Gross Margin – The SaaS Secret Sauce
Investors seem to have an insatiable appetite for software-as-a-service (SaaS) businesses. This love affair is largely due to two things: annuity income and gross margin. We’ll talk about annuity income in our next article. For now, let’s focus on gross margin.
Many founders don’t know how to calculate their KPIs. Gross Margin is easy: 1-(COGS/Revenue)
COGS is the cost of goods sold. Most SaaS businesses have very low COGS which is why the gross margins tend to be 85% or more.
Cost of goods sold is the measure of the cost of delivering the services that have already been purchased. It excludes sales and marketing costs, management costs and other overheads. In most SaaS businesses all that is included is the cost of servers, maintenance contracts, any software licenses and customer support costs.
The easiest way to think about it is to imagine selling your contracts off to someone else to support. What would the need to support the customers?
If you are trying to build a valuable SaaS business you really need to understand that you must have a gross margin over 85% which means your COGS need to be extremely low. Manu businesses fail to understand this and they accidentally devalue their businesses by adding too many servicing costs.
You need to focus on ways to take humans out of the product. A valuable SaaS business is one that scales well. If your product requires more humans as you scale, then you are doing it wrong.
A common mistake is to bolt on consulting and research services. This can be a real differentiator and in the short term can allow you to perhaps create more revenue. However, it is a terrible strategy for a SaaS business that is ever going to get investment. These human costs can dramatically lower the gross margin and as a result they significantly impair the multiple when looking at company valuation.
The area that you need to focus on is customer support. Ideally, the product is easy to use and stable such that users rarely, if ever, call the help desk. It is worth the investment to hire user experience and information architecture experts to ensure the product is very easy to use. You should also consider digital adoption platforms like WalkMe as well as chatbots. These tools can significantly reduce help desk volume. They can be expensive to setup, but the impact that they can have on the valuation of the business cannot be underestimated.
If you are going to have customisation options, makes sure the user can easily configure these themselves. Too many businesses use this as a way to generate a significant portion of their income by selling configuration services. This can be extremely lucrative and is a good business model. Unfortunately this business model does not scale and these servicing costs really kill the gross margin which will make it very difficult for the business to get investment or sell for a decent multiple later.
Focus on an excellent product that is easy to use and requires no support. If you get this right you will have excellent margins and a very valuable SaaS business.