Image: Bruce Clay, Inc

A dear reader, Taliba M., tells us she’s ready to make her second angel investment. She has an eye on a SaaS startup but lacks experience in this area. She wants to know how she should proceed. Read Effective Ways to Invest in the Unknown for our response and the purpose of this series.

Taliba also asks whether we’d cover some SaaS topics. Sure, why not? SaaS is getting sexier by the day. We’d be more than happy to look at the basics and point you to some useful resources.

* You do know that this is for informational purposes only and it’s not investment advice, right? This series is also by no means a comprehensive guide to SaaS. You can find the purpose of the series in previous post. Okay – let’s proceed.

What Is SaaS

SaaS (Software as a Service) is a software delivery/distribution model. The software is hosted on a remote server and delivered as a service. Users can access the software anytime, anywhere via a web browser. They don’t have to install anything on their computer or worry about upgrades and maintenance. Everything is handled by the vendor. Hence, SaaS is also known as Software on Demand or Hosted Solutions.

Many use the terms “SaaS” and “cloud computing” interchangeably. But they aren’t the same. Precisely speaking, cloud computing is made up of 3 segments: Software as a Service (SaaS), Platform as a Service (PaaS), and Infrastructure as a Service (IaaS). So, SaaS is the application segment of cloud computing.

Why SaaS Companies Rock

“SaaS companies move faster than big companies. They can introduce new features instantly versus waiting for the next major release,” Michael Skok of North Bridge Venture Partners shared at the Mass Technology Leadership Council session on Software as a Service.

Their feedback cycle is often “in days/weeks/months not in quarters/years/lifetimes,” writes Dharmesh Shah, founder of Internet marketing software HubSpot. “What this means is that when bad things start to happen (as many experienced during the start of the current economic downturn), [they’ll] notice it sooner.”

There are “lots of aspects [a SaaS venture] can tweak (examples include pricing, packaging/features and trial duration),” Shah continues. A SaaS company has more control than the traditional “shrink-wrapped business,” in which software is sold as a product to be installed on the user’s computer.

Why SaaS Is Costly

In a traditional shrink-wrapped software business, software is sold as a product where payment is received upfront. The company simply ships the software or makes it available for download, thus infrastructure costs are lower.

A SaaS venture, however, usually receives no upfront payment. Most SaaS companies are ad-supported (free), or usage or subscription based. Which means costs are front-loaded but payouts/revenues are delayed.

To deliver software as a service, not only does the startup need to finance the customers but it also needs to invest in architecture and infrastructure management. Shan points out that this can create cash flow issues. As sales growth increases, so does the gap in cash flows. This is why fast-growing SaaS companies often raise large amounts of capital.

Although “the best of the second generation SaaS businesses may be more efficient than [their] predecessors [like NetSuite and Salesforce],” Bessemer Venture Partners believes that “in almost all cases, significant capital will be required to build a dominant SaaS business.”

Next, we’ll look at Enterprise vs. Consumer SaaS and their respective capital requirements.


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