The Power of the SaaS Business Model

February 1, 2018 • #

We’re about to head to SaaStr Annual again this year, an annual gathering of companies all focused on the same challenges of how to build and grow SaaS businesses. I’ve had some thoughts on SaaS business models that I wanted write down as they’ve matured over the years of building a SaaS product.

I wrote a post a while back on subscription models, but in the context of consumer applications. My favorite thing about the subscription structure is how well it aligns incentives for both buyers and sellers. While this alignment applies to app developers and buyers in consumer software, I think the incentives are even more substantial with business applications, and they’re more important long term. The issue of ongoing support and maintenance with a high-investment business application is more pronounced — if Salesforce is down, my sales team’s time is wasted and I’m losing money. Whereas if I can’t get support for my personal text editor application that’s $5/mo, the same criticality isn’t there. Support and updates are just a small (and obvious) reason why the ongoing subscription model is better for product makers, and in turn, buyers. But let’s dig in some more. What’s better about the SaaS model?

First: subscription pricing significantly reduces the “getting started” barrier for buyers and sellers. If I go from charging you $1,000 up front for a powerful CAD application to a monthly subscription model for $79/mo, you and I both win. You like it because you’re comfortable paying that first $79 with no touch to get started, just subscribing online; no friction there. I like it because I don’t have to front-load investment in convincing you of the value. This potentially expands my customer count and gets past the initial transaction quickly.

Second: there’s predictability on the spending and earning side. If you’re a buyer of fixed cost products, you have to predict ahead of time what next year’s cost might be for the 2019 version, decide whether or not you need to include it in your budget, and have to forecast possible expansion use far in advance. With SaaS you can limit all three of those problems1. As the seller, I get to enjoy the magic of recurring revenue (or in the lingo, MRR – monthly recurring revenue).

Third: pricing is easier2. In an older “box software” model, I would have to figure out the appropriate “lifetime value” my product has on the day I sell it, and balance this with what price the market will bear. Once it’s sold, there’s no space for experimentation to map price to value, the deal’s done. SaaS can be fluid here, giving me space to fit the ongoing delivery of value to the price. Of course I don’t want to be changing pricing every month, but it’s within my control to keep the pricing at an effective and sustainable level. When setting pricing, I can break it down to a smaller unit of time, as in “what value does this have to my customer over a month or quarter?”, without trying to predict how long they’ll be my customer. That’s called CLTV (customer lifetime value) and it’s a key metric to track after signing on customers. After a year or so, I have CLTV data I can use to inform pricing. Managing CLTV versus CAC (customer acquisition cost) relationship is part of the SaaS pathfinding to a repeatable business3.

So what are the downsides? I don’t think there are any true negatives for anyone. For the seller, the major downside is that you have to keep earning the money for your product month over month, year over year. And I’d say buyers would actually call that a major upside! There’s no opportunity to sell a lemon to the customer and take home the reward — if your product doesn’t live up to the promise, you might only collect 1/12th of what you spent to get the customer in the first place (see CAC v LTV!). That’s no good. In SaaS you have to keep delivering and growing value if you want to keep that middle R in “MRR” alive. I call this a “downside” for sellers insofar as it creates a new business challenge to overcome. Selling your product this way actually has huge long-term benefits to your product and company health. It prevents you from taking shortcuts for easy money.

This is the greatest thing about the SaaS model: keeping everyone honest. It allows the best products to float to the top of the market. To compete and grow as a SaaS product, you have to keep up with the competition, track ever-growing customer expectations, release new capabilities, maintain stability, and continually harden your security. Buyers are kept honest by their spend; they have to keep buying if they want the backup of ongoing support, updates, new features, solid security, and more.

One thing I’ve seen with a SaaS business is the perception from buyers that the recurring costs will incur a higher total lifetime cost for a solution. So in the case above, if my CAD software is a subscription seat for $79/mo per license, customers will immediately compare it to the old model — “it was $1,000 one time fee, now it’s $79 each month. After a year I’ll be paying more than the one-time cost. The product is core to my business, so I’ll definitely be using it longer than a year.”

While this is true when strictly comparing costs, it doesn’t tell the whole story. In the early days testing a new product, it’s hard to see where the invisible costs will be. How much support will I need? Are there going to be bugs that need patching? What if I need to call someone to troubleshoot major issues? What’ll my internal IT costs be to roll out updates? The SaaS advantage is that (in general) there are good answers to these questions; ongoing support and improvements are part of the monthly tab. Another thing you run into, though less and less these days, is the compulsion to build the capability internally. The perception of high lifetime cost compels technical buyers to spend that money on their internal IT department rolling their own software to solve the problem. Not that this solution never makes sense, but most buyers are not software companies at the core. They’ll never build a great solution to their problem and be willing to commit to the maintenance investment to keep pace with what SaaS providers are doing. Over time as the SaaS model spreads, buyers will get more comfortable with the process and better understand where their SaaS spend is going.

These two posts from Ben Thompson give a great rundown of companies switching to SaaS, and why subscription business models are better for incentives.

  1. There’ll always be exceptions here, even in SaaS. But you can at least put most of your customers in a consistent bucket. 

  2. Of course a SaaS product could change their pricing along the way, too. But at least the individual purchasing events are more predictable, on average. And not to imply that pricing is ever objectively easy

  3. SaaStr is the best resource for all things unit economics and metrics. A gold mine of prior art for anyone in the SaaS market.