The How SaaS Works series simplifies the complex world of software-as-a-service (SaaS) into the practical fundamentals for anyone involved in SaaS. These are the real-world lessons learned from founding a SaaS company from ground zero to growing it all the way to acquisition as well as case studies from other SaaS companies who have both succeeded and failed.

Introduction

The software-as-a-service business model appeals to companies of all sizes from tiny startups to massive Fortune 500 companies. What company does not want predictable, recurring, scalable revenue? While the idea of SaaS has technically been around for decades, the proliferation of SaaS is still very much in its early stages today. Back in 2012 when I founded Initial State, there were not many people writing about SaaS, and a widely accepted “playbook” for building and scaling different types of SaaS companies did not exist. All too often we were winging it and learning the same marketing/sales/product lessons in parallel to other SaaS companies. The number of SaaS experts sharing their expertise on the interwebs has really ramped up over the last few years. All of these SaaS focused articles/podcasts/presentations have given us both invaluable help as well as contradictory advice as to what are best practices. The purpose of this series is to break down today’s SaaS playbook into easy-to-understand building blocks with supporting use cases and data.

What is SaaS?

Let’s start with what SaaS is and then clear up some confusion around offerings people incorrectly label as SaaS. SaaS is an economic model for software delivery in which centrally hosted software is continuously delivered to an end-user to create a continuous value exchange. The simplest example of SaaS is a product accessed by a user through a web browser for a monthly subscription fee.

SaaS has three primary qualifiers:

• The software product is centrally hosted by the vendor.
• The software product is continuously updated.
• The customer does not own the software but pays for the right to use it.

Is subscription-based, local installed software like Adobe Creative Cloud considered SaaS?

No! This is considered subscription software. The economic model is similar, but the product delivery is atypical of SaaS because the vendor does not centrally host the product. You lose out on some of the benefits of SaaS such as near-instant product updates (because a web-based product only requires a browser refresh) and are probably limited to specific operating systems. Licensing implementation will deviate from web-based SaaS and will present different security challenges (i.e. reverse engineering, pirating … arrgghhh!).

Subscription software qualifiers:

• The software product is hosted by the customer (e.g. on-premises, local-install).
• The software product is infrequently, if ever, updated.
• The customer does not own the software but pays for the right to use it.

If a customer purchases the software but pays for it over time, is this considered SaaS?

No, that is just called financing. You don’t go from an up-front perpetual license fee to a payment plan and get to call it SaaS. When someone using this model tries to tell you it is SaaS, just shake your head disapprovingly because they should know better.

The “service” part of software-as-a-service is often overlooked. There has to be a continuous value exchange for SaaS to be effective, which is why continuous delivery is a prerequisite for SaaS (i.e. new features, bug fixes, new UX, improving security/performance). You do not get to build it once and be done with SaaS. Those improvements are one of the big reasons why a user keeps paying every month to access your software product.

Why is SaaS such an attractive business model?

Let’s start with an analogy:

The Perpetual License Engine

Assume this is our engine, a perpetual license (one-time payment) engine. A customer wants a product, pays for that product up-front, and can use that product forever. This is how this type of engine runs:

All engines need some sort of input and produce some sort of output. This particular engine takes in sales/marketing efforts and produces revenue.

If our input energy, in this case our sales and marketing efficacy, is constant over time, then our output results, revenue, is also constant over time. In other words, there is no growth. This is because we have to repeat the sale over and over again to collect money over and over again.

Let’s say we want to grow our revenue (who doesn’t!?). The way this engine works means we will need to ramp up our sales/marketing efficacy to get a proportionally increased revenue output. Growth using this kind of sales engine is pretty hard to sustain forever. We need a product that is easier to sell, more sales people, a better distribution channel, a better marketing campaign, a bigger market … something has to always improve to sustain revenue growth.

There is a major downside to this type of sales engine. If our sales/marketing efficacy is reduced over time, then our revenue goes down with it. This makes our business very vulnerable to changes in market conditions, competition, employee attrition, etc.

The SaaS Engine

Let’s upgrade our engine to a SaaS model. This engine is a lot more complicated to build but is now based on recurring revenue from subscriptions to our software. The same principles apply in that we need to input energy into our engine to get an output. However, the characteristics of our input/output curves are significantly different:

If our input sales and marketing efficacy is constant over time, then our resulting revenue is growing over time! This is because every new subscription stacks new recurring revenue on top of existing recurring revenue. Growth is much more sustainable with this type of sales engine than with our previous one. It gets better …

If we increase sales/marketing efficacy at a constant rate, our revenue increases exponentially! Let’s state that another way. Growth is exponentially cheaper to obtain with a SaaS sales engine than with a perpetual license sales engine. Let that sink in for a bit …

If sales/marketing takes a complete dive, our output revenue is still constant or near constant (because your existing users continue to pay to use your service). This makes our business far less vulnerable to changes in market conditions, competition, employee attrition, etc. Our business can continue to achieve growth even in tough conditions as long as we have some level of sales/marketing efficacy.

Why Doesn’t Everyone Switch to a SaaS Sales Engine?

Your favorite stock is trading at its current price because of speculative growth. That startup you read about on Techcrunch raised all of that money because of speculative growth. A business’s ability to sustainably grow revenue determines a huge portion of its value. If growth is exponentially cheaper to obtain in SaaS, then why don’t we see more businesses switching to a SaaS model? Because building this engine is HARD!

Anyone who tells you that building and scaling a SaaS business is easy is delusional. Switching from perpetual licensing to SaaS is equally hard if not harder than building it from the ground up. The ways you build, market, sell, and support it are just different for SaaS. Required skillsets and experience levels for each area of SaaS are different than other types of businesses. Just because someone is a world-class perpetual software license sales phenom does not mean they will thrive selling SaaS (in fact, they often do not). Same goes for your software engineers, support specialists, marketers, and leadership. The first step in succeeding in SaaS is understanding how SaaS works in practice.

The Basic Components of a SaaS Engine

There are five major components to a SaaS engine — lead generation, lead qualification, deal closing (sales), customer success, and product. The SaaS engine is equally dependent on each component, each interacting with the other to make the engine run. Your business will not succeed if you overlook any part of the engine. You do not have a viable SaaS strategy unless you have a strategy for each part of the SaaS engine.

An entire semester course (and more) can be dedicated to each individual SaaS component. SaaS specialists dedicate their entire careers focusing on just one of these pieces and achieve truly remarkable results. Learning about practical SaaS implementation can be challenging even with the growing number of SaaS advice articles/podcasts/presentations out there. Specialists often dive deep into special cases, nuances, and their specific challenges but too often frame an interesting corner case as absolute advice for SaaS. You can easily obsess over one part of your SaaS business strategy, neglect the others, and not realize your mistake until a huge amount of market opportunity passes you by.

The purpose of the How SaaS Works series is to explain the fundamentals of how and why each SaaS component gets practically implemented in the real world — the basics, example use-cases, supporting data. Let’s dig in.

Up Next … Introduction to SaaS Lead Generation >>