02. What is SaaS?

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If you're interested in startups, tech, venture capital, or the stock market in general, you've probably heard the phrase "SaaS" thrown around a lot.

This section dives into the high-level basics of SaaS businesses and why they're so coveted by investors.

What is SaaS?

  • SaaS stands for Software as a Service
  • What does that mean?
    • As a user or customer, it means you pay a subscription fee, usually monthly or yearly, for access to an app or website that provides you a service
      • The company that sells the SaaS will host and maintain it in the cloud
      • All the customer has to do is sign up to start using the service
  • As a founder, it means you get your app or services in the hands of customers quickly
    • It also means your revenue becomes recurring, repeatable, and predictable over time

So, for the user, what are the benefits of a SaaS company?

  1. The cloud enabled the demise of disk downloads and installations, which improves customer retention and repeatable revenue
    • SaaS is simply available over the internet, instantly!
    • Think how easy it is to so sign up for a gmail account and have access on any device
    • If you use Slack, Notion, or Loom - think about how easy it was to sign up and start using those products!
    • In the old days, software companies would sell yearly (or multi-year) software contracts.
      • Then send a bunch of floppy disks or CDs with the software, and you'd have to download the software manually.
      • Which would then be native to that desktop computer
    • The cloud has made life so much easier for both companies and users
    • Now all it takes is a quick sign-in on a device and you have access to the software
  2. Users only need to focus on using the software, not maintaining it
    • SaaS companies update the product, fix bugs, and release new features all via the cloud
    • Users don't need to do anything except pay the bill, use the product, and hit "update" every so often
  3. SaaS apps get you up and running quickly!
    • For most SaaS apps, you can sign up and start using the software within minutes
  4. SaaS is subscription-based and usually affordable
    • You pay for each month (or year) that you want to continue using the service
    • Monthly SaaS employs a "Pay-as-you-go" model, where cancellations are incredibly easy and the customer is on the hook for next-to-nothing
    • That's why you'll often see 10-30% discounts to pay yearly
      • There is more lock-in and no month-to-month flexibility
      • Customers will typically get a substantial discount for committing to the product in this way
      • Founders are willing to give the discount to ensure the payments over the year
  5. SaaS apps can be very complex, sophisticated, and powerful
    • Companies aren't sacrificing features for speed
  6. You have access to them everywhere!
    • Most modern SaaS applications are browser-based with device-specific apps
    • For example, Slack has an iOS app, a macOS app, and a browser-based solution that you can access on either your iPhone or Mac web browser of choice
      • That means between your iPhone and your MacBook, you can log into four different versions of Slack
    • This goes for most versions of modern SaaS

So as a founder, why go the SaaS route?

  1. For the same reasons outlined above:
    • Complex apps, available anywhere, built and delivered to users quickly (and usually inexpensively!)
  2. Improved security
    • SaaS companies host data in the cloud
      • Many companies selling into other businesses will need to have cleared security compliance protocols (SOC 2, etc.)
      • The cloud providers are responsible for the security of the cloud
    • In a time when everyone worries about their data, SaaS is oftentimes more secure and more trustworthy than traditional data centers
      • Founders share the responsibility of security via a "shared responsibility model" with major cloud providers
      • The cloud providers spend a lot of resources on security
        • More than any startup could afford on its own
  3. Speed
    • You can ship features or fix bugs as fast as you can develop them
    • At the push of a button, all your users have the latest update
    • Being in the cloud also makes your app more reliable
      • The cloud has very fast upload times
        • Latency and scalability are two major features of being in the cloud
  4. But the biggest advantage of SaaS to a founder...
    • The ability to scale without impacting delivery costs
    • This opens up a much bigger market audience and helps maintain strong unit economics as you scale
      • For example, think of hardware companies
        • You'll need a lot of capital just to get started
        • As they scale, their costs increase with the number of goods sold
          • They'll need more workers to build the products
          • They'll pay more in shipping the products
    • However, SaaS businesses don't have to worry about any of this
      • They sell "bits" not "atoms"
      • This makes SaaS margins strong and scalable from the start
        • SaaS is built to scale by design
        • As more users frequent your site or buy your app the cloud scales accordingly
          • Often for pennies on the dollar
    • Here's a real-life example of software's powerful scalability and margins:
      • Amazon is on pace to do ~$443B in revenue in 2021
        • And is on pace to make ~33B in profit in 2021
      • AWS (Amazon Web Service) is on pace to do ~$56B in revenue in 2021
        • And is on pace to make ~$16.6B in profit in 2021
      • Break these numbers down,
        • While AWS only accounts for ~12.6% of Amazon's total revenue
        • They account for ~50% of its profits!
      • In other words, AWS is Amazon's main profit engine, because of the margins enabled by scalable software!
        • Or in their case, server farms and web hosting that enable software

Basic terms of SaaS

  • There are tons of terms to know when starting a SaaS company - let's touch on a few of the key ones
  • Annual Recurring Revenue (ARR) & Monthly Recurring Revenue (MRR)
    • ARR is subscription revenue for the year
    • Which is equal to MRR times 12
    • Founders can occasionally get too cute with the numbers when counting one or two really strong months (multiplied out) as ARR
      • For example, there were video conferencing SaaS companies that raised hundreds of millions of dollars during the pandemic when everyone was stuck at home attending virtual events
      • These companies were touting eight figures of "ARR" - while their LTM (last twelve months of revenue) was in the low seven figures
      • These kinds of calculations are often misleading and can lead to bad feelings from investors
        • Being credible is one of the best qualities you can have as a founder
      • Jason tries to cut through all this by asking founders for their last 3 or last 6 months of revenue
  • Business to Business (B2B)
    • The SaaS service or app is sold by a business to a business
    • Investors love investing in B2B SaaS because they can charge more and customers tend to churn less
      • Ex: Slack, Shopify, and Zoom
  • Business to Consumer (B2C)
    • The SaaS service or app is sold by a business to a consumer
    • B2C software is riskier than B2B SaaS (for founders and investors)
      • But if a consumer company succeeds the end result will likely have much more cultural influence and drive higher returns for investors
        • Ex: Spotify, Netflix, and Disney Plus
    • Some companies start as B2B but then venture into B2C when they hit scale
      • Ex: Adobe and Microsoft
  • Burn Rate
    • The rate that a company is "burning" cash per month
    • If you have $1 million in the bank, and last month you spent $100K, then you "burnt" 10% of the money in the bank
    • Burn Rate likens a startup losing money to fuel being burnt by an airplane in flight
  • Runway
    • The amount of months left until the company is out of money
    • Runway is calculated by adding the money in the bank and the revenue brought in that month minus the burn that month
      • You then divide this number by the burn rate
    • If you're not currently bringing in any revenue, are burning ~$100K every month, and have $900K left in the bank, that means you have 8 to 9 months of runway left... so it's time to start thinking about fundraising!
      • ($900k + $0) - $100k = $800k / $100k → 8-9 months of runway
      • Depending of if this is calculated at the beginning or end of the month
    • A Jason best practice... he likes founders to have at least 12-18 months of runway after the raise, to ensure no quick flameouts
  • Breakeven
    • Point when expenses are offset by revenue
    • When a company hits and passes the breakeven point, that means they are "default alive"
    • Being default alive (or profitable) is an amazing feeling
      • It puts the founder in a position of power during fundraising talks
  • Customer Acquisition Cost (CAC)
    • The average cost to acquire a new customer
    • Typically this is a marketing and sales spend divided by new customers added during a fixed time period
      • For example, spend ~$5000 on a marketing campaign and you get ~100 new customers, the CAC for that campaign is ~$50
  • Churn
    • The rate users are canceling their SaaS subscription
    • Low churn is great, high churn is bad
      • Ex: 2 out of our first 50 customers are no longer subscribing, the churn rate is 4%
        • In the early days, investors will often want to know the actual number of customers who churn as well as the percent
  • Customer Lifetime Value (LTV)
    • The average customer value (MRR times the number of months they are a customer)
    • LTV minus the CAC gives you a good indication of if you're on the right track to profitability
  • Free Trial
    • A set length of time that the user has full access to the SaaS service before they either have to pay or stop using it
  • Freemium
    • An offering of part of your SaaS service that is available for free to users
    • Freemium accounts have limited features available, and great SaaS products will keep driving Freemium users to "paid-only" portions of the app
    • For example, the "Freemium" version of Slack erases all messages after the 10,000 most recent
      • So, while you're on the freemium version and you scroll up to find a message that is no longer available
        • They have a clear call to action, a little box where you can click to upgrade and see all prior messages
        • image
      • This is a great example of how to withhold key features from freemium members to entice a paid conversion - known as upsell
  • Upsell
    • Selling of additional services or features to a current customer
  • Renewal Rate
    • The frequency with which customers renew their subscription
  • Ideal Customer Profile (ICP)
    • The user (or company) who is most likely to have their problems solved by your service
  • Customers vs Users
    • If a "customer" isn't paying you anything, they're not a customer; they're a user.
    • When an investor asks you how many customers you have, they are always referring to paying customers
      • They will want to know how many users (free tier, freemium) you have also and the conversion rate to paid
  • Total Addressable Market (TAM)
    • Often founders get overly focused on TAM
      • The main problem Jason sees is that they actually focus on the "wrong TAM"
      • Jason instructs all founders to focus on a bottoms-up TAM rather than a Lazy TAM
      • Lazy TAM is grabbing a giant number from a McKinsey study and referencing that as the TAM for your startup
        • For example, the global real estate market is $10 trillion, so that's our TAM
        • This is not insightful and is a bad signal when pitching investors because it lowers your credibility
      • Bottom-up TAM is reverse engineering your TAM based on who your ideal customers are, and how many of them exist
        • For example, you're going after single-family homes in the US, of which there were 82M in 2018
          • You think we can close 10% of this market, which would be 8.2M homes
          • If we take 10% on an average sale price of $300K, that's $30K x 8.2M, which equals a market size of $246B
          • Jason goes in-depth on TWiST episode 1244 Bottom-up TAM
        • This is VERY insightful when done right, and shows investors that you both
          • 1. understand your customer and
          • 2. understand your initial market very well
  • Full-Time Employee (FTE) vs Part-Time Employee
    • Who is working for and getting paid by you?
    • Full-time employees are working on your idea and only your idea
    • Part-time employees may be putting in a few hours here and there while working other jobs or going to school
    • Part-time employees should be differentiated from FTEs when discussing team size
      • When investors ask how many FTEs you should always be clear
        • Investors aren't judging you on this, they simply want to understand your team
        • For example, say we have 3 full-time employees, 6 part-time, and we occasionally hire 2 consultants to do X, Y, and Z.
        • Too often founders in this situation would say we have 3 employees, others would say they have 11 employees, and some would say something in between
          • Even if you are intending to be truthful this can hurt your credibility
          • Investors may think you either don't know the makeup of your team or for some reason want to hide that information
          • You can always ask them to clarify how specific they want you to be

Key concepts of SaaS and how it works

There are typically three phases at SaaS companies

  1. The initial, early, startup phase
    • This is where most of you are at...
    • An MVP is being built and put in front of users
    • This is typically before any funding
    • Maybe there are a couple of customers, but most users are often are on free pilots at this point
    • It's totally common to have only users at this point, so don't be discouraged,
    • If you have people using your product own that you have early traction
      • Even if they are using your product for free!
    • The company is likely still understanding which needs they are filling at this time
  2. Next is the growth phase
    • Some of you may be working towards this phase as we work through the content of Founder.University
      • Others may not get there until after the twelve weeks
    • At this phase, customers start coming on quickly
    • Some convert from free tiers to paid
    • MRR starts trending in the right direction
    • In order to scale with the demand, you may need some outside funding for hiring
      • If you can bootstrap - that is great
      • But accelerators, angels, and VCs are a few options for funding at this early juncture
  3. The last phase is the maturing phase
    • This can take several months or years to reach
    • Things are a bit more stable at this point
    • Still acquiring customers quickly, but predictably
      • The audience is defined with good product-market fit
      • The company understands the anticipated churn and can adapt
    • Additional rounds of funding to grow are options
    • Raising prices or reducing headcount to become profitable is also an option

How are you going to make money with SaaS?

  • Subscriptions
    • A unique part of a SaaS business is that there is no hardware
      • SOFTWARE as a Service spells this out in the name
      • Users pay to use your software or service on a monthly or yearly frequency
    • This business model creates "recurring revenue" for a startup
      • The users are paying to continue using the service
      • Each month a customer decides if they'll continue to pay
        • As a SaaS founder, you are always selling because a user can churn at any time
        • A lot of companies have customer success teams to manage the relationships of their current users to keep churn low
          • We'll talk about this more when we learn about building a team
    • Founders and investors love SaaS because (assuming low churn) you start every new payment cycle with ~100% of your revenue from the last month
  • Upsell
    • One way to increase MRR without bringing on new customers is to upsell
      • This is way more profitable than finding new customers
      • This increases the LTV of the customer and continues the relationship which also reduces churn
    • So what does upselling look like at a SaaS company?
      • One way is increasing the number of "seats" at an organization
        • Meaning the same company pays extra money for more employees to use it
          • For example, the sales team is using your product and you "upsell" the company to the next tier to allow the marketing team to begin using your product as well
      • Getting current customers to pay more for additional features or more expensive plans
        • This could manifest in multiple ways:
          • Moving users up a tier for extra features
          • Increasing the amount of storage or saving of data for longer
          • A personalized customer service rep
          • Access to APIs and customized integrations
          • White labeling of the service
  • Increase retention and limit churn
    • As outlined above, monthly recurring revenue (MRR) is one of the advantages of SaaS
      • The only catch is that you must retain these customers month-to-month to recognize that revenue
      • Customer success teams are so important to SaaS companies for this reason
    • Revenue goals for the company are often based on these MRR numbers
      • Typically, with a subscription model, you aren't getting paid upfront for the year (unless you charge yearly)
        • So the year-end goals around ARR are based on MRR projections
      • So if customers churn before you've realized the ARR on their MRR you won't hit anticipated revenue numbers
  • Bottom-Up SaaS
    • When selling at the enterprise level, it can be challenging to identify the buyer and then create buy-in for your product
    • The idea of bottom-up SaaS is to get the product into the hands of lower-level employees at the company where there is less friction
      • This land and expand concept gets the product to the users, for low or no cost, without the need for high-level approval within their company
    • As defined by David Sacks in his blog, bottom-up SaaS, this method "monetizes like an enterprise product but spreads like a consumer product"
      • It leverages the pros of consumer subscription
        • Ease of adoption, speed to market, and lower initial price
      • And neutralizes the negatives of enterprise SaaS
        • Slow to adopt, need approval from higher-ups in the organization, and expensive
      • The products into these companies, begins to spread throughout enterprise, and then becomes to valuable to get rid of so they begin to pay for a subscription

  • Net Dollar Retention
    • Net dollar retention, or NDR, can make a SaaS startup nearly invincible in terms of growth
    • So, what is NDR?
      • NDR is the metric that shows customer revenue on a cohort basis
        • Cohort analysis is something we'll dig deeper into when we talk metrics later
      • NDR can be positive or negative
      • If your NDR is positive, then you've achieved what David Sacks calls "net negative churn"
        • This means revenue expansion from the customers you retain exceeds revenue lost from customers who churn
        • In plain English, this means that your current customers are spending more from upsells or add-ons than the revenue lost from customers who churn or downgrade
    • You are growing revenue without having to make new sales
      • So... what happens if you have net negative churn, and you're closing new deals left and right?
      • Well, you'll become one of the most sought-after companies in the SaaS space!

Examples of SaaS companies

  • Here are a few public SaaS companies you might have heard of and their market caps (~Q3 2021) to show you just how big these software businesses can get:
    • Microsoft: $2.1T market cap
    • Adobe: $300B market cap
    • Salesforce: $228B market cap
      • Slack: Acquired for $27B
    • Shopify: $187B market cap
    • Zoom: $106B market cap
    • Atlassian: $84B market cap
    • Snowflake: $84B market cap
    • Hubspot: $31B market cap
    • Zendesk: $15B market cap
    • Asana: $13B market cap
  • Here are some popular private SaaS companies:
    • Stripe: ~$100B valuation (premium version is SaaS, the rest is transaction fees)
    • Sourcegraph: $2.6B valuation
    • Superhuman: $825M valuation

Why are SaaS companies so coveted by investors?

  1. Recurring revenue!
    • Predictable, monthly revenue provides visibility into the success of the company
    • This is especially true for B2B SaaS (sometimes called enterprise SaaS)
      • B2B SaaS can charge more per seat
      • Enterprise customers also tend to churn less frequently than consumer customers
  2. SaaS companies are capital-efficient
    • As outlined above - they can scale without a huge increase in fixed costs
    • It is much easier to scale bits than it is to scale atoms
  3. Opportunity to scale
    • The market size for software is only increasing
    • It will jump significantly as services like Starlink bring broadband to the entire planet
  • SaaS companies all follow a similar playbook
    • Experienced VCs have a pretty good idea who is following the playbook
      • Or who is calling audibles that might get them in trouble
    • Similarly, VCs can offer support to SaaS founders because they've seen it before
  • Software as a Service offers benefits to users, founders, and investors

Additional Resource


  • Note: Even if you are not a SaaS business these activities are valuable to understand
  • 🔲 Identify your bottoms-up TAM
  • 🔲. Brainstorm potential ways to upsell your product down the road; are these core features or can they be added to your backlog?