Investing in SaaS Ventures (Part 3): Monetization Models

A reader, Taliba M., said she wants to place her bet in a SaaS startup but she isn’t familiar with SaaS companies. She asked how she should go about it and we suggested some ideas. Read Effective Ways to Invest in the Unknown for our complete response and the purpose of this series. (Obviously, you’re smart enough to know that this isn’t investment advice and it’s by no means a comprehensive guide to SaaS.)

In our response, we also promised to discuss the characteristics of SaaS ventures in a series of articles.

• Investing in SaaS Ventures (Part 1): The Basics covers what is SaaS, why SaaS companies rock, and why it’s costly.
• Investing in SaaS Ventures (Part 2): Capital Requirements looks at Enterprise vs. Consumer SaaS and the capital required to get them to liquidity.

Here, we’ll briefly look at the monetization models for SaaS ventures.

Monetization Models

SaaS monetization can be put into 4 main categories, according to Gianpaolo Carraro, director of DPE (Platform & Developer Evangelism) at Microsoft:

* Some companies use a hybrid model, or mix and match.

• Perpetual license
• Subscription based (most common)
• Usage / transaction based
• Free, ad-supported

Perpetual License

Software is sold through a perpetual license. Once bought, customers can use the software, or that particular version of software, forever.

Advantages:

• Money is received up front, thus good for cash flow.
• Venture doesn’t have to worry about churn (attribution rate).
• No need to track usage and monitor customers. Relatively simple in an architectural standpoint, which lowers costs.
• Can charge for upgrades or new releases.

Disadvantage:

• Hosting the software for customers would incur an infinite hosting cost.

Carraro shares that a SaaS company selling perpetual licenses should either:

• justify that the money it receives up front can cover the hosting cost;
• impose time limit on servicing (e.g. provide support, hosting, and maintenance for one year, not forever); or
• attach additional monetization schemes after the license is sold (e.g. a monthly maintenance fee).

Otherwise, to eliminate hosting costs, software sold via perpetual license is best deployed on customer’s server.

Free, Ad Supported

The software and services are offered free to customers. Advertisers and sponsors pay the bills in exchange for ad spaces in or around the app.

Advantage:

• Easier to attract customers, which lowers customer acquisition costs.

Disadvantage:

• Entirely dependent on sponsors and advertisers, who may pull out quickly during economic downturn.

The startup must have traction to win sponsors and advertisers. To deliver value, it must be able to optimize ad placements by accurately target and make good assumptions about the users.

Subscription

Software is sold on a subscription basis, usually monthly, quarterly, or annually. Most SaaS ventures use this model.

Advantage:

• Provides a predictable revenue stream.

Disadvantage:

• Fees are received in a smaller amount on a recurring basis rather than a lump sum upfront. It often takes multiple billing cycles to recover customer acquisition costs. If churn is high, customers might not stick around long enough for the company to recover acquisition costs, states Carraro.

Bessemer Venture Partners has this to say about subscription model:

It can be argued persuasively that SaaS is a lousy business model because costs are front-loaded and revenue only arrives in modest monthly or annual payments. However, as we know from the cable industry, subscription businesses can be very profitable over time.

Usage/Transaction

Pay-as-you-go, or charging per transaction, event or other unit of value to customer.

Advantage:

• A usage based monetization model could eliminate the risk of offering free trials while lowering customer acquisition costs.

Disadvantage:

• The company’s architecture has to be able to meter the actual consumption of the service. Implementing a usage/transaction based system is heavier on the architectural side, thus may increase costs.

Carraro says that the goal is to convert customers from pay-as-you-go into subscription or other hybrid models once usage increases. For example, the company can upsell the customer to a $x/month, unlimited usage plan, or a plan which includes N transactions + $x per transaction once usage exceeds what’s included in the plan.

Freemium

“What about freemium?” You say.

Freemium — offering basic features for free and charging a fee for premium services — is in fact a marketing strategy, one that could spell disaster without clear understanding of the tactic. You can learn more about freemium in 16 Venture’s “The Reality of Freemium in SaaS.”

While you’re at it, check out their “Introducing the 7 SaaS Revenue Streams” to gain some understanding on SaaS revenue modeling.

Next, we’ll talk about how experienced investors evaluate SaaS startups.