SaaS vs. SaaS Margins

The concept of SaaS was launched in the 1960s, though it didn't really gain traction until Salesforce was founded in 1999. It didn't get widespread adoption until the 2010s. Today, it's a standard for how businesses use and buy software. 

SaaS was distinct from traditional, on-prem software in 4 main ways:

1/ Deployment location. The software was hosted on the vendor's cloud servers rather than the customer's servers. 

2/ Subscription pricing. SaaS typically uses a subscription model where users pay a recurring fee that includes maintenance, updates, and support, as opposed to on-prem where there's a large one-time fee, and then additional charges for updates. 

3/ Accessibility. SaaS products can be accessed from any internet connection, whereas on-prem typically can only be accessed inside a company's network.

4/ Customization. SaaS customers rely on the vendor for new features and configurations, whereas on-prem offers far more flexibility to meet specific customer needs. 

As a result of these and other distinctions, SaaS has become extremely attractive from an investor perspective. These companies generate recurring, high margin revenue that grows consistently as the company's customers grow. That equates to higher cash flows than traditional software products, which result in revenue multiples of around 10x for high-growth (30%+) SaaS companies.

Regarding these attractive margins, the most relevant feature is the fourth point: customization. Internet-based companies can become enormously profitable because the marginal cost of adding an additional customer is near zero. It costs Google almost nothing to add an additional user or search advertiser. SaaS is similar. Adding a new customer to Zoom costs Zoom next to nothing. Compare that to an office supply company. In order to add a new printer, the customer has to source parts, manufacture, sell, and ship a printer to the customer. That's a lot more work than adding a new user to Zoom. 

In order to maintain SaaS-like margins, SaaS companies have to limit and constrain their customers' ability to customize the product, ideally down to zero. The moment a SaaS product starts to build custom features for its big, important, strategic customers is the moment the company starts to lose the high-margin, near-zero marginal cost benefits of the SaaS model. Even if it charges very high prices for these customizations, the margins can get lost over time because the customizations have to be serviced in perpetuity and aren't amortized across thousands of customers.

Inevitably, every SaaS company will feel pressure from customers to customize. The high-margin, successful SaaS companies have resisted this pressure by creating roadmaps and features that satisfy most customers and/or have built configurable products where the customer can make their own customizations. Ideally, the customer actually likes the lack of customization because they pay less, but that won’t always be the case.

You could break software up into three distinct categories based on the amount of customization allowed for and the corresponding margins. 

SaaS software - High Margin (Hubspot, Zoom, Docusign)
Enterprise software - Medium Margin (SAP, Cisco, Oracle)
Custom software - Low Margin (Accenture, Infosys, Tata)

All of this is to say that there's nothing wrong with lower-margin software as there's an enormous market for it, and the growth inside of those markets could easily offset the lower margins in terms of cash flows. But it's really important to know which market you want to serve and to make a deliberate decision and stick to it. I've seen lots of companies that think of themselves as SaaS because their software runs on the cloud and their revenue is recurring have a roadmap full of customer customizations. I suppose you can call that SaaS, but it won’t have traditional SaaS margins. And that’s ok. But the decision to do so needs to be made deliberately with eyes wide open to manage the difficult tradeoffs associated with growth and profit.