How software and SaaS companies work
Customers, pricing models, the value chain from building to renewing, the cost structure, and the key metrics.
Industry brief, with a one-minute summary: Software and SaaSKey takeaways
- A SaaS company spends a lot upfront to build a product and win each customer, then earns a subscription every month or year.
- Software used to be sold as a licence: a large one-time payment plus a yearly maintenance fee, with the software installed on the customer's own computers.
- NRR counts only existing customers. Above 100 percent, upsell and expansion more than cover the revenue lost from churn and downgrades.
Key idea
A SaaS company spends a lot upfront to build a product and win each customer, then earns a subscription every month or year. It makes money only if customers stay and spend more over time, because the cost to serve one more customer is low.
Software used to be sold as a licence: a large one-time payment plus a yearly maintenance fee, with the software installed on the customer's own computers. SaaS (software as a service) runs in the cloud and is paid for as a subscription. Customers range from small businesses (often buying online by credit card) to mid-sized companies and large enterprises (buying through sales teams with long contracts). Horizontal software serves many industries (for example email, accounting, or customer management); vertical software serves one industry (for example hospital or hotel software).
| Model | How the customer pays | Example use |
|---|---|---|
| Per seat (per user) | A price per user per month | Office and collaboration tools, customer management software |
| Tiered | Packages (basic, pro, enterprise) with more features at higher prices | Most small-business software |
| Usage-based | Pay for what is used: data stored, calls made, messages sent | Cloud infrastructure, data tools, AI features |
| Outcome-based | Pay per result, such as a resolved support ticket | Some newer AI agent products |
So-what
If AI lets one employee do the work of several, per-seat revenue can shrink. That is why many software companies are testing usage-based and outcome-based pricing.
- SaaS value chain
- Build: research and development (R&D)Engineers and product teams; mostly a fixed cost.
- Host: cloud infrastructureUsually rented from AWS, Microsoft Azure, or Google Cloud; a variable cost.
- Key: Sell: go-to-marketSelf-serve online, inside sales, field sales, partners and resellers.
- Onboard and implementSetting the product up, sometimes paid professional services.
- Key: Support and customer successHelping customers get value, so they renew and buy more.
Build once, then win, serve, and keep customers.
| Line | Approximate share of revenue | What it contains |
|---|---|---|
| Cost of revenue | About 20 to 30 percent | Cloud hosting, customer support, third-party software, and now AI model costs |
| Gross margin | About 70 to 80 percent | Revenue minus cost of revenue |
| Sales and marketing | About 25 to 50 percent, higher when growing fast | Sales teams, commissions, advertising |
| Research and development | About 15 to 35 percent | Engineers and product teams. The average across all US-listed software firms is about 16 percent (NYU Stern data, January 2026), pulled down by large mature firms; in a 2025 survey the median was about 23 percent for listed SaaS firms and 34 percent for private ones (Benchmarkit) |
| General and administrative | About 7 to 15 percent | Finance, legal, HR, offices |
So-what
Ranges are rough and vary by company size and growth. Fast-growing SaaS companies often lose money because they spend on winning customers today for revenue that arrives over many years.
| Metric | Plain definition |
|---|---|
| ARR (annual recurring revenue) | The yearly value of all active subscriptions at a point in time; MRR is the monthly version |
| Net revenue retention (NRR) | Revenue this year from last year's customers, divided by their revenue last year; above 100 percent means existing customers grow |
| Gross revenue retention (GRR) | The same, but without counting upsell; at most 100 percent |
| Churn | Customers or revenue lost in a period (logo churn counts customers, revenue churn counts money) |
| CAC (customer acquisition cost) | Sales and marketing spend divided by new customers won |
| CAC payback | Months of gross profit from a new customer needed to repay its acquisition cost |
| Rule of 40 | Revenue growth rate plus profit margin (often free cash flow margin); 40 percent or more is seen as healthy |
| Gross margin | Revenue minus cost of revenue, divided by revenue |
So-what
McKinsey found that only about one third of software companies reach the rule of 40, and fewer stay there.
A SaaS company has net revenue retention of 115 percent. What does that mean?
Sources for this lesson (4)
- McKinsey: SaaS and the Rule of 40, keys to the critical value creation metric
- Benchmarkit: 2025 B2B SaaS Performance Metrics Benchmarks (2024 data, survey report)
- Aswath Damodaran, NYU Stern: operating and net margins by industry (US), data as of January 2026
- Recognized public explanations of case-interview concepts and frameworks
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