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Software as a Service (SaaS): Business Model Pros & Cons
By Ian Drogin
For those seeking to build a valuable online business, the SaaS business model has many advantages. However, there are also some key shortcomings that you should be aware of before getting started.
There can be many ups and downs along the path to owning a successful SaaS business. As such, some business owners choose to skip the startup grind and acquire a business that’s already profitable. Others, choose to fight it out and build a business from the ground up.
Whatever route you choose, it’s important to fully understand what you’re getting yourself into. This article will provide a detailed overview of the SaaS business model, which includes both its strengths and weaknesses.
SaaS Business Model Explained
First of all, what is SaaS?
SaaS stands for Software as a Service. A SaaS business is one that owns centrally hosted software which it licenses to customers. In other words, a SaaS business earns revenue by allowing customers to use its software.
Needless to say, there are numerous parts to an efficiently run SaaS business. Most SaaS companies engage in the following activities.
- Product development
- Marketing and Sales
- Testing and Iteration
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Like most companies, SaaS businesses rely heavily on the quality of their product. During the early product development stages, SaaS founders are intently focused on building a winning product.
Often, SaaS owners draw on their own experience as well as market research to craft a well-positioned software product. In addition to meeting functional requirements, they also need to ensure that it’s reasonably easy to use and has a robust user experience. In many cases, they’ll need to develop a variety of features to serve different segments of the market.
Marketing and Sales
In addition to developing a winning product, SaaS founders must also establish cost-effective methods of attracting customers. Paid advertising, content marketing, and influencer marketing are a few of the methods that SaaS owners employ.
Unlike many other business models, SaaS companies often don’t break even on a sale until several months after a new customer has been acquired. The exact breakeven point is highly variable between SaaS businesses.
“In addition to developing a winning product, SaaS founders must also establish cost-effective methods of attracting customers.”
In many cases, SaaS businesses employ salespeople to land customers and generate recurring revenue. Often, SaaS companies have both monthly recurring revenue and annual recurring revenue as part of their business model canvas.
Testing and Iteration
Most SaaS business owners don’t develop a perfect product on their first try. Rather, they narrow in on perfection through a constant process of testing and iteration.
In some cases, a SaaS application might offer a superior user interface but is lacking when it comes to core functionality. In other cases, a low touch SaaS business may underestimate its customer support requirements, leading to disappointed customers. Over time, smart SaaS founders identify areas of weakness and come up with improvement solutions.
As improvements take place, SaaS businesses are required to make updates to their software.
What Makes the SaaS Business Model Unique?
SaaS businesses offer several unique qualities compared to most other business models. Some of these are advantages, while others present challenges.
While the following collection of qualities is generally most common among SaaS companies, they are not exclusive to SaaS. In other words, some of these characteristics can also be found in certain other business models.
- Digital products
- Recurring revenue
- High capital requirements
- High valuation multiples (in some cases)
One of the most obvious unique features of a SaaS company is the fact that its products aren’t physical.
Instead of selling physical goods, SaaS companies sell software that is offered via the cloud. This allows them to avoid dealing with inventory, as well as some of the challenges involved in managing complex supply chains.
A SaaS company is generally one that operates based on a recurring revenue business model. This allows them to predictably earn revenue each and every month.
Although subscription memberships ensure that average revenue stays relatively stable each month, SaaS businesses also need to pay close attention to their churn rate. To maintain profitability, a SaaS business must always attract more new customers than it loses.
High Capital Investment Requirements
Often, SaaS businesses require significant capital in order to get off the ground. This is due in large part to high costs of development and break-even points.
Unlike businesses that sell physical products, SaaS businesses must usually invest heavily in development before they’re able to profitably generate sales. Often, it takes several months (or much longer) to identify promising selling propositions that make a SaaS product viable.
SaaS Businesses Can Sometimes Fetch High Valuation Multiples
The hard work of starting a SaaS business can really pay off if you decide to sell it in the future.
There are several reasons why selling SaaS businesses can be such a lucrative process. In addition to recurring revenue, they can often have high growth potential.
Pros of the SaaS Business Model
The SaaS business model provides enormous opportunities, as well as some disadvantages. Understanding the pros and cons of SaaS can help you determine whether or not the SaaS business model is right for you.
“The SaaS business model provides enormous opportunities, as well as some disadvantages.”
Some of the core benefits that the SaaS business model provide include:
- Recurring revenue
- High Customer Lifetime Value (CLV)
- Distributed work teams
- Ability to iterate and make updates
- Flexibility with licensing
- Business value
Every business owner loves recurring revenue! When you can predictably generate consistent revenue, it removes many of the challenges you might otherwise face.
There are several reasons why subscription revenue is important for business owners. In fact, recurring revenue is the foundation for several of the other key ‘pros’ of the SaaS business model.
With SaaS revenue, it’s much easier to predict what your finances are going to look like several months from now. As long as you know what your customer churn rate is, it’s not difficult to forecast your future revenue with a high degree of accuracy. In turn, this allows you to make informed investment decisions to fuel the growth of your company.
Additionally, recurring revenue reduces risk. Instead of relying entirely on your sales channels to sustain your revenue, you’re able to enjoy consistent income from your existing customers. Of course, sales are always going to be important, but it’s certainly nice when a substantial portion of your revenue is the result of recurrent billing.
High Customer Lifetime Value
There’s one very predictable outcome of subscription revenue: A high CLV.
If your SaaS business earns subscription revenue, it only makes sense that your revenue from each customer will add up over time. In turn, your business will have a high average CLV.
“With a high average CLV, it makes it possible for you to invest heavily in customer acquisition efforts.”
With a high average CLV, it makes it possible for you to invest heavily in customer acquisition efforts. If you know that your average customer sticks around for three years, you can accept a much higher customer acquisition cost.
Distributed Work Teams
Since SaaS companies operate via the cloud, they often don’t require a centralized work location. Instead, they can leverage technology to manage distributed work teams.
Having a remote workforce has several advantages. =
For starters, you can save enormous sums of money by not purchasing or renting a physical office space. This is especially true if you’re based in a major U.S. city where property prices are sky-high.
Additionally, when you’re hiring a remote team you’re not limited to the geographical location in which you’re based. Instead, you can hire the best talent from just about anywhere in the world. Everyone from your CFO to your virtual assistant can be spread out across the globe. Of course, many employees love being able to work from home as well.
Ability to Iterate and Make Updates
SaaS companies must constantly gather and integrate feedback into their development process. By paying close attention to what is and isn’t working, it’s possible to move ever closer to ‘perfect.’
When improvements are made, SaaS companies can easily deploy updates to their licensed users. This allows them to offer new features and resolve old issues that their SaaS app encountered..
Compare this to businesses that offer physical products. If a physical product brand rolls out production for a product that has a major design flaw, they could be in serious trouble. In some cases, an ecommerce business may end up with unsellable inventory. In extreme cases, they may need to announce a recall. This is not the case with a SaaS application.
“When improvements are made, SaaS companies can easily deploy updates to their licensed users.”
Flexibility with Licensing
As a SaaS provider, you have a lot of flexibility when it comes to licensing your software. This allows you to create multiple licensing tiers on one SaaS platform.
Having tiered pricing that corresponds with access to various features allows you to tap into different market segments. Some customers might be seeking a relatively basic SaaS solution, while others have more involved requirements. For some SaaS businesses, usage based pricing is an effective option.
As a SaaS Startup, you’re able to quickly adapt to the market and provide a variety of licensing options to satisfy your customers and maximize revenue.
The SaaS Business Model is Highly Scalable
Once you’ve built your systems and infrastructure, the SaaS business model has enormous growth potential.
During the early stages of SaaS startups, it may feel like a grind. However, once you’ve refined your processes and optimized your SaaS metrics, the world is your oyster. Since each new customer can represent a multi-year revenue stream, you’re able to continually add predictable income to your business.
“Once you’ve built your systems and infrastructure, the SaaS business model has enormous growth potential.”
Also, thanks to the power of cloud computing, you’re able to sell SaaS licenses to customers all over the world. Of course, additional steps are often necessary to sell in new markets, but the possibilities are there for you.
SaaS Business Valuation
All of the benefits mentioned above lead to one natural outcome: SaaS businesses can be extremely valuable.
It’s no surprise that investors seek businesses that are stable and have high growth potential. Above, we mentioned how SaaS businesses can check both of these boxes. With the SaaS revenue model, investors can often feel confident that a business is going to continue doing well.
Of course, the degree to which recurring SaaS revenue instills confidence is still based on several factors. For example, older SaaS businesses (mature SaaS) are going to be more valuable than those that are younger. If a SaaS business has consistently maintained a high customer retention rate for an extended period of time, investors will be impressed.
The growth potential of Saas businesses is another key element of value. Depending on the market and SaaS model, a business may enjoy promising opportunities for growth.
There are two additional elements that determine the value of a SaaS business.
If a SaaS business can easily be transferred to a new owner, it will be more valuable. Fortunately, as long as a SaaS business is well structured and doesn’t require unique skills or knowledge of the owner, transferability isn’t an issue. However, transferability can vary greatly from business to business so it’s important to speak with a qualified Advisor about specific SaaS businesses.
Similarly, documentation plays a key element in the valuation process. If your SaaS business has well-organized financials and clear Standard Operating Procedures in place, it will be worth more.
Cons of the SaaS Business Model
Although there are several attractive ‘pros’ of the SaaS business model, there are also some ‘cons.’ For some entrepreneurs, these challenges may not feel too threatening. Other owners may choose to avoid the SaaS business model due to these potential issues.
Some of the ‘cons’ of the SaaS business model include:
- Long sales funnel
- Security issues
- Complex data
- Capital requirements
Long Sales Funnel
From a customer perspective, subscribing to a new SaaS service can be a big decision. This is especially true for expensive B2B SaaS solutions that can affect a company’s entire operational systems.
Because adopting a new SaaS service can be a substantial decision for customers, many SaaS businesses have a long sales funnel.
Often, a SaaS business is required to invest significant time and attention into creating a winning customer journey. This can include a lengthy sales process involving sales reps, live product demos, team orientations, and more. These requirements can incur significant costs for SaaS companies.
“Because adopting a new SaaS service can be a substantial decision for customers, many SaaS businesses have a long sales funnel.”
SaaS businesses rely heavily on cloud computing, which means that they’re exposed to various security threats. As a software vendor, it’s important to have effective measures in place to protect the data of yourself and your customers. In unfortunate circumstances, a breach of security can result in costly losses of data.
Software companies often receive enormous amounts of data that need to be comprehensible.. From SaaS marketing to sales, to product development, SaaS businesses are constantly gathering and processing important information.
The enormity of data that SaaS businesses gather requires them to have effective data management systems in place. Without the right skill set, individuals and teams can encounter challenges.
As a SaaS founder, it’s essential that you’re well-equipped to manage large quantities of data. If you don’t possess the technical skills yourself, you may want to consider hiring someone who does.
SaaS is competitive. Since SaaS services can be easy to copy, you should count on other companies seeking to emulate your success.
As a SaaS vendor, it’s not enough to simply create a great product. That may help you get started, but it’s important to continually improve to maintain your competitive advantage. If your marketing strategy or product development falls behind, there’s a good chance you’ll start losing market share to your competitors.
You might be able to quickly design a SaaS product prototype in your living room, but scaling a SaaS business is a different story.
We’ve already mentioned that there are a lot of elements involved in building a successful SaaS company. Product development, data analytics, customer support, and a long sales funnel all incur significant costs. As such, many SaaS founders are required to seek outside investment to get their business off the ground.
Some owners may welcome the process of finding and working with investors. Others may balk at the idea of expanding the leadership team or giving up equity.
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How to Determine if the SaaS Business Model Makes Sense for You
Understanding the SaaS business model is one thing, but determining whether or not it’s right for you is another.
To decide if the SaaS business model makes sense for you, it can be helpful to ask yourself a few key questions.
- Do you have the skills required to build a SaaS business?
- Are you willing to have a longer sales cycle?
- Do you have an effective financing strategy in place?
- What are you passionate about?
Do You Have the Skillset to Build a SaaS Business?
In general, it’s a good idea to think about what you’re good at when making decisions about your work life.
Building a successful SaaS business requires advanced skills in several key areas. While you don’t need to be an expert at everything, it’s very helpful to have a solid foundation in the areas that matter most.
Not surprisingly, many SaaS founders have a strong technical background. Additionally, the leadership team should also have expertise in sales and marketing. Because SaaS businesses inevitably build teams, management and HR is another key area to be skilled in.
Are You Okay with a Longer Sales Cycle?
For some entrepreneurs, it’s important to leverage a business model that allows them to be profitable relatively quickly. If that sounds like you, it might be best to pursue a different model such as drop shipping or Amazon FBA.
On the other hand, if you’re willing to build a long and complex sales funnel, SaaS might be a good fit. In the long term, the recurring revenue model of SaaS can be worth the extra effort.
Do You Have a Financing Strategy in Place?
Since scaling a SaaS business can be capital intensive, it’s wise to have a financing strategy in place. If you have deep pockets or access to investment funding, SaaS may be a good option for you.
On the other hand, if you’re on a tight budget and want to avoid working with investors, it may be best to find a different business model to pursue.
What Are You Passionate About?
Like any business decision, it’s smart to consider where your passions lie. More than likely, you’re going to spend a lot of time building your next business. Therefore, it only makes sense to choose work that you’re passionate about.
“Like any business decision, it’s smart to consider where your passions lie.”
If you enjoy developing a strong value proposition, designing new customer journeys, and looking at SaaS metric reports, the SaaS business model may be a good choice. If all this sounds boring, you may want to try something else.
Wherever you are in your entrepreneurial journey, you’ll be better off choosing a business model that is congruent with your interests, skills, and passions. By exploring different opportunities such as SaaS, you’ll be in a solid position to make your next venture a great success.
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