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SaaS Business Model | On the Cloud, the Customer is King

This may sound like evangelical cloud mumbo jumbo, but I’m actually alluding to the central importance of the ongoing customer relationship in the SaaS business model and its direct linkage to the financial success of a SaaS business. In the SaaS business model, the ongoing customer relationship is a continuous source of revenue, cost, business activity and risk. This contrasts sharply with traditional software where the short-term sales transaction has always taken center stage.

The fundamental shift in value from copies to customers
turns the economics of licensed software upside down,
and is still an elusive financial concept for the industry
when evaluating SaaS business value, profitability
and capital efficiency.

A traditional software vendor makes and sells perpetual license copies, whereas a SaaS business makes and sells ongoing service subscriptions. Each new SaaS customer brings a new thread of recurring revenue and cost which are woven into the larger tapestry of customers to create the total SaaS recurring revenue stream and associated SaaS cost of service. This fundamental shift in the unit of value from copies to customers turns the economics of licensed software upside down, and is still an elusive financial concept for the industry when evaluating SaaS costs, profitability, business valuation and capital efficiency.

Customers vs. Copies

In traditional licensed software, value is equated to the intellectual property of the code, and is monetized using copyrights in a fashion similar to books, music, and movies. Volume is measured in licensed copies and value is measured by the price of a license. But in the SaaS business model, volume is measured by the number of customer subscriptions and value is measured by recurring revenue. A software vendor invests in developing code, and then operates a sales and marketing infrastructure that scales to sell more licensed copies. A SaaS business invests in acquiring customers, and then operates a service delivery operation that scales to service customer subscriptions. Mathematically….

software profit = ( license price – transaction cost ) x copies – R&D costs

SaaS profit = ( recurring revenue – recurring service cost ) x customers – acquisition cost

Operational costs that are fixed relative to the number of license copies sold in the software business model are now variable relative to the total number of customers in the SaaS business model, such as product development which in SaaS becomes part of the recurring service cost and extends far beyond the initial source code investment to the entire business infrastructure (see note below: Breaking Down Total SaaS Cost of Service and SaaS Do #5 – Build the Business into the Product). Alternatively, sales and marketing costs that are variable relative to the number of license transactions in the software business model are suddenly fixed customer acquisition costs relative to the total number of customers in the SaaS business model, variable instead with the number of new customers.

Happy Customers Drive SaaS Business Model ROI

Capital efficiency is about achieving the highest possible return on investment (ROI). High ROI in turn is achieved by minimizing the up front fixed costs of a business and then maximizing margin by scaling revenue well in excess of variable costs. Like putting a down payment on a rental property, and then making sure the the rental income covers the operating expenses and interest payments. In the license software model, capital efficiency is measured by product ROI, but in the SaaS business model the best measure of capital efficiency is customer ROI, or the average customer rate of return (aka Joel’s SaaS Magic Number).

SaaS Customer ROI = ARR – ACS
CAC

Where “ARR” is the average recurring revenue per customer, “ACS” is the average recurring cost of service per customer, and “CAC” is the average customer acquisition cost. Software ROI is achieved by selling more copies to cover your R&D investment. SaaS ROI is achieved by acquiring more customers and maximizing customer lifetime value through upselling and retention to cover your customer acquisition cost.

In the end, it all has to add up to happy customers. Service subscriptions are perishable. They can’t be copied and stored like a book or a movie or a software CD. A SaaS business without customers simply doesn’t exist—like the sound of a tree falling in the woods with no one around to hear it. In the SaaS business model, the customer really is king.

Breaking Down Total SaaS Cost of Service

Total SaaS cost of service is comprised of recurring service cost and customer acquisition cost. Both of these SaaS cost categories are variable in nature, because the SaaS business model has two primary drivers of variable costs (total customers and new customers) as opposed to the single primary driver of the licensed software model (transactions). Albeit both variable, customer acquisition costs are fixed relative to recurring service costs. And, it is worth noting that a very mature software business starts to take on this dual cost driver characteristic of the SaaS business model when maintenance revenue begins to dominate new license revenue. However, this duality is present in the SaaS business model from the very first customer subscription.

SaaS Costs – Variable vs. Fixed
I am of the opinion that there are very few fixed SaaS costs, at least in the long run. Most all operational SaaS costs can be included in either recurring service cost or customer acquisition cost. Once a SaaS business has launched the initial 1.0 version of its product and approaches a nominal efficient scale in terms of customers, you will be hard pressed to find a cost that does not scale roughly with either the total number of customers (recurring service cost) or the number of new customers (customer acquisition cost).

Customer acquisition costs are easily identified as direct sales and marketing expenses, but recurring service costs are often hidden in ostensibly fixed categories like product development and administration. While these costs are arguably fixed in the software license model, they scale quite consistently with the number of customers in the SaaS business model. For example, accounts receivable costs scale with renewals and accounts payable scale with operational expenses, all of which in turn scale largely with the number of customers.

After the 1.0 release, product development will spend most of its time adding features for upselling, enabling customer self-service, increasing system performance, expanding infrastructure and fixing bugs, all of which are costs incurred in the service of customers. In fact, once the nominal efficient scale of the operation is reached, they are likely to scale more or less linearly with the number of customers. Only in the case of creating and introducing a new SaaS product for an entirely new market are any operational SaaS costs likely to be fixed relative to the total number of customers, simply because there are no customers as yet.

SaaS Costs – Accounting vs. Economic
Variable recurring service cost is often equated with the accounting measure for cost of goods sold (COGS), which usually includes the most direct product delivery costs, such as infrastructure hardware and software, network fees, etc. However, there are two problems with this: 1) COGS accounting rules were designed with manufactured goods in mind and there is wide variability in what SaaS companies include or don’t include in it and 2) pretty much no matter what is included, the COGS measure is not wide enough to equate it to the variable SaaS costs for recurring service.

There is only one question you have to ask to determine where to place each component of total SaaS cost of service.

In the long run, does the cost scale with total customers (recurring service cost),
new customers (customer acquisition cost), or neither (fixed SaaS costs).

Fixed SaaS costs should be determined by what is left over after all recurring service costs and customer acquisition costs are identified. And, accounting costs are well, just accounting costs.

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