Are SaaS companies successful? As a way of selling software, yes. Software as a service (SaaS), meaning software rented by subscription and delivered over the internet, has become the normal way business software is sold, because it suits both sides: the customer avoids a large upfront cost and the supplier gets predictable income. Whether a particular SaaS company is successful is a separate question, and its profit and loss account is a poor guide in either direction. A fast-growing one can report losses while building something valuable. A steady-looking one can be quietly losing its customers.
This matters to more people than investors. If your business runs on a SaaS product, the health of the company behind it is your concern.
Why a growing SaaS company can look unprofitable
Under the older model, a customer bought a licence, paid for it at the start and then paid a yearly fee for maintenance. The supplier received most of the money at the moment it made the sale.
A SaaS company receives its money a month or a year at a time, over as long as the customer stays. Its costs run the other way round. Marketing, sales staff and the work of setting a new customer up are all paid for before that customer has contributed much.
Accounting rules widen the gap. Under IFRS 15, and under the UK standard FRS 102, subscription revenue is recognised as the service is delivered, not when the contract is signed or the cash arrives. A customer who pays for a year in advance appears first as deferred revenue, which is a liability, and is released into income month by month.
Take an illustration. Suppose it costs the equivalent of a year’s subscription to win a customer who then stays for five years. That is a good bargain. Yet in the month the customer signs, the accounts show one month of revenue against a year’s worth of cost. The faster the company signs customers, the worse this looks. The same company would report a profit if it stopped growing.
So a loss does not tell you a SaaS company is failing, and neither does it tell you the company is investing wisely. For that you need different measures.
The measures that show whether it is working
| Measure | What it is | What it tells you |
|---|---|---|
| Annual recurring revenue (ARR) | Subscription income expressed as a yearly figure | Size, and the rate of growth |
| Churn | The share of customers, or of revenue, lost in a period | Whether customers stay |
| Net revenue retention | What last year’s customers pay now, after upgrades, downgrades and cancellations, as a percentage of what they paid then | Above 100 per cent, existing customers are spending more than those who leave take away |
| Customer acquisition cost (CAC) | Sales and marketing spend divided by the number of customers won | What growth costs |
| CAC payback | The months of gross profit from a customer needed to recover the cost of winning them | How soon growth pays for itself |
| Gross margin | Revenue less the cost of hosting and supporting the service | Whether delivering the service is efficient |
Two of these matter more than the rest. Churn decides whether the business is filling a bucket or a sieve. Payback decides how much cash it must find to grow. A company with low churn and a short payback can choose to become profitable whenever it likes, by spending less on growth. One with high churn cannot, however much it sells.
Investors often combine growth and profit into a rule of thumb called the rule of 40: the yearly growth rate and the profit margin, added together, should come to 40 or more. It is a rough test, but it captures the trade-off between the two.
Why SaaS companies fail
The model works. Plenty of the companies using it do not, and the causes repeat.
- Customers leave faster than they arrive. Sales effort goes into replacing lost revenue instead of adding to it.
- Customers cost more to win than they are ever worth. This is common where the price is low and each sale still needs a salesperson.
- The money runs out first. A company built to grow on investors’ money has to keep raising it. If the next round does not come, it must cut costs sharply or sell.
- The product is easy to replace. A narrow tool that does one simple thing can be copied, or absorbed as a feature of a larger product. In our judgement AI-assisted development has made this more likely, because the cost of building such a tool has fallen.
- It depends on someone else. A product that lives inside another company’s platform, or earns most of its income from a few large customers, can lose its footing through a decision made elsewhere.
What this means when your business depends on one
The quality that makes SaaS a good business is the same one that creates risk for the customer. Once a product is woven into daily work, moving away is difficult. That keeps churn low for the supplier, and it leaves you exposed if the supplier struggles, is bought, raises its prices or withdraws the product.
A few checks are worth making before you commit, and again each time you renew:
- Who is behind it. For a UK company, Companies House shows how long it has existed, who controls it and whatever accounts it has filed, though smaller companies file little detail.
- How it is funded. A company living on its customers’ subscriptions and one living on investment behave differently under pressure. Either can be sound. Ask.
- Whether you can get your data out. All of it, in a format another system can read, at any time and not only on request. Find out what happens to it when the contract ends.
- What the contract says about price. Look for the terms on increases and the notice the supplier must give.
- Whether it has an API. An API is a defined way for other software to read and write the product’s data. Without one, you cannot connect it to your other systems or build around its gaps.
- How it has retired products before. The notice it gave and the help it offered are the best evidence of what it would do again.
If a supplier has already withdrawn a product you depend on, our page on what to do when a supplier stops supporting your software sets out the options.
Cost is the other thing to keep an eye on. Many SaaS products charge per user per month, so the bill grows with your headcount for as long as you use the product. For standard functions such as accounts, payroll or email that is still the right way to buy. Where the product fits your process badly and the bill keeps rising, the comparison in bespoke software or off-the-shelf software is worth making again.
If you are thinking of becoming one
Businesses with a good internal system sometimes consider selling it to others in their trade. The economics above then apply to you.
The software is the smaller part of the job. An internal system is built around one company’s way of working. A product has to keep many customers’ data apart inside one system, bill them, let them configure it without a developer, and satisfy the security questionnaires their IT departments send. Then come the costs this article began with: finding customers, setting them up and supporting them.
The question to answer first is what it would cost to win each customer and how long they would stay. A handful of businesses willing to pay before the product exists will tell you more than any forecast. If the answer is encouraging, the product can be built to an agreed scope like any other system.
One check is worth doing this week whichever side you are on. Take the SaaS product your business could least manage without, and try to export everything you hold in it. How long that takes, and what state the data arrives in, tells you how much you are relying on that company’s success.