Understanding the SaaS model

Today, software-as-a-service (SaaS) is the standard business model for monetising business-to-business software. In the SaaS model, software is licensed to customers through an ongoing recurring subscription (e.g., a customer might pay $25 per month for continued access) or another form of operational monetisation (e.g., transactional fees on application usage) which also includes customer services.

Traditionally, software was sold just like any other product: as a one-off purchase (sometimes on CDs!). This usually meant software had to be run on hardware owned by the buyer and updates had to be purchased separately. SaaS subscriptions are all-inclusive: the service provider includes hosting, upgrades and customer service in the ongoing subscription fee. Customers aren’t purchasing a one-off product (i.e., a single version of a software), they are subscribing to an ongoing service which includes software.

What makes SaaS special?

On the surface this may seem simple: customers are paying for a subscription rather than a one-off purchase. But, this difference has significant implications for both the service provider and the customer.

So, what makes the SaaS business model unique?

Revenue is recurring

The power of the SaaS business model is that it gives product companies the ability to monetise their efforts on an ongoing basis. Instead of worrying about having to produce entirely new products to sell to new and past customers, SaaS companies can continue to make money from their investments in research and development for as long as their customers are getting value from the product. Meanwhile, traditional product companies have to constantly manufacture new goods to be sold.

Continuous improvement and radical focus

Because SaaS customers are paying a recurring fee to use a single product, SaaS service providers can focus on continuously improving their core products, rather than build entirely new products. This enables SaaS service providers to create exceptional products, as their investments in research and development compound over time. This also enables a very high degree of focus on improving products that are already selling well in the marketplace.

In contrast, most traditional product companies cannot rely on their existing customers to continuously and frequently purchase from them. This forces product companies to constantly expand their product offering so they can target new customers.

Retention, and therefore quality, is critical

While most of the revenue for traditional product companies comes from new sales to new customers, the majority of revenue coming into a mature SaaS company is from existing customer subscriptions. This makes retention critical. It is far cheaper to keep a customer than to sell to a new one, therefore the first priority of any SaaS company is to retain their existing customers.

This makes the quality of both the product and customer service far more critical to a SaaS company.

Lifetime value is high, so continuous growth is important

For SaaS companies, the cost to acquire a new customer, compared to the lifetime value of the average customer, is very low. This motivates SaaS companies to constantly grow and invest the majority of their capital into the acquisition of new customers.

Successful SaaS companies retain their average customer for a very long time. This makes them very valuable compared to a customer who purchases a product once, and may take a long time to upgrade (if ever).

(Effectively) Zero marginal costs

While each new SaaS customer pays the same as the last, they do not cost the same as the last — they usually cost less! This is because cloud-hosted software has fantastic economies of scale. While traditional businesses need to manufacture and entirely new product for each sale, SaaS businesses are essentially selling the same bits and bytes to multiple customers.

Imagine if, for every new sale, we had to re-code the whole product from scratch? That’s essentially how traditional manufacturing-led businesses work. Software is extremely scalable because it is effectively free to replicate and distribute.

Not only does this make SaaS companies highly profitable, it makes them much quicker to grow because the money that would usually be spent on the manufacturing of each unit can be spent on sales and marketing.

Key SaaS metrics

While all businesses conform to roughly the same accounting standards, SaaS businesses are typically managed with some unique metrics that are critical to determining the health of the business.

Below is a collection of metrics I typically keep a close eye on, though there are many more metrics relevant to operators of SaaS businesses.

Monthly Recurring Revenue (MRR)

This is the most important metric in a SaaS business. MRR is the amount of revenue you get from your customers on a monthly basis. It only includes revenue that is recurring, so excludes any professional services revenue.

Related metrics include:

• Annual Recurring Revenue → The amount of recurring revenue you get from your customers on an annual basis.
• Monthly Recurring Revenue → The amount of recurring revenue you get from your customers on a monthly basis.
• New MRR → MRR gained from new customers.
• MRR Expansion → Additional MRR gained from existing customers (i.e., plan upgrades, additional products).
• MRR Contraction → MRR lost from existing customers (i.e., downgrades and removal of products).
• MRR Churn → MRR lost due to cancelled customers.
• MRR COGS → The cost of your MRR — this is the total of your cost to support your customers and the cost of any infrastructure, hosting and licenses for your software.
• MRR Gross Margin → The profitability of your MRR. This is your MRR COGS divided by your MRR (MRR COGS / MRR).

Customer Count

Simply put, your customer count is the number of customers subscribed to your SaaS product.

Related metrics include:

• Gross New Customers → The number of new customers you signed up in any given period.
• Churned Customers → The number of customers who cancelled their subscription to your SaaS product in any given period.
• Net customer movement → The net movement of your customer count over any given period. This is your Gross New Customers less the number of Churned Customers in the same period (Gross New Customers - Churned Customers).

Average Revenue per Account/User (ARPA/ARPU)

Your Average Revenue per Account value of the average customer for any given period (usually monthly or annually). This is calculated by dividing your MRR or ARR by your Customer Count (MRR / Customer Count).

Related metrics include:

• New ARPA → The value of the average new customer. This is important for tracking whether your current sales strategy is leading to bigger or smaller deals than your current average customer.

Growth metrics

There are a number of metrics critical to modelling your growth. These include:

• Sales & Marketing Costs → Simply put, this is your total costs of sales and marketing efforts, including fixed costs like salaries, over any given period (i.e., how much are you spending on acquisition?). This is an important dependency for other metrics.
• Cost of New ARR → This tells you how efficient your sales and marketing efforts are. It is calculated by dividing your Sales & Marketing Costs by your New MRR (Sales & Marketing Costs / New MRR). For every dollar you spend on acquisition, how much MRR do you earn?
• Cost of New ARR → For every dollar you spend on acquisition, how much MRR do you earn? This tells you how efficient your sales and marketing efforts are. You calculate this by dividing your Sales & Marketing Costs by your New MRR (Sales & Marketing Costs / New MRR).
• CAC Payback Period → You use this to benchmark the long-term sustainability of the business and its sales model. It estimates the number of months it takes for the SaaS provider to recoup the cost of acquiring the average customer and is calculated by comparing your CAC (Cost to Acquire a Customer) to your ARPA (Average Revenue per Account), while factoring in your Recurring Revenue Gross Margin (CAC ÷ (ARR ARPA × ARR Gross Margin) × 12).

Research and Development metrics

There are a number of metrics critical to modelling your investment in product development. These include:

• R&D Spend → Simply put, this is your total costs of product development. This is primarily the cost of your development team as well as any licenses/tools related to the development of product.
• R&D:MRR Ratio → This metric tells you how much you spend on R&D in comparison to your MRR and is a useful for benchmarking R&D spend against other SaaS businesses. It is calculated by dividing your R&D Spend by your MRR (R&D Spend / MRR). Mature SaaS companies typically aim for an R&D:MRR ratio of around 30%.