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SaaS

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?

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

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

SaaS apps get you up and running quickly!

For most SaaS apps, you can sign up and start using the software within minutes

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

SaaS apps can be very complex, sophisticated, and powerful

Companies aren't sacrificing features for speed

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?

For the same reasons outlined above:

Complex apps, available anywhere, built and delivered to users quickly (and usually inexpensively!)

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

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

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

Since the law of small numbers is at play

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

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

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

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

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?

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

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

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

Activity

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?

02. What is SaaS?