeat business.

3. Churn rate

It is the rate at which your customers stop doing business with your SaaS company over a period. It may also apply to the number of subscribers who renew or cancel a subscription.

Breaking down your churn into segments will reveal the different reasons behind customers leaving you. In addition, failing to account for trial users or seasonal customers accurately can negatively impact the entire picture.

4. Monthly Recurring Revenue (MRR) and Annual Recurring Revenue (ARR)

These metrics are the lifeblood of a SaaS business. Both measure the total amount of revenue that you can expect to make every month or year.

Research shows that one in five SaaS companies do not report expenses properly when accounting for MRR, and a majority cannot rightfully differentiate between monthly, quarterly, and annual payments.

Monitoring the two metrics properly helps monitor the status of your company and plays a vital role in plotting your growth trajectory.

5. Retention rate

It measures how successful a SaaS company is at acquiring new customers and retaining them. The retention rate is on the opposite side of the churn rate. Keeping the former high is just as important as keeping churn low.

SaaS business: Challenges vendors may face

In an economy where competition is rife and SaaS companies, both big and small, face roadblocks in the marketplace and struggle to gain legroom. Before you decide to start working on or pivoting your SaaS business model, be aware of the following challenges:

1. You are catering to unique customer needs.

SaaS development involves building a generic solution for a variety of customer types. However, this does not mean you unnecessarily create special features upon every user request and load your application with one too many features.

If you get distracted easily, you may lose the sense of what your target audience precisely needs and become incapable of solving their existing platforms with your SaaS solution.

2. You cannot unsee your hyper-growth stage problems.

Managing all the processes during the growth stage can be a massive headache! Many SaaS businesses give up on this phase as they cannot handle the rapid rise in responsibilities, workforce, and customers.

Plus, it can be hard to manage the costs needed to acquire new customers while striving to deliver the best possible service to the existing ones. You must, therefore, have a well-thought-out plan to expand your business without compromising on quality organically.

3. You have to take data security seriously.

SaaS products are not immune to malicious cyber attacks and data loss. Protecting customer information has to be a top priority for SaaS businesses.

To avoid data leaks and other issues, track the best security testing practices and use robust programs to protect your customers’ data.

Build your thought leadership

A thought leadership strategy involves applying an organization’s best thinking to bolster brand equity, create customer relationships, and create new opportunities for sales and partnerships. Regardless of your industry niche, you must try to become an “expert” in that space.

If your company blog offers value to your end-user outside of your SaaS product, that credibility will spread. For instance, an employee engagement platform, Lattice has built a free community of more than 10K HR leaders.

These leaders use the space for exchanging content and ideas on what to write about in their company blogs or share on their podcasts. There is no talk of Lattice or what benefits it can provide. Having such a community online makes the SaaS product more in sync with what the intended audience feels interested in.

Over to you

SaaS as a business model indeed appeals to a large volume of entrepreneurs as today, almost anyone with basic industry knowledge or skill can contribute to building a SaaS company. Plus, more and more customers are preferring no-long-term commitment subscriptions.

However, despite the model being popular, 92% of SaaS startups fail within the first three years due to a lack of product-market fit and cash flow problems.

Even if a software company grows at 60% year on year, its chances of becoming a multi-billion-dollar enterprise are no better than a coin flip.

Coupled with the fierce competition and market demand, you must pay attention to the SaaS industry dynamic and provide solutions of value to your customers.

Keep analyzing software usage internally, conducting customer surveys, and making changes to accommodate what your target user base requires.

Image Sources – Statista.com, Chargify, Trello, Viral Loops

Author

Pratik Dholakiya

Pratik Dholakiya is the Founder of Growfusely, a SaaS content marketing agency specializing in content and data-driven SEO.