Gross margin is a very important metric for Software as a Service (SaaS) companies. It allows startups to fund large investments in product and sales during periods of rapid growth and be profitable when growth slows. Many factors contribute to a company’s ability to maintain high gross margin, including pricing discipline and power, a product that delivers high ROI for the customer, efficient and scalable infrastructure, and an easy to use product that requires little ongoing support by the vendor, to name a few. Gross margin has a significant impact on a company’s ability to invest in R&D, sales, and marketing, which may ultimately determine the winner in a competitive market. It is also an important valuation driver, which is why I am often surprised how little attention companies pay to gross margin in SaaS businesses. From what I’ve seen, founders have little appreciation of why gross margin matters until a startup reaches some scale. Venture capitalists often ignore it. Even public investors seem to overlook the importance of gross margin (though, not for long). In this post, I wanted to provide some additional insight on the impact gross margin has on a SaaS business.
Gross Margins Are Sticky
It turns out gross margin is really hard to improve. Startups often naively assume that with scale, gross margin will improve, and are surprised a few years later when they realize there is very little in their control to move margins. In SaaS, reaching scale counterintuitively does not provide much leverage, but oftentimes puts downward pressure on gross margin as the complexity of running massive multitenant apps increases. This is certainly the case for public SaaS companies, which by the time of IPO are already locked into their gross margin profile. The chart below illustrates the point, by showing gross margin of many public SaaS companies for the 12 quarters post IPO.* While the average trends slightly positive, you can see that any improvement is marginal and usually mostly the result of professional services declining as a percent of revenue.
Gross Margins Remain Stable Post-IPO
Gross Margins Drive Valuation
Valuation is highly correlated to revenue growth. This makes sense because investors are happy to pay a high price for an asset that is growing fast. What is less obvious is that gross margin can also have a meaningful impact on value, by demonstrating the profit capacity of any given company. Not today, but when the company reaches maturity (i.e. steady state). Gross margin, in my view, offers insight into the cash generation potential of any given SaaS company at maturity. The chart below shows the correlation between gross margins and valuation.
Higher Gross Margins Drive Higher Valuations
To illustrate the impact gross margin has on profitability, let’s look at a simple example. I will ignore the complexity of SaaS revenue recognition in this example, which should not have a meaningful impact on the analysis. We can compare two mature SaaS companies that have very standard SaaS metrics.
These two companies are identical, except for their gross margin. But as you can see, for the same revenue, unit economics, and operating cost structure, Company 2 is generating more than twice the operating profit of Company 1. Every incremental dollar of gross margin drops straight to the bottom line. If we were to value these companies and build out our discounted cash flow model, we would see that Company 2 should be valued more than 2x the value of Company 1.1 And of course, this also explains why Company 2 would receive a much higher valuation multiple.
This simple example demonstrates why many SaaS companies will actually never generate meaningful profit. Let’s go over my assumptions and explain why. Even the largest SaaS companies have a hard time getting G&A below 12%, so that is about as low as it gets. I have assumed a modest R&D expense of 15%, which is far lower than the vast majority of public SaaS companies (and probably constitutes the bottom of what is realistic). Between G&A and R&D, that is 27% of margin gone. Thus, to have a profitable SaaS company on low gross margin, you have to be doing something different on the go-to-market side and acquiring customers very efficiently. Good examples for this are Dropbox and Atlassian,2 which have substantially more efficient go-to-market motions that allow them to keep sales and marketing expense at much lower levels than the average SaaS enterprise company (CAC breakeven < 12 months). But those companies are the exception. As we can see from our example, if you assume a reasonable payback period on sales and marketing expense of 18 months (most public SaaS companies fare much worse), it leads to a substantial investment in sales and marketing. A company growing at a modest 10% in our example would still be required to spend 30% of revenue on sales and marketing.1
To summarize, G&A is largely out of our control, R&D cannot be eliminated without losing customers in a competitive market, and replacing customers that churn and finding growth requires a substantial investment in sales and marketing. So, what can startups do about their gross margin? First, pay attention to the metric from the inception of the company. Great SaaS companies (Salesforce, Shopify, etc.)2 have great product gross margins >85%. Second, if you are in a business that cannot support a gross margin of >70%, you need to think about how you price the product and how you reach new customers. The traditional direct sales model with CAC to breakeven of 18–24 months is likely not going to work. Twilio2 for example built a massive company with a relatively low gross margin product, but they had an efficient developer-focused sales strategy that allowed their customers to buy the product without ever talking to the company. In my opinion, the go-to-market strategy has to take gross margin into consideration and vice versa. When you are a rapidly growing startup, revenue with high gross margin helps bring non-dilutive capital to fund your growth and outpace your competition. As you mature, investors should reward you for the earnings potential of your company.