What a Software as a Service (SaaS) Company is?


Unless you’ve been living under a rock the past few years (or you just don’t care about stocks/tech at all), you’ve probably wondered what is a SaaS Company (Software as a Service). As a group, SaaS stocks have done amazingly well relative to both the broader market and the tech sector:

SaaS, Tech Sector, and S&PSaas-Returns-Relative-to-SP500  500 Returns (Source: Sharadar)

Part of the reason is that the pandemic has shifted many employees to work from home, and so investors expect businesses to become even more reliant on SaaS vendors than before in order to keep operating as usual. But that can’t be all there is to it. SaaS has been one of the hottest trends for years — if your company was fortunate enough to be classified as SaaS, it received an earnings multiple many times that of non-SaaS software vendors. And if there were no earnings, no problem, your company got a sweet price-to-sales multiple instead.

So what is it about SaaS that lets these companies be perceived so much more optimistically than their peers? More importantly, do SaaS companies possess business models that are differentiated and advantageous enough to justify the hype? Let’s explore!

# What Is Software As A Service Company?

SaaS is a subcomponent of the broader cloud computing sector. Back in the day before cloud computing, a company needed to buy its own servers, storage, and networking hardware. Then it needed to install an operating system and basic software. And finally, it then installed end applications (using CD-ROMs, remember those?) or hired engineers to write and maintain its own applications that did everything from tracking payments to vendors to sharing, archiving, and visualizing data.

You can imagine what a headache this was. Often, it was difficult enough just to keep everything running. Updating widely used company software like corporate email or Microsoft Windows was considered a major and massively risky event. Many companies with overworked and understaffed IT departments opted instead to go with the, “if it ain’t broken, don’t fix/upgrade it” approach. For example, at a previous job, I used a laptop running Windows 2000 in 2011!

This meant that software consumers were often missing out on the latest and greatest features. It was also a headache for software vendors. For example, in 2011, Microsoft still needed to devote engineers to support Windows 2000 and all the other older versions of Windows that were used by important corporate customers. If it could just get everyone on the current version of Windows, then it could spend its effort iterating and improving the current version as well as developing the next version instead of wasting time fixing bugs and fighting fires on obsolete software.

Enter cloud computing. Cloud computing re-envisions the software (and hardware) tech stack as a utility. Much as things like electricity or the internet are plug and play (requiring zero thought from consumers), the cloud computing sector aims to do the same for businesses and their software needs.

Nowadays instead of setting up their own data centers, companies can sign up for AWS (Amazon Web Services). Doing so allows companies to tap into as much of Amazon’s vast computing capacity (Infrastructure as a Service) as they need. There are also operating systems and a whole host of nuts and bolts software that’s ready to go with it (Platform as a Service).

And finally, there’s an entire ecosystem of software vendors, the SaaS industry that this post is about, that develops software applications that meet specific needs like messaging (Slack), video meetings (Zoom), or analytics (Tableau). These applications take corporate pain points that are widely shared across companies and address them with software solutions, which are subscription-based and delivered over the internet.

# How Is SaaS Different From Traditional Software?

A question many might have is how SaaS is any different or better than traditional software. Since it almost seems like another world, let’s run through some of the key characteristics, as a refresher, that defined software in the pre-SaaS software era:

  • Instead of one standard product like right now, traditional software came in the form of many versioned products (Windows 2000, Windows XP, Windows Vista, etc.).
  • Enhancements were mainly bug fixes and significant new features were reserved for newer versions (otherwise there would be little motivation to upgrade).
  • Software vendors mainly got paid when customers upgraded to a new version. Ongoing servicing costs post-installation were also a lesser but still significant source of revenue.
  • Installation of new software and major updates to that software were both major endeavors in terms of time, money, and risk. This incentivized consumers of software to stay with the existing version for as long as possible.
  • Software was run on-premise on the customers’ own servers.
  • On the flip-side, for software vendors, the ongoing maintenance of older versions dragged significant resources away from research and development and was generally regarded as a financial drag. For vendors, there was an incentive to depreciate older versions of software over time in order to motivate customers to upgrade to (and spend money on) the latest and greatest version.
  • This meant that like a car, from the moment you purchased new software, it was depreciating— less support devoted to it over time and suboptimal features compared to newer versions.
  • This also meant that the combination of hardware, tech stacks, and applications used by individual companies were massively variant with big differences across both vendor and version (because data centers and software installations were all on-premise). And software vendors could provide value by being more willing than their peers to make their application work across various configurations — willingness and ability to customize used to be a source of differentiation.

SaaS eventually turned all this on its head. In the SaaS era, software is:

  • Subscription
  • Generally, there is only one version, the most current one.
  • And that version is hosted on the software vendor’s servers(that they either own or lease). A side benefit of this is better analytics into how customers are using the software.
  • Customers access the software via the internet in much the same way as we watch YouTube or use Gmail.
  • And that version is constantly being updated as bugs are fixed and new features are rolled out. These updates happen behind the scenes without any required actions from the customer (they occur on the vendor side and are pushed to all customers simultaneously upon release).
  • SaaS era software is constantly improving as new updates roll in while the cost remains fixed (same ongoing subscription fee). There is even the potential for cost declines as more customers allow the SaaS vendor to spread its fixed costs over a larger base (and SaaS software has little in the way of variable and marginal costs — once developed, it costs almost zero to bring on a new customer).
  • And as the data center moves off-premise and increasingly to the cloud, the hardware and software that companies run on becoming increasingly modularized. I am somewhat overly simplifying things, but nowadays it is more like selecting from a streamlined one-page menu whereas before it was more like a thousand-page catalog of endless options and combinations.

The last two points have the biggest business implications. Being able to offer more value for the same price (or a declining price) is huge for customer retention. As is the fact that modularization via a simpler menu of cloud offerings has done away with much of the stress and headache of installing and maintaining a data center and its software (this represents substantial financial cost savings for customers as well). Moreover, the easier it is to set up and use new software (and the cheaper that software is), the more likely customers are to consider a software solution for areas they wouldn’t have in the past — where 10 years ago, an Excel spreadsheet (and a team of analysts to manage it) might have been a clunky but good enough solution, today it would probably be replaced by a SaaS solution.

So I don’t think it’s hyperbole to state that SaaS has significantly increased the size of the market and types of end applications that are considered addressable by software. And as more companies move to the cloud and conduct more of their day to day business via the web, that migration in itself creates new markets and business opportunities such as cloud-centric cybersecurity.

# SaaS Stocks Are A Risky Bet On High Growth

Everything I described is well and good. But is there more? SaaS companies trading at 30 times sales (compared to 1.6 for the S&P 500), often with no earnings and substantial losses.

This means that the future that investors envision for these companies is one of sustained and massive growth and eventually significant profits. But the SaaS model seems easily replicable — nowadays every software company that wants to solve some sort of business problem with their application will adopt a SaaS approach (single version hosted vendor side, web-based delivery, and subscription-based).

And the SaaS blueprint for scaling is also pretty set at this point:

  1. Raise a ton of money from venture capitalists and eventually an IPO.
  2. Spend some of it developing and iterating the product.
  3. Spend a lot of it acquiring customers (marketing expenses) in order to grow as quickly as possible.
  4. Hope that customer churn is low so that over time the cashflows produced by each cohort of new customers is greater than what it costed to acquire them (customer lifetime value > customer acquisition cost).

This plan has a chance of working because the market is still somewhat young and unsaturated — new applications are still migrating towards SaaS software based solutions at the same time that businesses are considering automating more and more of their functions (starting with the most manual, error-prone, and costly ones).

And as businesses increasingly turn over the automate-able aspects of their record keeping, data management, monitoring, and reporting to SaaS vendors (and become increasingly reliant on and tied to these vendors), the amount of customer lock-in that SaaS vendors enjoy will only increase. Thus, it’s conceivable that each customer ends up producing as much cashflow over its life as investors are betting they will.


At the same time, the SaaS industry faces significant risks. There is tremendous pressure to get to scale — the point where revenues are enough to cover both fixed development costs as well as customer acquisition costs (the majority of which are paid upfront). The latter point is also why currently the majority of SaaS vendors are operating at a loss — current expenses generally reflect all of both the R&D costs as well as the customer acquisition costs, but the offsetting subscription revenues trickle in slowly over time. In fact, because customer acquisition costs (CAC) are upfront, a period of high growth at a SaaS company often looks like a period of larger and larger losses.

To see why this is, imagine our company spends on average $100 to acquire a customer and then earns $25 a year from that customer once acquired. If we acquire 10 customers this year, then at the end of the year our company will show revenues of $250 and expenses of $1,000 for a loss of $750. If instead, we acquired 100 customers, we would show revenues of $2,500 and expenses of $10,000 and a much larger loss of $7,500. Of course, if the additional customers we got, stay with us for a long time, then its money well spent. If they churn in a year or two, then we’re in trouble.

Another risk comes in the form of Big Tech. There’s nothing stopping cash-rich companies like Amazon, Microsoft, and Google from offering their own competing solutions and duking it out with the leading SaaS vendors via price wars.

Finally, it’s important to note that a major reason for the SaaS sector’s success up until now has been the willingness of venture capitalists and the equity markets to fund these companies at very high valuations. Without this inflow of easy capital, SaaS vendors would not have been able to market their products and acquire customers as aggressively as they do.

# Conclusion

When I used to think about SaaS, the first (and only) thing that came to mind was that it’s subscription-based. But after learning more about it, I realized that the following two reasons are more critical to its hype:

  1. It allows customers to pay a fixed price for a constantly improving product.
  2. SaaS software’s ease of setup, maintenance, and use (and relative cheapness) has opened up more and more end applications to be automated via web apps. As each individual component of the cloud ecosystem improves, cloud computing’s total addressable market increases as well.

That said, investing in SaaS stocks at this point in time is a high-risk bet that the rosiest of customer lifetime value estimates and expected growth rates are realized.


Written by: Tony Yiu.

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