What makes a SaaS startup?
Margins
It’s often heard in Venture Capital investment circles that companies should target “SaaS” revenues - the threshold for this is when a company is achieving 70-85% margins “at scale”.
What is SaaS?
A Software as a Service (SaaS) business provides on-demand computer software as its main product. SaaS is the foundation of the business strategy behind nearly all enterprise software companies.
The service component differentiates the licensing and ownership model - with SaaS products, customers pay for access to a software application hosted on the service providers infrastructure, often through a thin web client.
This business model has been made possible (on an industry wide scale) due to the commoditisation of server infrastructure through cloud computing, drastically reducing the barriers to entry for large-scale hosting.
The key component of a true SaaS business is zero or near-zero marginal costs - we’ll explore this in more detail in a future post, but essentially this means the firm doesn’t need to pay for extra inventory or extra labour in order to serve an additional customer. This is a big deal when we look at the economic model and assumptions for a typical startup business.
85% margins! Holy economic rents batman!
Nothing says economic rents like 85% margins, yet many SaaS businesses boast margins in this order - what’s going on?
While SaaS businesses may enjoy near-zero marginal costs, they face huge upfront development costs.
The development of most SaaS applications requires many months or years of work by highly skilled engineers - these don’t come cheap.
These upfront development costs form a very strong barrier to new firms entering the market and copying an existing SaaS product.
SaaS business customers are often sticky - getting humans to change their behaviour is hard, and getting organisations to change their behaviour is even harder. This represents another barrier to entry as a new entrant needs to show that their product is substantially better than existing firms if they want to attract customers - sometimes even years after a new market entrant, incumbent firms still enjoy customer retention simply due to legacy and habit.
Key disclaimer - “at scale”
The reality for most SaaS businesses is that they are still in the “very expensive years of development” point on their journey, and haven’t got to the “enjoy economic rents” bit (relatively few currently operating SaaS businesses are genuinely hitting 85% margins).
These businesses see very high fixed costs - despite commoditisation, cloud computing is still pretty hard to set up (requiring people who know what they’re doing).
At scale just means that once a company has enough customers, the near-zero marginal costs mean the fixed costs component of goods sold (or services provided) asymptotes to 0.
This is very handy when you have expensive software engineers and executives to pay - get enough customers and who cares what your fixed costs are!
Also very handy when you’re calculating future expected value of a business: no need to worry about those pesky costs - just pure ARR to the moon.
Why do we care?
The ability to charge economic rents (or the theoretical ability to do so at some point in the future) is a huge driver behind company values for SaaS businesses. High revenue multiples flow from the simplification that a high margin SaaS company should be so profitable that revenue is almost as good a predictor of underlying value as profit.
SaaS margins are basically why Venture Capital (at least, those focussed on SaaS startups) exist - it’s a bit circular, but high margins lead to a high valuation which in turn means a good exit for the VC.
Not everything is SaaS, and not everything can have 85% margins. It is nearly impossible to achieve margins this high in anything but software - software is unique because the value created is very detached from the cost of production. Software is ultimately just electrons in logic gates, and the resource cost of using a piece of software can be as cheap as running a lightbulb.
Obligatory AI mention
Like pretty much everything, AI could revolutionise the space - AI doesn’t have practically 0 marginal costs, so it’s possible that AI startups will move away from the “85% margins” focus in the future.
This is going to be a very interesting thing to watch in the coming years.
My feeling is the margins will end up somewhere between full-software and service-based businesses, with scaling difficulties also being somewhere in between. Could AI mean the end of the (effectively) zero marginal cost per user SaaS?