With Tech stocks driving the recent bull runs, it is understandable that most aspiring entrepreneurs have their sights set on the tech industry. Within technology startups, Software as a Service (SaaS) businesses are the most lucrative for investors because of the possibility of having up to 99.99% profit margins. But realistically, SaaS businesses need a lower profit margin to remain competitive.
A good profit margin for SaaS is 70% because it leaves room for research and development and customer acquisition. A SaaS business must maintain its competitive edge and grow, so having at least 30% of the revenue dedicated to the growth and retention goals is ideal for most SaaS companies.
This article will teach more about setting profit margin targets and related goals for a SaaS business. We also cover the ideal budget distribution across different departments, the difference between active and passive retention, and what makes a SaaS business attractive to tech VCs.
But before that, we must discuss key metrics worth considering.
Before setting a price point for your SaaS business, you must consider the nature of service and the purchasing behavior of your target audience.
While a good profit margin for SaaS is around 70% to 80%, most publicly traded SaaS companies operate at -20% because their growth and acquisition interests supersede their short-term net profit.
That’s not the case for most proof-of-concept stage startups. This section covers the metrics that you must consider in your SaaS business plan, including growth and acquisition.
Customer retention is the most crucial metric for your SaaS company because if you do not retain customers long enough, your margins should be extremely high.
If you retain customers for over eight years, you can afford to have negative net profit and still make money over the long run.
Here, one should use standard target market data instead of desired customer retention to get the most realistic foundational data point. The length of time a SaaS business retains its customers depends on three factors:
- Relevance of value in customer’s daily life – High with consumer-oriented services like Netflix and business-vital services like MailChimp.
- Lack of alternatives – High with first movers in a market like Shopify and ClickFunnels.
- Active interest vs. Passive billing – Covered in a later section.
This metric is directly related to the marketing goals of your SaaS business but also has a consequent relation with your profit margins. If the business has achieved critical mass, it can afford to reduce its marketing budget and have a better profit margin.
Silicon Valley startups are notorious for having nil to negative net profit when they’re in acquisition mode. That’s not because their price margins are low but because what they receive per customer gets reinvested in the service of a higher target growth rate.
In the presence of venture capital or outside cash injection, the higher one’s target growth rate, the lower one’s profit margin can be. As long as the pressure on the profit margin is not due to HR or essential operating expenses, the business survives in the long run. This brings us to the crucial question of budget distribution.
A SaaS business should dedicate 40% of its operating expense to Research and Development and 60% to marketing and growth to be lucrative to VCs and investors.
More specifically, 20% of the marketing and growth budget should be dedicated to customer acquisition, while 40% should be allocated to broader marketing campaigns.
Related: What makes a Good SaaS product?
Customer retention refers to how long a customer stays with a business. This metric affects SaaS businesses far more than transaction-oriented businesses.
A car repair business might retain a customer for thirty years and generate 30 transactions only, but a SaaS service that bills monthly can generate 30 transactions in 2.5 years.
There are two methods of having recurring revenue in subscription-based businesses online:
- Active customer retention (active billing)
- Passive customer retention (passive billing)
Depending on the service’s price point, software companies lean towards active retention of passive retention. Here’s how the two differ in value and revenue generation:
A software business that aims to have high active retention invests in R&D to provide consistent value. Its service is used at a high frequency, and its customers would add a new payment method when the first one expires.
The ideal profit margin for Active retention SaaS businesses is 70% to 80%.
Passive retention is a much smaller category of SaaS businesses that charge a much smaller amount per month and usually bill per year. These companies retain customers by avoiding active cancellations. Their services are used only occasionally, but customers either don’t want to go through the steps to cancel or overlook the subscription altogether.
Passive retention is terminated when the payment method expires.
The ideal profit margin for passive retention SaaS companies is 50% or more. Passive retention companies do not have as much prestige and suffer from poor long-term reputations, making them hard to grow.
SaaS business founders focus on providing an offer so compelling that customers would manually pay for it every month. When such a service is introduced to the market, its founders can operate at a -50% annual net profit and still produce a profitable business in the long run.
Considering customer retention types, research and development needs, and maintenance budget for various SaaS categories, you should aim for the following conditional target margins:
- Streaming service with exclusive content – 20%
- Platform as Service – 40%
- B2B SaaS company – 70%
- Mass Market SaaS company – 80%
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A good profit margin for a SaaS is 70%, which is possible in the B2B space because of the high day-to-day relevance of specific software.
The exclusive content streaming business has the lowest practical profit margin because it contains content production and licensing alongside the software access subscription.