Nothing's perfect

(Part one of this series was called SaaS: First, the good news)

While there are many inherently good things about the SaaS (Software-as-a-Service) business model, there are also some unique challenges.

Higher cash requirements (Please deposit $24 for the next minute…)

SaaS companies can be very cheap to start, but because they tend to produce recurring (usually monthly) revenues rather than large lump-sum payments, it’s hard to use current cash to finance future growth. VCs often assume that it takes about $50 million to build a profitable SaaS company. Assuming a 4 year path to profitability, you’re burning through $24 a minute. This problem is made worse by…

…Lower price points (including FREE)

Because they’re typically based on a subscription model, SaaS companies try to maximize lifetime customer value through a low entry price and a long subscription duration. This approach, combined with intense competition and strong customer expectations that online content and services should be free or extremely cheap, means in order to reach profitability…

…You gotta have scale

If you’re entry price point is free (or something close to it) and you’re relying on some advertising revenue plus conversion to higher priced offerings (a conversion rate of 1% of your total customer base is considered typical) then you have to be able to attract and retain a very large number of customers before you’re in the black. That means your infrastructure and application need to be engineered accordingly, of course. But more importantly…

…Customer acquisition will be a major expense

While the online nature of SaaS suggests a pure online selling strategy, the reality is that SaaS companies tend to be very omnivorous in their drive to acquire customers. Between PR, search engine optimization, keyword advertising, webinars, email campaigns, reseller compensation, and other direct and indirect sales efforts, you could easily be spending 2/3 of your money on sales and marketing expense. To get a return on this investment, especially in the early days before your market matures, you’ll need to reach and convert a pool of savvy and influential people who prefer your vision of the future to that of your many competitors. In other words…

…You’re competing for the attention of Influencers, not just customers

Early customers are different. They know that others look to them for guidance about which technologies or services to adopt, and that their opinion counts. They will be very hesitant to risk their reputation on a company that doesn’t deliver a good experience and good value to their friends and colleagues. To be successful, you’ll need to build specific programs and efforts for reaching, influencing and recruiting these early adopters. These programs may be very different (and much more expensive, on a cost-per-customer basis) than your “typical” customer acquisition programs.

More on this in a separate post.

Whoopee!

There are a lot of great things about the Software as a Service business model. Here are 7 of them…

Cheap to start

SaaS companies can be very cheap to start because you can leverage existing infrastructure (Amazon’s EC3, Google, etc.) and great open source tools and languages to deploy powerful applications fairly quickly. This means you can keep your team small and agile while you figure out your offering and business model. This is closely related to…

…Faster development cycles

You can add functionality incrementally, see how customers respond, and react accordingly. It’s also fairly easy to run “beta” features side-by-side with production code, allowing the adventurous ones to get the new stuff early and give you feedback, without having to worry about upsetting the “just keep it working and leave me alone” segment of your customer base. You can also create a…

…Rapid “Find it, try it, buy it” sales cycle

This not only helps reduce your cost of sales, it’s a great way to understand what customers are responding to. You can test new messages and benefit statements, target new types of customers, even quickly roll out new offerings. This direct sales cycle, coupled with your faster development cycles, makes it much easier to…

…Stay close to your customers

Through methods both active (blogs, online surveys, email) and passive (measuring ROI on AdWords, reviewing log files to see what features are used most) you can get lots of information about what your customers like and want, and what they don’t care for. This not only helps you use your engineering resources efficiently, it means you can do a better job than the next company of meeting their needs and keeping them happy, so you can benefit from…

…WOM economics

Simply put, word of mouth is the least expensive and most desirable customer acquisition strategy. There are some very smart people who specialize in WOM marketing (for example, Seth Godin), but the key idea is simple: recommendations from existing customers are more influential than your own marketing messages, and cost a lot less money.

While we’re on the subject of money, SaaS companies are very well suited to…

…Recurring revenue models

It would be hard to convince someone to send you money every month for a piece of software they installed on a desktop computer, but customers are comfortable with the idea of paying a recurring fee for a recurring service. Part of the reason is simply psychology (customers don’t feel like they own the application), but another aspect is the understanding that you’ll continue to develop and enhance the system over time.

Recurring revenue is good not only because it’s predictable, but also because it compounds your growth tremendously. With the exception of churn, your year 2 revenue starts at your ending revenue for year 1. With traditional software, your year 2 revenue starts at zero. It’s also good for the customer because your interests and theirs are closely aligned. You have to keep them happy every day, not just when a new version comes out, or you’ll lose them.

This recurring revenue stream also helps you to…

Build partnerships quickly and cheaply

Recurring revenue is a powerful inducement to potential partners. You can both share in the wins, and no one has to pony up a bunch of money up front for something that may not produce a lot of results. It’s not only much easier to put together meaningful marketing, distribution or customer acquisition partnerships, but the technical advantages of web-based integration (usually much faster and cheaper than for installed software) mean you can deliver a wide range of functionality to your customers without having to build it all yourself.

So much for the good news. Next, let’s look at some of the inherent challenges of the SaaS business model.

(Part two of this series is called And now the Bad News… )