How Does a SaaS Business Model Work? Types, Stages, & Key Benefits
A successful SaaS business model supports fast revenue growth, efficient operations, and scale. That’s why so many SaaS leaders subscribe to the philosophy of the “Rule of 40,” which argues that a SaaS company’s growth rate and free cash flow rate should add up to at least 40 percent.
Despite this industry maxim, most SaaS businesses fall very short of this mark. According to McKinsey, the median combined growth rate and free cash flow rate of the top 100 public SaaS companies in the U.S. was only around 32 percent. To push this number higher, tech companies need a SaaS business model that aligns with the brand’s stage of growth, go-to-market strategy, funding runway, and overall business strategy.
SaaS Business Model Definition
A software-as-a-service (SaaS) business model is a software delivery service that licenses access to a centralized software product on a subscription basis.
From Netflix to Microsoft Office to countless cloud-based business software solutions, the switch from traditional product-based software purchases to a SaaS business model has brought a number of significant changes to the brand-customer relationship. Even some non-tech businesses have shown an interest in developing new products that allow the company to leverage the core pillars of a SaaS business model.
Recurring Revenue
We’ve come a long way from the days of selling software on a CD. Today’s software is more commonly sold via cloud-based SaaS services which charge a subscription in exchange for access and usage.
The recurring payments from these subscriptions provide a more consistent stream of revenue to stabilize cash flow and the ability to forecast future earnings.
Heightened Customer Retention
The subscription-based structure of a SaaS business model inherently supports customer retention by requiring an ongoing subscription to license the company’s software. For mission-critical technologies (like CRM) and consumer products that offer a strong user experience, the potential for continued customer retention and brand loyalty is high.
SaaS business models can further support high customer retention by creating value out of long-term relationships.
Consistent Updates
Traditional, one-time software purchases meant that software licensees were stuck with a static product. Small security updates may have been available for download but dramatic changes to the software’s capabilities and functionality were nearly impossible to implement.
This limitation doesn’t exist with a SaaS solution. Cloud computing allows the software provider to continually release new updates that keep the software on the cutting edge.
Creating a Moat
An effective SaaS business model will build a formidable moat that insulates the brand against the threat of competition. It’s about more than just the value the SaaS solution offers; this represents the difficulty rival brands will face in trying to recreate this value through services of their own.
The cost of switching away from your business can also support your moat. When customers risk losing efficiencies, data, or other assets and advantages they enjoy with your software, the cost of jumping over to a rival is greater. As your business scales its customer base, consider how new economies of scale can help control expenses and optimize pricing.
If you want to create a business with a nearly inescapable moat, try your hand at creating an ERP system… most companies choose their system once, refusing to change ever again.
Utilizing Customer Feedback
Real-time feedback from existing customers can be directly applied to your software development and UX design processes. Whether launching new features or taking the pulse of the capabilities your customers are clamoring for, this feedback can support more iterative development that accelerates innovation and improves the quality of your overall product.
SaaS Business Stages: A Three-Phase Approach
By the time SaaS businesses become industry leaders and household names, they’ve already slogged through the early growth stages and long-term planning that made their present-day success possible.
Here’s a look at the lifecycle of a typical SaaS business:
Early Stage
In the earliest stages of building a SaaS business, operations are lean, and many employees, from the entrepreneurs that founded it to the newest recruits, may be expected to wear multiple hats.
Products are likely to be still in development, with limited features and few—if any—customers. Early-stage SaaS businesses may be seeking pre-seed funding to accelerate their growth timeline and make strategic hires that will prepare the company to scale its operations.
Growth Stage
Most SaaS businesses enter their growth stage with an infusion of funding to support marketing and other mechanisms designed to scale the software’s user base. Monthly recurring revenue will start to develop, and the company’s growth rate and free cash flow rate should start to tick upward.
The business itself is probably filling out a number of new positions to support its operations at scale. New investment opportunities may also arise as the SaaS offering shows promise and popularity among a select audience. At some point during this growth phase, the company may achieve profitability.
Mature Stage
Once a SaaS business has built a stable customer base driving monthly recurring revenue to support its operations at scale, it has entered the mature stage. This means the company has a core customer base, is retaining customers, and is performing well across other key performance metrics prioritized by the company.
Despite achieving profitability, mature-stage SaaS companies may want to re-evaluate their pricing and revenue models to make sure they fit the company’s goals at this point.
As customer growth slows, for example, new pricing strategies may offer a path to reviving their revenue growth rate (or disconnecting it from new customer growth altogether).
Types of SaaS Revenue Models
Even before you’ve converted your first customer, every SaaS business needs to identify a revenue model that will guide its approach to revenue generation.
As SaaS companies grow, new revenue models may be necessary. Here’s a look at six of the most common revenue models for SaaS CFOs to consider.
1. Ad-Based Revenue Model
Ad-based SaaS revenue models generate earnings through ad impressions when the user is active on the website or app. Businesses can sell this ad space either directly to advertisers or through a third-party ad vendor.
This revenue model allows users to access the SaaS solution without paying for a subscription, eliminating a key barrier to entry and increasing the potential for new customer acquisition—although too many ads can degrade the user experience.
- Best for: SaaS solutions that involve a lot of active user time in the app or platform.
- Worst for: Early-stage and other SaaS businesses whose small customer base severely limits the revenue generation from ad exposures.
2. Affiliate Revenue Model
Instead of selling ads to generate revenue, an affiliate revenue model offers paid affiliate links that generate revenue in lieu of a paid subscription. Revenue is earned whenever users click on paid links.
While the potential earning from affiliate links can be higher than paid ads, audience relevance can be a big factor in determining this earning potential. And earnings can be uncertain: while ads generate revenue by impressions, affiliate links are dependent upon a user's action.
- Best for: Niche SaaS solutions that can refer customers to related services and integrations without the risk of losing customers.
- Worst for: Growth-stage and mature SaaS businesses hoping to deepen customer relationships through bundled services. Plus, as with the ad-based revenue model, early-stage businesses may not have enough customers to generate significant affiliate revenue.
3. Channel Sales
Channel sales is a revenue model that leverages established partners and sells the SaaS solution to their built-in audience. Many SaaS businesses will identify opportunities where an existing tech partner or vendor could promote and sell the SaaS product to their audience in exchange for a sales commission.
This revenue model can be a great way to drive sales without your own in-house sales team, and it can offer a path for early-stage SaaS brands to acquire new customers in spite of limited brand awareness.
- Best for: SaaS solution providers building products on top of supportive architecture such as VMware, Azure, etc.
- Worst for: SaaS businesses without clear technology partners or “channel agents” to drive referrals and sales.
4. Direct Sales
Direct selling puts your sales team in charge of customer acquisition, cutting out the commissions charged by channel sales models. In this scenario, your own sales team is directly engaging with new prospects and is responsible for growing your customer base.
The challenge of direct sales is that your growth is limited by the bandwidth and efficacy of your sales team, which can turn direct selling into a drain on resources. But direct selling also offers a more strategic path to qualifying prospects and onboarding promising new customers.
- Best for: SaaS solutions with a high entry price-point and/or customer lifetime value; particularly B2B SaaS solutions.
- Worst for: Consumer SaaS solutions with low monthly price-point.
5. Freemium Model
The “freemium” approach offers some version of your SaaS product for free in hopes of earning the trust and appreciation of those customers. Ideally, freemium SaaS models lead to paid conversion opportunities as customers opt for subscriptions that deliver more capabilities and value (think Slack to Slack premium).
Freemium is a great way to get a foot in the door with customers, particularly for B2C SaaS businesses, although a poor user experience can lead to wasted expenses that don’t deliver worthwhile revenue returns.
- Best for: SaaS solutions that can tier solution performance and capabilities to create upsell opportunities.
- Worst for: B2B SaaS products catering to a niche audience.
6. Subscription Revenue Model
One of the most popular SaaS revenue models is the subscription approach, which charges accounts on a regular basis (usually a monthly subscription) for access to the software. While not always feasible for younger SaaS brands without a proven product-market fit, subscription models offer recurring revenue and a relatively clear annual recurring revenue (ARR) figure, which makes it a preferred strategy among CFOs and business owners.
- Best for: Later-stage growth- and mature-stage SaaS businesses prioritizing recurring revenue and free cash flow.
- Worst for: Early-stage SaaS businesses focused on building brand awareness and demonstrating the value of its product to customers.
Types of SaaS Pricing Models
Your revenue model determines the mechanisms by which your SaaS business will bring in money. Your pricing strategy, on the other hand, is the process by which you choose how much to charge your customers, and how that pricing will be charged to those users.
Here’s a look at the most widely used SaaS pricing models:
Flat-Rate Pricing
It’s a simple transaction: customers are billed a flat rate for access to your SaaS solution. The selling and accounting is easy this way: unlike other pricing models that can involve complex calculations, a flat-rate approach is easy to record.
At the same time, flat-rate prices are an all-or-nothing approach, which may not offer the most optimized approach to revenue generation. This pricing model can also be inefficient in cases where SaaS customers can vary widely in their usage and resource requirements.
Consumption-Based Pricing (AKA Usage-Based Pricing)
Consumption-based pricing can be highly scalable based on how much each customer uses your SaaS solution. This ensures that the price is always aligned with the value it offers your users. It also makes it easier for customers to test-drive your solution before choosing their level of investment.
The drawback of usage-based pricing is that, as usage fluctuates, so does your company’s revenue, which can impact financial forecasting and free cash flow. Variance in pricing can also frustrate customers billed for high-usage periods, putting them at risk of seeking out a more stable alternative.
More and more SaaS businesses are turning toward usage-based pricing models over the last few years, which indicates where consumer demand is headed.
Tiered Pricing (Model)
Tiered pricing is one of the most common SaaS models thanks to its flexible pricing options and recurrent revenue generation. With tiered pricing, SaaS businesses offer a select number of pricing options that are targeted to specific buyer personas and use cases.
These tiers make it easier for customers to find a price level that fits their needs and budget, and it creates a natural upsell opportunity. But managing these tiers can also mean more work for the business, and broad-tiered options could pull internal resources away from focusing on your core offerings and audience.
Per-User Pricing
B2B SaaS solutions may be interested in adopting per-user pricing, which charges accounts upfront, then recurring, based on the number of users accessing the platform. This is a common pricing model used by businesses where multiple employees will be regularly using the SaaS solution, with examples ranging from project management tools to e-commerce platforms.
Per-user pricing is simple, easy to adjust over time, and scales along with the customer’s use. But it’s inevitable that some customers will try to cheat the system, and governance of these accounts is another expense cutting into your profits.
Netflix and Costco have both made headlines for their crackdowns on membership sharing.
Per-Active-User Pricing
One risk of per-user pricing is that customers could end up paying for users that aren’t active on the platform. To guard against this, some SaaS businesses—including Asana and Salesforce, among others—charge only for active user accounts. This lets customers create as many user accounts as they want with the assurance that only active users will be billed.
Per-Feature Pricing
Although similar in design to the tiered pricing model, per-feature pricing sets different price levels based on the features and capabilities at each level of investment. The value proposition is clear to customers: if you want better performance from the platform, you can upgrade to a higher tier and unlock new benefits.
A per-feature approach can lay a foundation for upselling, and it offers transparency when customers want to know what they’re getting for their investment. Choosing how to separate features across different tiers can be complicated, though, as you don’t want to turn your entire company into an a la carte menu.
Freemium Pricing
Freemium pricing can look a lot like a tiered or per-feature model, with the exception that one tier offers basic access to the SaaS solution, free of charge.
As with a freemium revenue model, there are benefits to this approach—particularly when trying to onboard a broad customer base that can create upsell opportunities. But giving away part of your SaaS solution experience can be risky, and you might miss out on a lot of revenue that could have been generated by making your entry-level tier inexpensive, rather than free. Generally speaking, this model is favored by companies that have a lot of close substitutes and alternatives. If your market isn’t yet saturated and your product is easy to understand, I wouldn’t recommend this.
SaaS Distribution Models
Your distribution strategy dictates the channels through which your SaaS solution will reach your customers. Distribution can take two forms: direct distribution between the SaaS business and its customers, and indirect distribution facilitated by a third party.
Although some businesses—such as Amazon—use direct and indirect distribution alongside one another, many SaaS solutions are reliant on just one approach.
Direct Distribution
With direct distribution, SaaS solutions are delivered directly via a sales team or are accessed through an online self-service portal, such as a website. Direct distribution may also enlist the help of consultants and account managers to help onboard new software solutions for each customer.
Direct distribution is beneficial because it lets you control the full supply chain and maximize the value of each new customer acquisition. SaaS sales teams can operate with greater independence through this model. However, the lack of a third party can hinder your reach and customer acquisition opportunities, making it difficult to scale your company with limited resources.
Indirect Distribution
App stores, white-label resellers, and professional services firms are examples of indirect distribution that leverage an existing channel to reach new users with your SaaS solution. These indirect channels are often prized for their ability to quickly engage a large, relevant audience.
This reach comes at a price, though: some resellers will want a commission for their referrals, while app stores and marketplaces will come with additional requirements, fees, and dependencies that can impact the speed and quality of your delivery. These third parties may also handle customer service issues on your behalf, which can reduce your workload but also limit your ability to control the customer service experience (and receive direct feedback).
The 5 Biggest Benefits of the SaaS Business Model
The most significant benefits of adopting a SaaS business model will depend on your company’s growth stage, your industry, and the composition of your customer base.
Regardless of your company’s individual priorities, though, SaaS business models have inspired copycat modeling among non-tech businesses because of the distinct benefits this approach can offer. Here are five of the biggest advantages businesses are targeting when they develop a SaaS business model.
Build Once, Sell Twice
Software products are sold once. Software-as-a-service, though, is continuously sold through its subscription model.
This ongoing relationship allows software to essentially be re-sold not just once or twice, but many times over the lifespan of each customer relationship—as long as the software continues delivering value for its users.
Income Predictability
After the initial investment to develop a SaaS infrastructure, subscription-based customer acquisition offers a fast path to revenue generation and free cash flow at scale.
Incoming revenues are more predictable, which supports financial forecasting and re-investment into initiatives aimed at continuing to scale the business.
Speed of Innovation
Customer feedback influencing iterative development cycles is easily supported by a SaaS approach. These inputs, combined with recurring revenue, allow SaaS businesses to be more agile and responsive to market changes—even when that market change requires the business to change its core offerings.
Sometimes this means developing new products to meet a market need. Other times, it may mean simplifying SaaS services to improve the customer experience—which motivated Shopify to sell its logistics business and focus on the core offerings that mattered most to its business model and customer base.
Anywhere, Anytime
SaaS businesses aren’t limited by geography, time, or product availability. A SaaS solution can be accessed anytime, from anywhere—and, in many cases, regardless of the scale of your SaaS needs.
Minimum Viable Product
Since software offerings can be iterated and optimized over time, SaaS brands don’t have to hold the release of their product until it’s been perfected. A SaaS business can (and should) start small with a minimum viable product release that can start generating revenue, user feedback, and brand visibility.
Once this minimum viable product is launched, additional capabilities and products can be considered as strategies for enriching the brand’s value to its customers.
Disadvantages of the SaaS Business Model
For most software-as-a-service businesses, the benefits of a SaaS business model far outweigh the possible disadvantages of this approach. Still, certain limitations could present problems for certain companies, and CFOs must know how to recognize and adapt to these challenges.
Here are the most common disadvantages brought on by a SaaS business model.
Large Capital Requirements
Recent access to AI coding tools may help lower the cost of SaaS product development, but the total investment to build a SaaS company remains significant—especially if you want to develop a solution that can’t be quickly replicated by your competition.
Funding and investor support are essential to launching a SaaS product and laying a foundation for revenue growth. These capital requirements can make a SaaS business model untenable for a small startup brand eager to bootstrap its way to success.
Security is Your Responsibility
SaaS companies are in the business of handling their users’ data. Before you convert your first customer, your business needs a comprehensive security strategy that mitigates the risk of network breaches and data loss. Depending on your industry, this security infrastructure may also be subject to compliance requirements.
Remember: it only takes one security breach to frustrate customers, tarnish your brand’s reputation, and undo all of the hard work you’ve done to build your company on a strong financial foundation.
Your Offering May Be Easily Replicated
For all of the cost and complexity of building a SaaS business, new SaaS operations must be mindful of how easily a deep-pocketed competitor could build and launch a comparable product that cuts into your potential market share.
A good SaaS business model not only considers the value offered to its customers but also the likelihood that another company could copy this offering. Greater complexity can make your product harder to replicate, but this may further increase your capital requirements.
High Competition & Low Customer Loyalty
It’s the biggest downside of having a low barrier to entry: even if your offering can’t be perfectly replicated by a competitor, you still have to worry about alternative solutions crowding your market and attempting to undercut your pricing, beat your solution on performance, upstage the value of your product through bundled services, or all of the above.
The accelerated time-to-launch is a great benefit of building a SaaS business, but it also means the market can evolve quickly—and early industry leaders can quickly get swallowed up by the competition.
No/Low Early Profitability
Most SaaS businesses don’t achieve profitability until they’re well into their growth phase. Even as revenue starts, those funds must be reinvested into growth strategies to help achieve the growth required for long-term profitability and sustainability.
It’s an investment in the future: profits take longer to achieve, but the overall profit potential is greater. In the short term, however, this means early-stage SaaS CFOs are going to see business expenses far exceed revenues.
SaaS Metrics to Track for Success
Performance metrics will tell the real story of whether your SaaS business model is delivering results. But different metrics can offer a different perspective on your company’s success.
To paint the full picture, pay close attention to the following data points.
Churn Rate
Churn reflects your company’s customer attrition. The more active customers your SaaS business loses over a certain period of time, the more difficult it will be to sustain MRR and growth.
Churn is different from your total customer growth because it reflects how often active customers are leaving your solution. While ideal churn rates can vary, a healthy B2C SaaS company will have a churn rate between two and eight percent. For B2B SaaS brands, the ideal monthly churn should be under five percent.
Customer Lifetime Value (LTV)
Your customer lifetime value reflects the average revenue each new customer relationship will generate. LTV is an important metric when funding marketing and sales efforts and calculating ROI.
The aggressive advertising investments by Starbucks are a great example. While the cost of a cup of coffee is relatively cheap, Starbucks has calculated its average customer LTV to be greater than $14,000. As a result, the company can still turn a massive long-term profit even if it spends hundreds of dollars trying to convert a single customer. LTV can also help you determine whether your SaaS solution is doing enough to generate long-term revenue from your customer relationships.
Customer Acquisition Cost (CAC)
Customer acquisition cost is the amount of money required to acquire a new customer. This encompasses all of your acquisition expenses, including marketing, advertising, sales, promotional offers, and other related costs.
A lower CAC equates to faster growth potential within your fixed advertising and marketing budgets. CAC must also be considered alongside LTV, though: the lower CAC is in relation to LTV, the better your long-term profit potential.
CAC Payback Period
This metric refers to the amount of time it takes for a customer’s revenue generation to exceed their acquisition cost.
While this payback period can vary depending on the type of SaaS solution, the industry, and your company’s stage of growth, a general rule of thumb is to aim for a payback period of 12 months or less. High-performing SaaS businesses may complete this payback in as little as five to seven months.
Customer Engagement Score
CES is a measurement of how engaged customers are with your SaaS solution. This calculation can be more subjective, and the methods of scoring may vary depending on what your want to prioritize in your SaaS experience, but typical customer engagement score metrics will include the frequency of accessing and using the product, the time spent on your SaaS platform, upgrades and renewals, referral rates, and frequency of customer support tickets.
Align Your SaaS Business Model With Your Brand’s Immediate Goals
SaaS business models are never set in stone. Instead, the pricing, revenue, distribution, and other facets involved should all be chosen with a focus on reaching your company’s next stage of growth.
As SaaS brands scale and evolve, changes to this business model may be necessary. As you approach these tough decisions, it’s helpful to talk with other CFOs who have been through these growth cycles and can help you balance your company’s short-term revenue needs with your long-term growth goals.
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