Understanding the SaaS Business Model and Unit Economics

One of the best things about working at HubSpot is the education I’m gaining each day. Not only have I deepened my knowledge of inbound marketing and the company's industry leading platform, but I’ve learnt about the software as a service (SaaS) business model, as well as how subscription based businesses operate, make money and grow.

In fact, the more I understand the SaaS business model, the more it interests and impresses me. For those unfamiliar, SaaS companies charge a subscription for their software products which are delivered and stored within the cloud, with customers typically paying each month and on a per user basis.

The emergence of SaaS has been driven by technology, which has made it possible for complex software to be easily accessed within the cloud. Most SaaS businesses continually update their product and release new features, so customers are in effect, paying to always have the latest version of the software. These are important characteristics of the SaaS model and in contrast to how software used to be purchased and delivered. In the past most software products were paid for up-front, often at great cost and the customer used the product until a new one was released.

Understanding the SaaS Business Model

Salesforce.com is the posterchild of what a successful SaaS company looks like with over 16,000 staff and $6 billion dollars in annual revenue. What makes the SaaS business model appealing to both business leaders and Wall Street is it generates predictable revenue, which makes it easier to plan future investments. Recurring and predictable revenue is what business leaders strive for and the SaaS model, thanks to its monthly subscription plans provides it in abundance.

As my colleague, Mark Roberge states in his book The Sales Acceleration Formula: Using Data, Technology, and Inbound Selling to go from $0 to $100 Million HubSpot like all good SaaS businesses measures LTV:CAC.

What do these acronyms mean and why are they important to SaaS businesses? These metrics are part of unit economics and the numbers are the direct revenues and costs associated with a business model expressed on a per unit basis. Let me explain more:

Lifetime value
LTV represents the lifetime value of an individual customer. For example, if a licence for a product costs €1,000 per month and the average customer remains for three years before churning, the LTV of a customer will be €36,000.

Customer acquisition cost
CAC is is the cost of convincing a customer to buy a licence for a product. This figure includes the cost of maintaining the product, as well as marketing and sales expenses. If the cost of maintaining the product is €2,000 and the sales and marketing costs are both €5,000 each, CAC will be €12,000.

Understanding LTV:CAC
Based on these sums the LTV:CAC would be 3:1. This is often given as a healthy ratio (a greater ratio is even better) at which to benchmark the LTV:CAC of your SaaS business. Importantly, this ratio is telling us that for every €1 it costs to acquire a customer the business gets €3 back. When a business knows it’ll get €3 back for every euro invested, their attention typically switches to scaling the business quickly and investing in growth.

First mover advantage is hugely important for a SaaS business and in Marc Benioff’s book Behind the Cloud: the Untold Story of How Salesforce.com Went from Idea to Billion-Dollar Company - and Revolutionized an Industry he advises measuring a fast-growing company on revenue, not profitability. This logic may seem counterintuitive at first, but in the early stage of a fast growing business, revenue growth and capturing market share is crucial. “It’s just not appropriate to stress profits over revenue in the beginning when you are starting out and building a company,” says Benioff. It’s also worth noting there’s growing consensus among venture capitalists (VCs) that conventional metrics for tracking the progress of SaaS companies are inadequate.

Succeeding with SaaS
Unit economics is an effective way to analyse the financial health of a SaaS business and understand its long term profitability, however it’s the levers and strategies which influence LTV:CAC that excites me. The most successful SaaS businesses have products that increase in value the longer you use them (just like compound interest) and with every company now becoming a software company, it’s clear that the SaaS business model is here to stay.