The SaaS Business Model: How it’s Different

So how is the SaaS business model different from other business models? And is it possible to attract early-round investors while building a SaaS product? By understanding your unique cash flow, it’s very feasible to build a business that can achieve growth through investment and mentorship.

In the last decade we’ve seen a dearth of new business models, but one that’s definitely here to stay is SaaS, or Software-as-a-Service. The rising “subscription economy” is based around customers finding long-term value in a service and constantly renewing their subscriptions monthly, quarterly or annually. Whether it’s a question of resources, ease of use, or industry practice, the SaaS Model won’t be going anywhere any time soon.

The SaaS model has many financial and product benefits when it comes to growing a company. Finances can be a very difficult topic, however, and reporting meaningful numbers to partners and investors requires some accounting knowledge to ensure that you’re properly capturing the unique financial properties of a SaaS Business.

So how is the SaaS business model different from other business models? And is it possible to attract early-round investors while building a SaaS product? By understanding your unique cash flow, it’s very feasible to build a business that can achieve growth through investment and mentorship.

SaaS Business Models vs. the World: Why it’s Very Different

Comparatively speaking, traditional business models are much more straightforward in nature than SaaS business models. While they both have the same goal of offering a product or service that will drive value for an end customer, going about the business of doing business is completely different.

In a traditional business model, a company identifies a product or service need in their industry. From there, they can take many different approaches – including direct sales, advertising-driven, or franchising their idea – to grow their revenue through transaction based sales. The result is a steady flow of income through recurring product or service sales, which support growing both facilities and staff.

With a SaaS business model, some principles of direct sales or advertising-based business plans may apply, but as noted above, the business is dependent on the subscription economy, specifically renewals. As a result, understanding value and planning for growth is less about selling products, and more about building long-term value with customers, ensuring that there is a customer success strategy for each customer, and managing how recurring income is coming in month-over-month and year-over-year.

In order to be successful, the SaaS business model has to manage one-time purchase value against recurring value, measure past subscription performance data to guide future subscription growth, and maintain enough of a cash buffer to mitigate mid-cycle cancellations and refunds. It’s all about how well a business can manage Average Contract Value, Annual Recurring Revenue, and the overall Churn rate.

ARR, ACV and Churn: Making it All Make Sense

Many SaaS business models can be measured by three key metrics that drive their potential growth: Annual Recurring Revenue (ARR), Average Contract Value (ACV), and churn rate. These three factors are important to help determine your revenue trends, customer retention, and will be key talking points for any investor conversation.

Annual Recurring Revenue measures how much you expect to make in a full year, based on a single month’s worth of revenue: put simply, your monthly revenue multiplied by twelve is your ARR. Your ARR value reflects how many clients you expect to sign, upgrade and retain every year. Complementing this measurement is Average Contract Value. ACV measures how much every new and upgrading customer is worth, typically this is viewed at an aggregate level and by cohort if you have enough data. If your ACV number increases, then your ARR can expect to grow as well. Setting goals around these metrics and watching their trend over time will help you see results in your bottom line and potential growth.

The one thing that can hurt these numbers is your churn rate, and it is arguably the most important of the three. This measurement notes how many clients you can expect to lose in any given year, and is typically measured as a percent over a period of time. This also includes service downgrades as well, if you are looking at revenue churn or customer churn. If any contract is either lowered or cut completely, it contributes to your Churn rate. Understanding churn and retention, for both revenue and customers, is absolutely critical to growing your business and should be understood at a cohort level if possible.

All that being said, it’s important to understand that, like any business challenge, churn is a naturally-occurring issue. Even in losing clients, with the right customer success and offboarding processes, your business can become stronger and better prepared for future success with timely product feedback. Customer success teams and product managers will be critical in your fight against churn.

When you combine these numbers – ACV, ARR and Churn – you get a clearer understanding of your cash runway and profit and loss (P&L) statement. Armed with this information, leaders can create better plans and ensure long-term growth.

Selling the SaaS Business Model to Future Partners

Although the journey of a startup is long and arduous, getting support from others typically makes it easier. However, getting others to buy into a business service may be challenging when you don’t understand your own financials. How do you prepare your books for presentation to future partners, early phase investors and venture capitalists? Feel free to take a look at our piece on revenue recognition to ensure that you’re booking revenues correctly.

Once you get an understanding of the three key performance indicators that drive your P&L – ACV, ARR and Churn – you can better explain your growth trajectory and narrative. While those numbers will be affected by infrastructure costs, sales and marketing budgets, and customer acquisition costs, mastering your metrics and financials will be the most painless path when trying to raise money.

Not sure that you have everything in place to drive your SaaS business model forward? It’s ok to ask for help. The startup experts at airCFO understand the unusual demands that come on SaaS startups, and can help your executive team chart a pathway to success.

Need help? Let’s talk.

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