As a founder or CEO of a SaaS company, one of the metrics your investors and buyers will probably scrutinize most closely is your gross profit.
Gross profit, or GP, is simply defined as your revenue minus your cost of goods sold. For example, a business that generates $100 in revenue and has a cost of goods sold (COGS) in delivering the product to customers of $15 has a GP of $85. Its gross profit margin is 85% — calculated as $100 minus $15, divided by $100.
Gross profit matters because the higher it is, the more capital you have to invest in other operational areas of your business such as sales and marketing, research and development, and general administrative purposes. Higher gross profit also reduces your reliance on external equity or debt capital.
Below is a simple example comparing two similar companies with one key difference: their gross profit margins.
While Company A and B have similar revenues and operational expenses, Company A is 2.5x more profitable than Company B due to its higher gross profit margin.
Company A produces $85 of profit in comparison to $65 of at Company B. That allows company A to invest significantly more in other areas of the business, which will help it compete and win against Company B.
In our analysis of 146 public SaaS companies, the median expense for sales and marketing is 21%. R&D is 16%, and general and administrative expenses are 12%, meaning that SaaS companies generally will spend a total of 49% of their revenue on operating expenses.
If your gross margin is less than 51%, chances are that you may never be profitable and grow in a capital-efficient manner.
What you can do to improve gross profit margin
There are essentially two dials you can turn to improve your gross profit: increase revenue and lower COGS.
When it comes to revenue, are you pricing your products in a disciplined manner in line with the value being provided to your customers? Are you benchmarking your pricing appropriately to competitors’ pricing, which can help improve and grow revenue? Simple playbooks like automatic price increases built in annually can help ensure improving gross profit margins over time.
For COGS, one of the biggest drivers for most SaaS companies is cloud-hosting costs. Have you negotiated the best pricing for your cloud spend and compared pricing options across different vendors? Cloud vendors often provide substantial discounts for multiyear contracts — have you taken advantage of that? Are your infrastructure engineering practices optimized to reduce cloud spend, and are you monitoring and eliminating unused cloud resources using various cloud cost-monitoring tools?
Another major component of COGS is usually the cost of product implementation, DevOps and customer success teams. Much of this work can be done remotely, so have you considered using resources in less expensive locations?
Have you explored a product-led growth strategy appropriate to your product complexity? Have you considered designing your products in such a way that your customers can implement and integrate your software themselves vs. deploying significant professional services that can reduce gross profit margins? Do you have accessible digital resources in case they need support?
We have found that product-led growth, or PLG, strategies typically lead to lower COGS and higher gross margins. We have also seen situations where a company has lower gross margins, in the 60s, due to costs of third-party software embedded in its product but its entire go-to-market was driven by PLG vs. expensive sales-driven growth, still enabling it to hit profitability.
We also see founders calculating COGS incorrectly. It should only include direct costs of revenue such as cloud costs, customer support, customer retention related costs, engineering salaries directly supporting product delivery, professional services (only if they are part of the product offerings), costs of third-party software used in your product, royalties, and commission and transaction fees.
Indirect costs such as R&D, G&A and other expenses should not be included in COGS. A qualified CFO can help identify the relevant costs and ensure that only those attributable to COGS are included.
Higher valuations correlate with higher gross margins
Below is a chart of 146 SaaS companies. As you can see, companies with higher gross margins trade at better multiples.
It is interesting to note that this correlation holds true in bull markets like 2020 and 2021 as well as in periods like 2022 and 2023 when valuations are muted.
Higher gross margins are attractive to investors and buyers
High-quality SaaS businesses have gross margins between 75% and 90%. They should ideally be above 80%.
If a software company’s gross margin is below 70%, it can be a cause for concern. The company may get overlooked by an investor who wants to back a more capital-efficient business, or by a strategic buyer that wants to ensure acquisitions are accretive by buying companies that are at or higher than their own gross margin.
By and large, having a high gross profit margin is a time-proven way to grow successfully and build a company of consequence.
Gaurav Bhasin is managing director with Allied Advisers, a global technology-focused boutique advisory firm headquartered in Silicon Valley (with a presence in Los Angeles, Tel Aviv and Mumbai) focused on investment banking for entrepreneurs and investors.
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Illustration: Dom Guzman
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