Table of Contents
What is the SaaS Revenue Model?
The SaaS revenue model is a form of software distribution where users pay recurring fees to access cloud-based applications through the Internet, typically in a pay-per-use or subscription-based model. The vendor maintains the application and stores its data on the cloud.
The ability to store, maintain, and update software programs on the cloud has revolutionized the software industry, providing increased flexibility and convenience to both vendors and customers.
- Vendors don’t need to deliver the physical product and release updates.
- Customers don’t have to maintain the software at their end, and they can access it from anywhere in the world.
Since Salesforce released the world’s first SaaS platform in 1999 (its CRM), software companies had to create a revenue model that was both sustainable and scalable. And with that came the modern-day subscription economy.
Since they get most of their revenue from recurring subscription fees, SaaS companies have a steady stream of income, predictable cash flow, and a lower barrier to entry for smaller companies.
- SaaS revenue strategy
- SaaS monetization model
SaaS Revenue Model vs. SaaS Business Model
You’ll sometimes hear “revenue model” and “business model” used interchangeably. In reality, the former is a single component of the latter that focuses on generating income from the core product/service.
Of course, revenue is the be-all-end-all for businesses. But it doesn’t tell the whole story. A business model is a comprehensive overview of how a SaaS company’s…
- cost structure
- internal team structure
- value proposition
- buyer personas and ideal customer profile
- product differentiation
- operational processes
- customer experience
- retention strategies
- and, yes, revenue model
…come together to form a successful business.
It’s worth mentioning SaaS companies rely heavily on recurring subscription payments from customers. So, unlike other types of companies, they dependso on customer retention. Although the SaaS revenue model considers this, it only does so in the context of revenue.
While revenue models focus on income-generating activities and initiatives, business models consider the entire picture and find ways to maximize profits in all areas.
SaaS Revenue Models Explained
Subscription revenue is where a software company makes most of its money. Typically, it’ll at least be 75% of the company’s income. And according to insights from Statista, 11% of companies earn more than 90% of their income from subscription subscription sales.
A subscription to a software product uses three types of pricing:
- Tiered pricing — Customers choose between a basic, mid-tier, high-end, or enterprise-class package. Tiers progressively include more advanced features at a higher cost. Enterprise pricing is usually quote-based.
- Flat-rate pricing — Each product tier has a fixed baseline price.
- Seat/user-based pricing — After a certain number of team members (usually between 2 and 10), customers pay a fixed recurring amount per additional user. They can onboard new users at any time.
SaaS companies sell subscriptions on a monthly and yearly basis. A monthly subscription costs the full amount. To incentivize long-term retention, they’ll take 10% to 20% or 1-2 months off the monthly price to calculate the annual subscription cost.
Customers subscribe to SaaS applications hoping for cost savings. Usage-based pricing allows them to pay only for the extra resources they consume. That way, they can’t run out of resources in the middle of a project and won’t end up overpaying and underusing certain features.
The pricing structure for usage-based revenue depends on the company and its product. For example:
- Data storage fees
- API call fees
- User action (e.g., clicks, logins) fees
- CRM/marketing automation contacts
- Lead generation fees
Although revenue from new users on a team account is a form of usage-based revenue, pure usage-based revenue is transactional and happens within the product. It’s typically somewhere between a fraction of a cent and tens of cents for each action.
Within a SaaS org, an inside sales team sells directly to prospective customers. For a brand-new startup, this is almost always the first approach because they don’t have good enough branding or product validation to dive into marketing (nor do they have the network to leverage other strategies).
The inside sales team is responsible for:
- Finding and connecting with leads
- Educating the prospect on their product’s value proposition and differentiation
- Coordinating virtual product demos
- Handling contract negotiations (e.g., getting sign-off on pricing)
As SaaS companies grow, they continue to expand their sales force because it’s easy to calculate how much they need to invest in sales to predict specific revenue. This is one of the main selling points (pun intended) of SaaS companies for investors. However, they branch off into different strategies as well.
Even as a new market entrant, getting others to sell your product for a piece of each sale is incredibly easy. So, most software vendors set up an affiliate program as soon as they launch their new product or service.
The most significant advantage of affiliate partnerships is that they’re success-based — you only pay for conversions. If you get paid, they get paid next. It’s an easy, low-risk, and low-cost way to piggyback off of others’ audiences.
Sales reps and partners outside of your company can also sell SaaS products. This could include:
- Partnerships with other software companies
- Referral partners
- Value-added resellers
- Consultants who use their product
- White-label licenses
- Co-branding with a trusted business
- Marketplace sales (e.g., AppExchange)
Channel sales give others the chance to build a business off of your product. The tradeoff is that you have less control over the end customer experience. But, with a fraction of the investment and less effort than going after new customers yourself, SaaS companies can massively scale when using this strategy.
The vast majority of B2B buyers are already spending $50,000+ on single online transactions. 35% of buyers say they’re willing to make purchases over $500,000 through a web interface. Although traditional sales infrastructure has its place, most of today’s buyers want to talk to company reps as little as possible.
In B2B SaaS (e.g., a streaming platform) and low-tier B2B platforms, web sales are straightforward:
- You create a self-serve sign-up process
- Users to enter their credit card details.
- They’re now a subscriber.
For larger B2B sales, it’s a little more complex because of the high-ticket, long-term nature of their commitments. But within a SaaS application with assistive features (like live chat), it’s still possible to land clients directly through the website.
Freemium pricing reduces customer acquisition costs, speeds up growth, and increases the chances of reaching product-market fit. The most basic freemium pricing model looks like this:
- Free — Users can test out your software’s core functionality without a time limit.
- Premium — Once they’ve grown familiar with your product, they’ll either continue using the free one, realize its limitations and upgrade, or realize it isn’t for them. If they
Not everybody will convert from free to paid immediately; some customers may never move past the free plan. But a good freemium strategy can create a large user base that you can upsell later. Usually, SaaS companies aim for a freemium-to-paid conversion rate of 2% to 5%.
Ads become a part of the SaaS revenue model once there’s an established market for the tool you’re selling. For example, a project management software vendor knows exactly what to call their platform (“project management software”). So, they’ll advertise for those keywords to get leads that way.
Startups usually don’t know how to talk about their product, and therefore, won’t see the benefits of ad-based revenue for a while. But once they do understand how their buyers search for them on Google and social media, ads become an advantage.
SaaS companies with proprietary software often license some or all of it to other companies that want to build their own products with it. They’ll pay a percentage of their revenue to the software owner for the privilege. The licensing fee is typically much less than purchasing the same software as SaaS and includes one or more of:
- Code libraries
- UI design elements
This strategy can also be an effective way to leverage your product’s branding by getting it into many different applications. Over time, it familiarizes more of the market with your interface (plus, you’re making money off their success).
In-App Purchases (IAP)
In-app purchases are a popular revenue model for mobile apps but are also relevant to the SaaS world. They’re meant to add additional functionality or convenience to the app experience.
For example, website builders and design tools like Webflow and Canva offer some pre-built templates for free. If their users want to use others, they can pay on a per-template basis.
These applications also have marketplaces, where users can list their own templates and the parent company takes a small cut of each sale.
When another platform wants to integrate with your SaaS software, you can charge API fees for access to your system. As long as the other application continues using yours, they’ll pay recurring fees for each integration.
Ad Hoc Fees
Implementation, consulting, and setup are all examples of non-recurring engineering services to get a customer started with your product. These fees are in addition to their subscription cost and can vary over time.
Since word-of-mouth is the most profound form of marketing (at the lowest customer acquisition cost), SaaS businesses heavily prioritize it. To create a customer advocacy program, you’ll need to:
- Identify who your most loyal customers are and reach out to them using a customer advocacy tool.
- Once they’re in, get to leave positive reviews on the biggest review sites for your niche (like Gartner or Capterra). And enable them to create testimonials, share data you can turn into case studies, and refer new customers.
- Give something back based on each activity (e.g., a quick payment).
Customer advocacy helps drive new leads, increases conversions, and keeps churn rates low. It’s also a cost-effective way to get more referrals and recommendations from satisfied customers.
Phases of SaaS Revenue Models
Phase 1: Initial Sale
In the first phase of a SaaS revenue model, the goal is to acquire new customers and get them started with your product.
This phase includes:
- Demand generation campaigns to create brand awareness
- Lead generation marketing and outbound sales to bring in potential customers
- Sales demos and negotiation close deals and onboard new clients
- Channel sales
- Freemium conversions
- Implementation and setup fees
- The initial subscription sale
- API fees and software licenses (for third-party apps building your platform into theirs)
At this point, you’re only concerned with closing the deal for your core product. And, for long-term retention purposes, you’re looking for highly qualified prospects who will actually benefit from your product long-term.
In earlier growth stages, you won’t have as many revenue streams. Relationships with channel partners, system integrators, and others using your software usually develop after you’ve reached product-market fit.
Phase 2: Retention Revenue
Once you’ve onboarded your customer, your focus shifts from revenue generation to creating a product experience your customers want to keep paying into. As far as retention goes, you’re mostly concerned with preserving and increasing customer lifetime value.
You can accomplish this in the following ways:
- Use email marketing to share valuable content with customers and keep them engaged with your product
- Implement a customer advocacy program to encourage positive reviews and referrals
- Focus on customer success, addressing concerns quickly and effectively, and ensuring your customers are getting the most out of their subscription
- Streamline your customer support workflow
- Create helpful content that helps users get more out of the product
- Automate the renewal process
This phase is all about minimizing friction while helping your customers maximize their ROI from using your solution.
Phase 3: Expansion Revenue
At this point, you can shift your focus back to the money. Sometimes, you’ll focus on expansion and retention in tandem, but you want to avoid being overbearing on new customers (who are still familiarizing themselves with your product).
That said, with retention, it’s natural for customers to expand their product usage and increase their subscription levels as they grow their own businesses. As the vendor, you can encourage that in the following ways:
- Upselling your customers
- Cross-selling other solutions within your product suite
- Developing add-ons or complementary products as in-app purchases
- Expanding usage of your software across different teams or departments within the same company
- Bundling software products together to encourage users to build more of your tools into their tech stack
- Using differential pricing to more accurately match pricing with a user’s value
Expansion revenue is generally seen as the most valuable for software companies. Net negative churn — where expansion revenue exceeds customer churn — is a strong indicator of product-market fit and long-term business success. It’s one of the main factors investors look at when valuing your company.
SaaS Revenue Metrics
As far as revenue is concerned, these are the most important SaaS metrics:
Monthly Recurring Revenue (MRR)
Monthly recurring revenue (MRR) is the total amount of predictable revenue that a SaaS business earns in a month. It’s the running total of revenue from subscription sales and other recurring customer payments. It does not factor one-time payments into the total.
Annual Recurring Revenue (ARR)
Annual recurring revenue (ARR) is the total amount of predictable revenue that a SaaS business earns in a year. It’s calculated by multiplying MRR by 12.
You’d look at ARR over MRR when you want to understand how your company has performed YoY. It’s a fantastic metric to understand revenue performance on a macro level, but it won’t tell you much about the success about any one campaign or initiative.
Customer Acquisition Cost (CAC)
Customer acquisition cost (CAC) measures how much you’re spending to acquire a new customer, on average. It considers your entire sales and marketing spend, including headcount and program costs.
You can measure your SaaS churn rate in two ways:
- Customer churn — The percentage rate at which existing customers cancel their subscriptions over a given period of time.
- Revenue churn — The financial impact of that customer churn.
A lot of businesses fall into the trap of looking at one or the other. You have to look at both.
It’s entirely possible you’re losing very few customers, but they’re your most valuable ones. It’s also possible your product isn’t satisfying a low-value segment you’ve decided not to focus on, and that’s the reason for your high customer churn rate.
Customer Lifetime Value (CLV)
Customer lifetime value (CLV) measures the amount of revenue your average customer will bring in over their time subscribing to your product. It’s an important metric to consider when determining your pricing strategy and understanding the value of each customer. It helps you plan out how long you need to retain each customer for them to be profitable.
How to Choose a Revenue Model
The exact revenue models and monetization strategies you choose will depend on your target market, industry, and specific product. Different models work well for companies in different growth stages, with different funding levels, and targeting different customer segments.
There are five key questions to ask yourself when evaluating different revenue models.
- What do your buyer personas look like? Defining your ICP is the logical first step because. The primary goal of product development is to create something that’s most useful for them.
- What is your product differentiation strategy? You have to examine how your product’s nuances could justify one revenue model over another. For instance, a company selling route optimization software might build an advanced algorithm, then license it to other vendors in the space.
- How mature is your company? You don’t want to add too many products or features before you have a core one that serves a specific customer base. That’s the key to sustainable revenue growth.
- How can you capture value through your product? The ultimate goal is to add additional value without adding any friction to your product experience. Look at others in your industry and see what most customers expect. For example, the project management tool Notion sells templates for different workflows and customer segments.
- Which additional areas can you capture revenue? There’s probably some low-hanging fruit. You might not have an affiliate program yet. Or, your product might have potential to improve tons of other SaaS platforms with an API connector.
People Also Ask
How does a SaaS company generate revenue?
SaaS companies generate the vast majority of their revenue from subscriptions. Other sources of revenue include one-time purchases, add-ons or complementary products, and in-app purchases.
What counts as SaaS revenue?
Anything a SaaS company does to generate revenue counts as SaaS revenue. This can include subscription sales, implementation fees, professional services, and any other sources of income related to the product.