Profitability is the most important concern when running a business, and with SaaS it’s not an exception.
Many SaaS startups operate successfully in the initial phase of the life cycle, and successfully reach later stages.
What is it that distinguishes a profitable SaaS company from a non-profitable? Are all SaaS companies profitable?
Here we help you have answers for these crucial questions.
Located centrally on a remote cloud and offering subscription basis models, SaaS is becoming a preferred choice for most companies.
SaaS as an entity is not a money-spinning business model itself and becomes profitable only when it is combined with a planned revenue model.
Within the SaaS area, there are endless subjects and variations like the theme for the right pricing structure.
If we want to build a successful SaaS start-up, we need to plan for profitability from the beginning phase itself.
The software-as-a-service (SaaS) as predicted by Gartner, grew to USD 113.1 billion by 2021. So, in terms of market, yes, there is profitability in SaaS Business and certainly an opportunity, too.
It is because of the fact that the customers represent lifetime or long-term revenue streams as their pay for the subscription to software is good.
Additionally, SaaS companies tend to have low churn rates and high renewal because of their focus on providing a service and providing it too well.
Some of the most popular SaaS companies like Salesforce, HubSpot, Zendesk, Slack, Dropbox, and Atlassian show how SaaS companies can script long-term success.
A good SaaS business addresses consumer needs in a highly relevant way because it has:
Above mentioned consumer-focused elements combined with the market prediction by Gartner ensure us to say that, yes, in general, SaaS is profitable.
Now if we look at the profitability of every SaaS business then, of course, we do not see a similar picture.
Every SaaS business is not profitable. There are some well-known SaaS companies that have made strong revenue but not profit.
This can be due to many reasons.
Any business takes time to build profitability.
The profit margin of SaaS companies/startups is dependent on two things:
- The overall size and age of the software company.
- The subscription model (monthly/annual) and the business model (B2B or B2C) impact the revenues and cost of service build.
In the beginning years of SaaS companies’ lifecycle, startups tend to make losses.
In later years, it becomes necessary to balance revenue and operating expense growth with gross and net profits.
There are basically two metrics through which growth and profitability are balanced:
- The Growth Efficiency Index (GEI): It is defined as the cost of growing the subscription business.
- The Recurring Profits Margin (RPM): It is the variance of the recurring revenue and recurring cost.
The three primary financial criteria are selected for choosing between profits and growth:
- The Return on Investment (ROI) of the revenue acquisition expense.
- The effect of a company valuation.
- The ability to benefit from economies in regions such as COGS and improvement expenses to collect the higher income.
Based on a KeyBank Capital Markets, in the year 2021, a survey of 354 private SaaS companies, unearthed the following facts about SaaS profit margins:
- The subscription gross profit margin was around 80%. The total gross profit margin, including customer support, was found to be in the range of 68% and 75%.
- The net profit margin of a new SaaS business was negative as they invest substantial resources in sales and marketing, R&D, and general and administrative expenses.
Excessive-boom SaaS businesses are often unprofitable. Ideally, revenue acquisition costs (the cost of advertising and the cost of marketing to feature new revenue) are paid in advance.
However, the revenue diagnosed under the GAAP guidelines is submitted over the period of the SaaS sales.
Still many unprofitable SaaS groups keep spending as prompted by the lucrative prospect of engaging with more and more customers.
Here we can say that deferred revenue is equal to deferred profits. SaaS revenues are eventually greater than the product sales.
Also, the profit of SaaS companies tends to increase as customer life increases.
This results in decreased churn rate.
SaaS profitability is attained when the company extends operational efficiency and moves beyond its break-even point.
This suggests that total revenue is higher than the total operational cost. Once continual revenue from current customers is able to cover up new customers’ acquisition costs (CAC), it can be said that SaaS Company is profitable.
A rule of 40% for building a healthy SaaS business
Following the rule of 40%, one can achieve high profit in the SaaS business.
Growth and profit are the two parameters that are considered for a subscription company.
The rule’s simple formula is GP Ratio = Growth Rate + Profit, which means the growth rate plus profit should add up to make 40%.
To make it simple, if the business is growing at 20%, then 20% profit is generated.
If the business is growing at 40%, one could generate a profit of 0% and if the business is growing at 50%, one can even lose 10%.
So, one can consider having a healthy SaaS business when they do really well at 40%.
Incidentally, it was also found that the average sales commission for a SaaS company is approximately 10%.
Different types of SaaS compensation models are:
- Base salary only
- Base salary + commission
- Tiered commission
- Profit-based commission
- Residual commission
Of all, Profit-based and Tiered commission models are highly successful in the market.
When can we say a SaaS Company is Profitable?
A good ratio of gross margin for a SaaS business is over 75%.
Usually, most privately held SaaS businesses have a profit margin in the range of 70% to 85%.
Anything below 70% begins to raise a red signal for business owners and prompts them to do deeper research on several other metrics.
The growth of a SaaS business can be described in terms of:
- Adapt Client Success
- Client Maintenance
- Expansion of SaaS business
- Promotion of brand
- Use the right metrics to measure the performance of the SaaS business
- Form a strong partner network
- Adopt product-based growth
- Set an industry-based example
To Sum Up
When there may be the possibility to grow a SaaS business, the SaaS company needs to act so long as there may be a robust ROI on the growth investment.
This growth will be gated by cash availability, which is a greater practical barrier to growth than profits.
If the possibility for hypergrowth exists, investments are easier to obtain which highlights that the authentic answer to the question is: “It depends”. However, in general, SaaS is certainly a high potential market.