Strengths
Software-as-a-service companies can be highly lucrative enterprises given that they produce recurring streams of revenue by rendering their services to both individuals as well as other companies. As a result of this recurring income, numerous software companies have adopted this business model in order to have regularity of their earnings on a month-to-month basis.
This model has not only applied to online driven enterprises, but also enterprise level software that is used within the framework of a desktop or laptop computer. Most importantly, the use of the software as a service business model (commonly referred to a SasS), provides the owners of these firms with substantial valuations once they establish a significant user base. Unlike traditional ecommerce websites that typically have price to earnings multiples of two to four times the previous year’s income, software as a service companies can often have valuations ranging from 5 to 8 times the prior year’s profit. For this reason, numerous entities have entered the field with this type of business model.
The startup costs for most software-as-a service enterprises are also relatively low. This is especially true if the founder or founders are highly experienced software professionals that are able to produce the underlying technology on their own. For state-of-the-art applications that can be deployed using the SaaS model, typical costs can range from $50,000 to $1,000,000 depending on the complexity of the software that is being offered. One of the most important things to note when establishing this type of software business is that a vast majority of the capital that is going to be required will be focused on marketing. Over the past ten years, there has been a substantial amount of competition that has entered the market. It is for this reason that these enterprises need to create unique software that will find an immense audience.
It should be noted that the common metrics that are applied when determining the viability of a SaaS company is monthly recurring revenue often abbreviated as MRR as well as annual recurring revenue which abbreviated as ARR. When approaching a potential funding source, these are the key metrics that should be shown within your business plan. Most importantly, an investor is going to want to see that the monthly recurring revenue increases significantly on a month-to-month basis while also maintaining a very high client retention rate. The most successful software as a service enterprises typically have a retention rate of 85% or higher on a per annum basis.
Globally, the software as a service industry continues to expand rapidly. As of this year, total industry revenues from software as a service enterprises are expected to reach $300 billion. The compounded annual growth rate of the industry is expected to remain near 15% over the next five years. One of the major benefits of operating this type of business is that they always have global reach. Any software entity is able to market their services on a global basis through multiple forms of online marketing including targeted advertisements on social media platforms (especially LinkedIn).
Below is an overview of recent statistics regarding the growth of the software as a service industry:
Weaknesses
As it relates to weaknesses, software as a service companies typically have very substantial ongoing business development costs as they need to continually improve their underlying software and technology to maintain their user base. Additionally, and as noted above, these enterprises have very substantial marketing costs. It is not uncommon for a SaaS enterprise to incur up to 50% of their total revenues as marketing expenditures within the early years of operation. One of the other issues that is commonly found among these types of businesses is that they need to maintain a very large customer service department in order to ensure that clients are satisfied with the specialized software-driven services being provided in order to keep the retention rate high.
Payroll costs can also be a significant factor for this type of business given that highly specialized software development professionals and information technology professionals are needed to properly develop and expand software modules for client use. In order to address this issue, many startup SaaS companies will typically work with third party entities that can produce software, or they will retain independent contractors that can develop specific aspects of the operations but do not operate as standard employees within the firm. Again, some of the most successful businesses within this industry were created by software professionals given that they can create the underlying technology on their own time without incurring any direct expenditure.
Opportunities
There are numerous opportunities for software as a service enterprises to expand their operations. Most importantly, the ongoing use of high impact marketing strategies to drive traffic to the business’ website as well as their respective application suites can be increased on a yearly basis. Additionally, new components that improve the user experience can be created on an ongoing basis period this not only ensures that the monthly retention rate remains high, but it will also contribute to greater word of mouth promotion especially as it relates to enterprise level software for use among large scale corporations.
There is also the possibility that a business that operates within this industry can conduct acquisitions of companies that operate in a similar or identical capacity. The internet has made it very easy for entrepreneurs of all sizes to find existing businesses that can be acquired and cost effectively integrated into their respective ecosystems. On this note, a software as a service business can also acquire companies that offer complementary services to expand the scope of the offerings of the firm. This is a very easy way to expand the value of these types of businesses, especially as smaller SasS firms can be acquired at lower price to earnings multiples.
As it further relates to expanding the operations of these types of businesses, many entrepreneurs will focus on their client’s pain points. In most cases, SasS firms typically render their services to other businesses. As such, software that is able to improve time efficiency, cost efficiency, or reduce business risk are typically the types of services that are most sought after by small businesses, medium-sized enterprises, as well as large corporations.
In fact, most successful business firms have an extensive market research component so that they completely understand the needs of each of their clients and how they can better improve their operations through state-of-the-art software. It is very important that ongoing client outreach is conducted so that new software modules as well as new services can be integrated cost effectively and with the intention of creating significant streams of occurring profit.
In furtherance of expanding revenue, some entities that operate on a software as a service basis will concurrently offer specialized services that can be purchased on a one-time basis. This is very common among software as a service companies that operate in industries where products are sold. As an example, a software company that specializes in providing real-time listings of inventory listings on a global basis can integrate a service that would allow for direct communication with an overseas supplier for a fixed fee. Usage fees of this nature can further boost revenue as well as the overall valuation of any software company period
Beyond growth through increased marketing and acquisition, SaaS companies are able to easily acquire additional funding as needed. Once established and the initial monthly recurring revenues commence, there are a number of financing options that are available to entrepreneurs within this field. First, most financial institutions are willing to extend a revolving credit facility based on the anticipated receivables over a 12-month period. This is a very cost-effective way of obtaining financing in order to cover much of the marketing expenditures as well as the software development expenditures that are faced during the early years of operation.
There is also the possibility that a successful and rapidly growing SaaS firm can acquire ongoing funding through private investors such as private equity groups or venture capital firms. However, this type of financing can be extremely expensive. Most private equity firms or venture capital groups typically want to have a controlling interest in the business in order to ensure that it is expanding properly and within the framework of their anticipated rates of return. Once the business achieves profitability, more favorable terms from private funding sources can typically be acquired given that their risk is has been substantially reduced.
Once a SaaS software enterprise generates in excess of $50 million a year of revenue, there is also the possibility that they are able to carry out an initial public offering or IPO. Many entrepreneurs view this as the holy grail of business success given that they can have access to public markets for ongoing capital needs as well a ups for divesting shares at a substantial profit. While this is a possibility for highly established firms, the vast majority of SaaS companies typically are sold to third parties or are acquired by private equity firms once they achieve a substantial level of profitability.
Threats
The primary threat faced by a software as a service company is the ongoing competition that is faced as these businesses established their operations. Software development has become somewhat of a commodity over the past 15 years given that there are now a number of global software developers that are able to showcase their work to a worldwide audience.
As such, it is imperative for any software as a software service enterprise to find a unique niche within a specific field. For smaller entities, this is really the best way to thrive within this market given that larger companies that offer enterprise level solutions are extremely well capitalized and are able to more effectively market their services to larger entities.
As with any company, inflation and challenging economic climates are also a potential threat that are faced by these businesses. As it relates to inflation, this can cause upward pricing pressure on the underlying marketing expenditures that are needed to establish a client base. This can also contribute to higher personnel costs for both directly employed staff as well as independent contractors as they raise their rates in lockstep with inflation. Depending on the specific type of industry that the SaaS company is operating within, challenging economic climates can also limit demand for specialized services. It is very important that any new enterprise within this field tightly control their operating costs to ensure that they are able to remain profitable and cash flow positive.
Finally, an ongoing threat for SaaS businesses is that they need to continually understand and adapt to the continually changing business environment. It is no secret that economic conditions can change rapidly as well as trends within the technology industry. As a result of this, senior level management employed by software as a service companies need to be continually aware of changing market conditions so they can properly adjust their software or create new services that focus on the challenges that their clients face.