Not too long ago, the business world debated whether or not software-as-a-service (SaaS) would be a blip or trend. In the early days, knocks against it ranged from security issues to stability to simply thinking “the cloud” was too ambiguous to trust as an infrastructure. Fast forward to present times and its rapid growth says it all: the SaaS business model not only works, it’s transformed the way many B2B and B2C companies operate.
SaaS brings many advantages for both the vendor and user. Here we offer a breakdown of how it works, comparisons to traditional on-premise models, and how businesses can wrap their heads around the complex financials of the SaaS business model.
The SaaS business model in a nutshell
There’s a lot going on behind the scenes of SaaS, but the basics are fairly straightforward. The first thing to understand is that SaaS vendors build their offerings on a cloud-based infrastructure. Through the cloud, vendors deliver their applications as well as support for the user experience, maintain systems, and manage data. This means that there’s no software installations or need for onsite servers (however this is possible through hybrid SaaS and on-premise models).
How SaaS compares to on-premise
Prior to SaaS, software applications were mainly installed locally and on-premise servers held company data. Internal IT teams provided user support, data management, and upkeep for the technology. The SaaS model puts the on-premise model on its head by using the cloud to put everything on a vendor server offsite.
There isn’t much of a toe-to-toe fight between SaaS and on-premise models like there was when SaaS was the scrappy disruptor. Today, both models are viable. As two sides of the same coin, comparing SaaS to on-premise is a helpful way to examine the ins-and-outs of the SaaS model while offering some context into just how novel and innovative SaaS was when it came onto the scene.
Software licenses versus ownership
A SaaS vendor sells licenses to use software while an on-premise model sells the software “over the shelf.” With a license model, you’re charging for either monthly or annual subscriptions, while a software sale is a single upfront purchase. The upside of recurring charges for businesses is that they’re spared the burden of clearing budget and approvals of large cash outlays. Rather, they fold SaaS expenses into operational expenses, which are typically much easier for financial teams to manage.
On the vendor side, charging monthly fundamentally changes how tech providers grow. Customer churn is never fun, but on-premise companies could weather the losses as they collected their profits as soon as the ink dries on the contract. For SaaS companies, churn is a direct path to doom. Without solid retention and the reliable recurring payments from users, your SaaS business is built on quicksand.
When delivering systems through the cloud, SaaS vendors are also collecting data from the users – lots of data. Instead of on-premise servers, they use a cloud infrastructure (or build their own) to manage all the data. In the early days of SaaS, this was a scary proposition. Companies weren’t ready to trust a third party with their IP, customer data, or private employee information. It was a valid concern as “the cloud” was more of a mystery then.
Now we’re learning that the cloud is not only arguably safer than on-premise, the limitless availability of bandwidth via the cloud helps businesses scale faster. For example, if a toymaker has a new action figure (if that’s still a thing) go viral over the holidays, it can process more orders than usual without any hiccups or system instability. With traditional on-premise servers, unexpected spikes could crash systems or otherwise bottleneck the speed of business.
Keeping up with software updates, server maintenance, security certifications, configuring tools, deploying to users, data backups, troubleshooting, and other systems management in-house swells IT headcount, impacts user productivity across the business, and can even affect customers. (If that sentence was a lot to handle, just imagine how IT feels actually managing all of it!) The good news for many companies is that SaaS changes all of that.
The SaaS business model builds system, user, and data management into the package so your SaaS partner handles all of it. Instead of just keeping technology running, IT gains the ability to oversee their cloud-based systems and configure settings from dashboards. This frees a hand for internal IT teams to focus on more impactful projects that add value to the business.
When it comes to data and system resiliency, cloud has more resources at its disposal than on-premise. Most cloud systems offer various levels of redundancy, meaning that even in the event of unplanned downtime and crashes, systems and data will be preserved.
Keys to a SaaS financial model
The name of the SaaS game is all about sticky customers – reducing churn and opening the door for your customers to add seats or opt into additional services that grow your revenue (and value as a partner). Losing subscribers is inevitable, but you can stay ahead of churn rates by using your data and building smart financial models.
Here are some key metrics for your SaaS financial planning:
CAC: Customer acquisition cost represents the marketing spend and other costs associated with bringing on new subscribers. This is key to understanding your net profitability and identifying the right amount of marketing budget to grow your subscribership.
MRR: Monthly recurring revenue represents how much you bring in based on your monthly subscribership.
ARR: Annual recurring revenue represents how much you bring in based on active annual subscribers.
Reactivated customers: Some subscribers will inevitably drop from your subscribership. But, all is not lost. Some of these customers may reactivate their subscription with some gentle nudging from winback marketing campaigns or just when the time is right.
Renewed customers: These should be your favorite customers -- subscribers that are happily continuing their contract.
This only scratches the surface of the metrics you’ll need for successful SaaS financial modeling. For a more comprehensive look, take a look at our SaaS financial template and plug in some numbers to see how our modeling works. You can also check out our deep-dive guide to SaaS metrics.