The Impact of Gross Profit Margin on Software Company Valuations (plus Strategies)

Gross Margin is a hot topic among software PE investors and Strategic Buyers. In fact, it’s one of the main factors they prioritize when valuing a company. For Software Executives, understanding Gross Margin and its role in valuation is critical for navigating growth, profitability, and eventual exit opportunities. 

Gross Margin reflects the efficiency of delivering software or services to customers, making it a key metric for evaluating the financial health and operational performance of a software business. 

Read more to learn about Gross Margin and what it means for your software company’s valuation. 

Defining SaaS Gross Margin

Before working through the numbers, take a moment to understand what Gross Margin actually represents so you can calculate it accurately and with confidence. Gross Margin is a straightforward measuring tool because it simply looks at Gross Profit as a percentage of total revenue. 

In short, Gross Profit is the amount available to cover operating expenses and reinvest back into the business. GPM also serves as a good indicator of scalability for software businesses and is an essential part of valuing a company—but more on this later. 

Gross Margin reveals how efficiently a company converts revenue into profits after accounting for the Cost of Goods Sold (COGS), which is essentially the sum of all expenses directly related to delivering a product or service. GPM varies by industry, and software companies tend to have lower COGS and higher Gross Margins than companies that produce physical goods, as they don’t require the use of raw materials in the production of their product.  

Calculating Gross Margin

Gross Margin is a function of revenue and COGS and can be calculated with a straightforward formula:

Gross Margin = (Revenue – COGS) / Revenue

More specifically, Gross Margin is the percentage of revenue remaining after deducting the direct costs to deliver a company’s product. 

The Importance of Gross Margin to Software Valuations  

For software companies, maintaining a Gross Margin above 75% is attractive to buyers and investors because it signals scalability potential. 

Gross Profit Margins specifically offer insights into the company’s operational cost structure. Software companies with low Gross Margins (below 60%) might be experiencing higher delivery or support costs, which could indicate challenges in their ability to scale. These challenges can be red flags to potential buyers. 

While high Gross Margins are desirable, they must be considered alongside Customer Retention rates. For example, if a company has strong Customer Retention but low Gross Margins, it could mean the company is over-investing in support or customer service, which impacts Profitability.  

Gross Margin as a Signal for Scalability

Gross Margin is also an indicator of a software company’s financial health and potential for growth. As GPM increases, more funds are available for reinvestment or to support a company’s operating expenditures. 

Gross Margin is distinguishable from Net Profit Margin in that it accounts for only the expenses a company incurs to produce and sell an additional unit of its offering. Gross Margin helps companies identify the true cost to produce each item of its output. Additionally, the formula offers visibility into where software companies might be over- or under-spending so they can stay competitive. 

A company with strong unit economics has more leeway to reinvest its Gross Profit into sales and marketing. Similarly, a company whose customers are clamoring for new features and additional modules may decide to invest more in research and development.  

In contrast, although Net Profit Margin is a good measure of overall profitability because software companies typically spend more upfront on R&D, this formula is less likely to show the company’s true scalability.

What is a “Good” Gross Profit Margin?

In the software space, companies with Gross Margins over 75% tend to outperform their peers, and most privately held software businesses we work with have GPMs in the range of 70% to 85%. Anything below 70% will prompt a deeper dive into the product delivery motion of the business to understand what could be mitigating GPM expansion. 

For example, as of the fourth quarter of 2023, we saw businesses with Gross Margins in the 70% – 80% range hold a median EV/TTM Revenue multiple of 5.9x, and those with Gross Margins above 80% had a median multiple of 6.9x, which surpassed the SEG SaaS Index™ median EV/TTM Revenue multiple of 3.8x by 82%. 

Software companies are increasingly recognizing the importance of Gross Margin. As of the fourth quarter of 2023, 57% of companies in the SEG SaaS Index™ had a GPM above 70% with seven companies moving up from the lower cohort since the fourth quarter of 2022. The percentage achieving Gross Margins above 80% rose from 19% to 23%, while the percentage with 60% GPM or less fell from 19% to 17%. 

Understand Your Company’s Revenue Streams

Ben Murray of The SaaS CFO writes about the importance of understanding how and which revenue streams are contributing to a company’s Gross Profit. “The blend between services, recurring, and any other revenue stream is important.” 

Software businesses occasionally incorporate ongoing services into their business models. While this should prompt a deeper exploration into the company’s scalability, these added services often result in exceptionally strong gross retention and net retention rates. 

We recommend calculating GPM by type for each product and service your company offers. Whereas your software offerings may very well have higher Gross Margins than your services, those services may be essential based on the nature of your product, industry, or vertical. The key is to achieve an appropriate balance between the software and ancillary services your company offers to meet the unique needs of your market.  

As expected, public software companies in our SEG SaaS Index™ with higher Gross Profit Margins continue to be well rewarded by investors and buyers. 

Company Scenario: How GPM Impacts Valuation

When assessing a software company’s value, investors often talk in multiples of ARR or multiples of revenue. But GPM is every bit as important in assessing value. 

Let’s consider a Gross Profit Margin example featuring two similar software companies, where one has a Gross Margin of 80% and the other just 60%. Assuming all else is equal, what is GPM’s impact on valuation? 

Assume Company A is purchased for $72M. As a multiple of revenue, this would be 7.2x. As a multiple of Gross Profit, this would equate to 9.0x.

Now let’s look at Company B. Because Company B has the same revenue as Company A, it is easy to assume the 7.2x comparable multiple is appropriate, so Company B is also worth $72M. 

However, in this Gross Profit Margin example, Company B’s Gross Profit is significantly less than Company A’s. For every dollar of revenue Company A generates, 80 cents are available for operating expenses. In contrast, only 60 cents of every dollar of revenue generated by Company B are available for operating expenses. Because these figures are materially different, the better comparable for Company B to use is Company A’s 9.0x gross profit multiple.   

Applying this multiple results in a valuation of $54M for Company B. This is not what Company B’s shareholders were hoping to hear. However, if Company B had a Gross Margin of 95%, these shareholders would likely be more than happy to use a Gross Profit multiple. 

8 Strategies to Improve Your Software Company’s Gross Margin

Even if your software company has a Gross Margin below 60%, there is no need to panic. Here are some ways to improve this metric and potentially achieve a higher valuation. 

1. Optimize COGS

There are several possible ways to improve unit economics. One is to streamline and automate manual processes in areas like customer support, onboarding, and other services. Automation can help reduce labor costs associated with delivering your product. You can also look to negotiate better pricing on your hosting and infrastructure costs, which for software companies can be a significant expense, or optimize your back-end architecture to enable the product to be delivered more cost-effectively at scale. Lastly, look for opportunities to outsource non-core functions like customer support and administration to reduce costs. 

2. Improve Product Efficiency

You can also improve Gross Margin by enhancing product self-service features and investing in product improvements that reduce the need for customer support. Making the product easier to use decreases reliance on customer support teams, lowering costs, and improving margins.  

Look also to reduce costly one-off customizations by standardizing your offerings or creating tiered packages. 

3. Efficient Scale Support and Delivery

To reduce customer support ticket volume, build out a comprehensive knowledge base and self-service tools for customers. Then implement AI-driven chatbots or automated customer service tools that can handle common queries. This reduces the need for human support resources.  

Finally, provide your customers with effective onboarding and training materials to help them self-solve issues, reducing their dependence on your support teams.  

4. Increase Pricing Without Raising Costs

Strategic price increases are among the quickest ways to improve Gross Profit. One popular approach is to offer a tiered pricing model where customers pay more for additional features or usage. This model allows you to charge your top customers higher prices without significantly increasing costs.  

Also, if your product delivers outstanding value for the investment, consider increasing your prices to reflect this. For software businesses with high customer retention and satisfaction, a price increase can improve margins without dampening customer demand.  

Lastly, look to launch additional or premium features that existing customers can opt into. Premium features boost the Average Revenue Per User (ARPU) without increasing the associated cost of delivery.  

5. Focus on High-Margin Customer Segments

Customer segmentation is a tried-and-true method for improving Gross Margin. By targeting your highest-value customers—those that have high usage but require less support— and shifting more of your sales and marketing efforts to this group, you will optimize your Gross Profit. 

Also, seek to increase revenue from your current customers by upselling them to higher-priced plans or cross-selling additional services, all of which boost Gross Margins.  

6. Improve Vendor and Supplier Relationships

Shifting to the cost side of the income statement, it never hurts to periodically review your supplier contracts. Work with your suppliers and service providers to renegotiate contracts for better rates. This is especially effective with infrastructure providers where usage may have grown since the original agreement. In certain cases, it may make sense to consolidate your vendor relationships to negotiate better pricing or access volume discounts.   

7. Optimize Team Structure

One mistake many young software companies make is growing too fast. Ensure your team skillsets and structure align with your software company’s current stage. Avoid overstaffing or keeping large teams for non-essential services that drive up operational costs.   

It is also extremely important to track the efficiency of customer-facing (e.g., support and success) teams, and incentivize cost-saving measures without compromising service quality.  

8. Reduce Customer Churn

Customer attrition can be the death knell for otherwise promising and fast-growing software companies. However, companies can effectively lower churn by improving product quality, customer satisfaction, and engagement. Lower churn rates translate to less revenue shrinkage from downgrades or customer attrition and reduced acquisition costs, leading to a more efficient revenue model and higher Gross Profit Margins.  

Begin with your onboarding process and ensure customers understand how to use your product effectively right from the start. A smooth onboarding process helps reduce support costs and increases the likelihood of long-term customer retention.  

Get a Snapshot of Your Company’s Valuation Potential

Gross Margin is just one of several important metrics in determining the valuation potential and go-to-market readiness of your software company. To get a snapshot of where your company stands in your specific software vertical, check out the Interactive SEG SaaS Scorecard™, a confidential scoring tool designed especially for software companies. 

Upon entering your company’s key financial metrics and operational readiness, you will receive customized insights on metric benchmarks, potential outcomes reflecting buyer preferences, and more. This tool helps you identify your company’s strengths and pinpoint areas for improvement, guiding you toward informed strategic decisions to enhance your company’s value.