Software-as-a-Service (SaaS) is a growing sector in the technology industry. It is a software distribution model where the software is present in the cloud, and users are charged monthly or yearly. The core benefit of this model is that it has the same utility for the user at a reduced cost.
In the last 8 years, SaaS has shown more than a 6-fold increase in market size from $31 Billion in 2015 to $195 Billion in 2023. This marks a sweet time for investing in such an exponentially growing sector at extremely comfortable valuations.
Why are SaaS Companies highly profitable?
SaaS companies have high-profit margins due to the low delivery cost to the end user.
As fast internet connections have started appearing in every other town and city, the ability to send and receive complex data has increased for the common user. SaaS providers leverage this fast internet connection to deliver software using the cloud.
Using SaaS products is beneficial for both consumers as well as the vendor. The consumer does not have to pay upfront costs or worry about having suitable hardware. For the vendor, they do not have to identify distribution channels, logistics handling, both physical and digital, and they also do not have to share margins with the intermediaries like distributors and retailers.
Due to these benefits, the gross profit margin of SaaS companies has risen exponentially. Typically, a SaaS company can have a profit margin of up to 80% of sales value.
Why do investors like SaaS startups and companies?
Many investors like investing in SaaS companies, specifically startups, because of easy revenue predictability, scalability on demand, and high-profit margins.
Investors like SaaS mostly due to revenue predictability. Most users subscribe either monthly or on a pay-as-you-go model. This creates a constant stream of revenue.
Further, since the software has been created, the fixed costs are already accounted for. SaaS is highly scalable because only more cloud instances are required to accommodate more users. Interestingly, Cloud instances can be predicted using machine learning algorithms. This convenience makes it easy to predict future growth based on past industry trends.
Another reason investors like SaaS is that the barriers to entry have been minimized due to increased profitability and reduced costs. Startups can easily enter the field and create much more affordable software because they do not have many legacy costs for administration, training, or infrastructure. Several startups work remotely to reduce input costs. Startups save an estimated $10 Million yearly due to remote work.
How to choose a good SaaS company?
Valuation games are a significant problem while investing in new-age digital companies. Many companies are not originally in the market for doing business but just for obtaining venture capital. Avoiding such companies is essential to get a high ROI (return on investment) out of investments. Here are a few rules that one should keep at the back of their hand for evaluating SaaS companies without much effort.
Customer Acquisition Costs (CAC)
The cost of acquiring a customer matters the most for any company. Several companies have high customer acquisitions, but they are rarely profitable.
In addition to CAC, there is an additional metric called LTV to CAC ratio. LTV is a user’s lifetime value (amount) on the SaaS subscription. If the LTV/CAC ratio is greater than 1, then the business is profitable. For LTV/CAC ratio greater than 5, it means that the business is spending little on marketing and should scale up its activities to increase business reach.
Price to Sales (P/S) Ratio
This ratio is of the utmost importance for an investor to gauge investment return. A high price-to-sales ratio means that your investment will take longer to recover. The later the cost recovery period, the more delayed the investment’s profitability will be. But a higher P/S ratio also means investors are optimistic about the business.
There is no fixed or optimum value for the P/E ratio, but keeping it less than the industry average is recommended.
Good Consumer Support
The most important aspect of building long-term value is post-sales support. Poor post-sales support leads to bad consumer experiences, reducing consumer retention.
Good consumer support can be identified with 24×7 availability, multiple communication channels, and the professional behavior of service representatives. Further, the company should also evaluate consumer satisfaction after assisting them.
Number of Active Users
Active users denote the customer retention capability of a company after initial onboarding. Identifying active users is also helpful for companies that wish to analyze usage patterns and consumer needs. This data can be used to develop the SaaS product even further. The type of active users can differ from company to company. Most SaaS platforms are used during office hours and working days, while others, like LinkedIn, are also used during weekends.
Understanding these usage patterns can help identify whether the users rely on the SaaS product or are just casually browsing.
The SaaS market is growing rapidly due to higher profit margins, low barriers of entry, and cost-efficient startups. The sector presents a valuable investment opportunity that can deliver high returns. However, it is also equally important to invest in healthy companies that have long-term potential. Sound investment principles and wise decision-making can help reap good returns for investors.
[…] Billion in global SaaS spending. Over the last six years, the industry sector has grown more than eight times in size. Top companies like Microsoft, Alphabet Inc, Google, Salesforce, and Amazon, are already […]