How Do SaaS Companies Work?

Of all the tech companies that have been popular over the last decade, SaaS (Software as a Service) companies are arguably the most popular in the last few years.

Now, you can see, all around, different kinds of SaaS companies for many different use cases. Some are as small as an auto-DM product, and others go all the way to enterprise level.

With so much proliferation of SaaS, there are some misconceptions that have started to appear. In this article, we will explore how SaaS companies operate and clear misconceptions about their most important areas.

How to Start Building SaaS Companies

The most important part of this stage is to first identify a specific group of people (target audience) and understand what problems or pain points they have.

You want to start by solving the problem with your existing knowledge and skills before you get into building any fancy software.

The most common advice here is to start with yourself as a representation of your target audience. If you have found ways to solve your own problems, chances are other people like you still have them and would benefit from what you discovered.

Once you have identified a specific problem and a solution for it on a small scale. It's time to find others like you to see if your solution works for them as well.

Notice that, so far, we haven’t talked about any SaaS development, software, tech stack, or anything like that. And there’s a reason for it.

You don’t need to know about code or have a development team to build a successful SaaS.

Very counterintuitive, I know.

You might be thinking, “It’s called software as a service and you’re saying that you don’t need to build software? Wut?“

Yes, but hear me out.

You don’t need to reinvent the wheel first of all. You can use software that exists out there and test out your solution with more people.

For example, if your SaaS idea is a system that lets people auto-schedule posts for social media, you can use a free version of existing services that work for one platform and aggregate several of them to get the end result for the user.

The main point here is to make sure your solution is something that people want and are willing to pay for, even if it’s a bunch of different services that you pieced together.

There’s nothing worse than coming up with a great software product, super polished, and with the latest technologies if it doesn’t solve a need and very few people, if any, want to pay for it.

Once you have a proven solution for a problem that has people willing to pay for it, you can even build it using no-code tools and have users finance the costs of building and maintaining the product with their money.

How do SaaS Companies make money?

Now, the next important step after the building phase is getting paying users.

SaaS companies can employ various monetization strategies to generate revenue.

The most common approach is subscription-based pricing. This is where the users pay a monthly (or yearly) fee to access and use the SaaS platform.

It is the most common strategy because it gives you a predictable income stream, you can look forward to having that amount every month (as long as the users don’t leave).

But there are also other options available.

For instance, you can provide different “service tiers” ranging from basic to enterprise. With this model, every tier has more features, more capacity, or more speed. And every tier has a different price with the initial one being the most affordable and the bigger one the most expensive.

You can also have an enterprise-level tier which would have a particular price tailored to the company that makes use of the services.

Depending on your SaaS, you can have a usage-based model or a token/credit model. In this case, there would not be a subscription but rather users would pay for their use of the platform within a period of time (e.g. monthly, quarterly, yearly)

Another strategy is the use of “lifetime deals'' (LTD). It’s best to use this at the time of the launch of the platform or when a major update to the platform is released.

Used properly, this strategy can net you a great amount of money from the start that you can use for improving the product, acquiring new users, or increasing marketing efforts.

You can even use a combination of all the previous strategies, mixing and matching to find the proper combo that will be the most profitable for your SaaS.

How are SaaS companies valued?

Once you have a SaaS up and running with paying users, you want to look into how it is valued. Whether you’re aiming for a potential exit or a merger with another company in your current niche, knowing the value of your SaaS is important.

Traditional valuation methods for tech companies don’t apply well to SaaS companies because there are many different factors that don’t apply.

For instance, a SaaS company doesn’t usually have a headcount, it’s just the founder (or founders) working on it. There are no offices or tangible assets and no divisions or departments.

And so, for SaaS companies, there are other metrics that are important for investors and potential buyers.

For starters, the recurring revenue is measured in MRR or ARR (monthly or annually), and future revenue projections.

However, even though it is important, it’s not only about revenue. There are 2 other metrics that are equally important (if not more).

The first one is SDE (Seller’s Discretionary Earnings). These are all the expenses specific to the previous owner that can go back to the total profit amount.

Say, for example, a SaaS company owner makes $120,000 a year in profit. This is after the owner took a cut of $30,000 to use as salary. In this case, a new owner needs to know that he/she has $150,000 in total profit to work with.

The other metric to look at is EBITDA. A long acronym that means earnings before interest, taxes, depreciation, and amortization.

When using this metric for valuation, instead of the owner’s salary, what’s added back into the total are the interest, taxes, depreciation, and amortization.

This is done for the same reasons as the SDE calculation. Giving potential buyers and investors a more complete picture of how the SaaS company is doing financially.

How to sell a SaaS company

One of the logical next steps for many people after knowing how much the SaaS is valued is to think about selling it.

Since SaaS is not a traditional tech company, other factors apply as well. We don’t need to talk about initial public offerings (IPOs), private equity, or reporting to stakeholders.

Things that do happen, however, are mergers and acquisitions. This all depends on the size of the SaaS companies we are talking about. The situation of a SaaS that makes $2k MRR is much different than the one of a SaaS at the $20k MRR (and it’s not only about money).

A great example of a merger in the SaaS world is one from a few years back with the fusion of ConversionAI built by Dave Rogenmoser and Headline built by Danny Postma.

In a situation like this, the founders do their due diligence and negotiate the terms of the deal. Once they reach an agreement, the 2 SaaS companies join forces and become 1 for the public.

The other case is an acquisition, where one person sells their SaaS to another person who from that point on becomes the operator and proprietor of the company.

Acquisitions are much easier to carry forward nowadays than they were before. All that risk associated with selling your assets to a person that you don’t know and can potentially scam you of your hard work is now neutralized with intermediary platforms.

In these platforms, there’s a “trusted third party” that ensures that both parties receive what they expect in a fair agreement.

Examples of these third-party platforms are Acquire and Microns. They are also called “Startups Marketplaces”. The places where you go to buy or sell a startup.

They work with different kinds and sizes of SaaS companies. Acquire now handles bigger and more reputed SaaS, while Microns focus more on the niche of so-called “micro-saas”.

You can list your SaaS there, get offers within a few days, and fully sell it in a week or two. The process is much more streamlined in comparison to the DIY approach.

You can also buy a SaaS that has a good base and some traction for which the original founder doesn’t have either the time, money, or expertise to grow further. And you can come along with your own resources to keep it going and turn a profit in the following months.

You have the flexibility to either build a SaaS from scratch and then sell it for a higher price or buy an existing one and then grow it by multiples of its initial revenue. Plus, in many different countries, SaaS income is tax deductible so you can repeat this process more than once if you choose.

Conclusion

There you have it. Besides the technical aspect of how a SaaS can be built, there are other, arguably more important, aspects that will determine whether it has the chance to be a success or a total flop.

It’s important to remember that SaaS companies are only as useful as the value they provide and the problems they solve for other people. Because without people with a need, there are no paying customers, and without those, there is no actual business.

Creating and putting a SaaS out there in the market is not only for developers or indie hackers. They can also be a great bet for other types of profiles that are non-technical and have an entrepreneurial spirit.

Having one (or more) of these SaaS companies is a great way to use the internet to create leverage. And what’s more?  You don’t have to trade time for money in a traditional job.

I hope this has been useful and informative.

Thanks for reading!

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