Software as a Service (SaaS) is an elegant business model. Once you build the product, you can sell it to any number of customers. The only changes required are minor tweaks to the configuration. SaaS businesses work by charging a recurring fee. At each billing cycle, we need to re-earn the trust of our customers, creating a powerful alignment of interest between us and the customers we serve.
For customers, SaaS just works™. They don’t have to install anything, and paying a smaller recurring fee is a lot more palatable on the balance books. For us, SaaS has two benefits. First, having recurring revenue makes our finances predictable. Second, it cuts down development overhead, since new products can be rolled out simultaneously to all clients.
To understand the SaaS business, let’s deconstruct the levers that control it.
Financially, the objective of a business is to increase profitability, where:
Profit = Revenue — Cost
There are two ways we can increase profitability. Either we increase revenue or decrease costs.
For a SaaS business, revenue can be modeled as:
Revenue = Number of customers * Revenue/Customer
or more completely,
Revenue = Number of customers * Number of product types * Price per product type * Number of seats/customer * Retention rate
To increase revenue, we control the following levers:
There are two ways to increase the number of product types we sell to customers:
The easiest way to grow revenue is to raise the price of each product line. As long as the market is willing to pay more, growing revenue by raising prices requires no development. In an ideal world, we have perfect price inelasticity, i.e. we can raise the price without losing any customers. That will only happen when our product offers unique value that no-one else can match.
To figure out just how high we can price the product, we triangulate pricing for SaaS through a few strategies.
A non-exhaustive set of strategies to increase the number of seats:
Retention is a measure of the number of completed payment cycles. Customers churn when someone else does a significantly better job of delivering value. Competitors need to create such a compelling proposition that it persuades our customers to overcome inertia, training, and migration costs. To lose a customer means that we weren’t listening.
To ensure customers stay, SaaS businesses need a Customer Success (CS) team. The tactics used by CS to drive retention are:
The number of customers can be modeled as
Number of customers = Acquisitions * Conversion rate
The levers we have are either increasing the number of leads coming in through the gate, or increasing our success at converting them into paying customers.
While the strategies for growing the number of customers is too broad a topic to cover here, we have marketing and sales organizations that are uniquely focused on this.
Key costs in a SaaS business can broadly be identified as:
The core thesis of a SaaS business is that the costs grow roughly linearly, whereas revenue grows exponentially. To see it in action, let’s create a very simple business model:
Where revenue is:
Revenue = Number of product lines
* Avg price per product line
* Number of customers * (1 + customer growth) ^ n
* Avg # of seats/customer * (1 + upsell rate) ^ n
- Previous payment cycle revenue * Churn rate
and cost is
Cost = (Operational cost of deploy * Number of customers)
+ (Avg annual salary * (Number of engineers + New engineers/year * n))
- (Transaction fee * Gross Revenue)
While we start in the red, over a period of time we see incredibly attractive returns.
Plotting the cumulative values against each other, over time we get:
Understanding the levers at play empowers us to diagnose issues and drive outcomes. What levers have you found impactful in managing your SaaS business?