Gross margin, also known as gross profit margin, is an essential metric for SaaS businesses. Simply, this metric looks at gross profit as a percent of total revenue. It is the amount available to pay operating expenses and reinvest back into the business. Gross margin serves as a good indicator of scalability for SaaS businesses and is an important metric investors consider to determine valuation.
Calculating Gross Margin
Gross margin is a function of revenue and cost of goods sold (COGS):
Gross Margin = (Revenue – COGS) / Revenue
Gross margin is the percent of revenue that exceeds COGS. More specifically, gross margin is the revenue remaining after the direct costs to deliver a company’s product. For more insight on calculating COGS, please see SEG’s recent Virtual Coffee with Grant Thornton on this subject, or SEG’s past blog, What Every Software Executive Should Know About COGS.
Gross Margin as a Signal for Scalability
Gross margin is an indicator of a SaaS company’s financial health and growth prospects. As gross margin increases, more money (i.e., gross profit) is available for reinvestment into a company’s operating expenses. A company with strong unit economics may choose to invest more cash into sales and marketing. A company with customers clamoring for additional modules may decide to invest more into R&D. It’s no surprise valuation is positively correlated to gross margin.
Gross Margin Benchmarks for SaaS businesses
Gross margin is a very important metric Software Equity Group looks at when evaluating a business. Based on our experience, a good benchmark is over 75%. Typically, most privately held SaaS businesses we work with have gross margins in the range of 70% to 85%. Anything below 70% begins to raise a red flag, requiring additional analysis. It is important to note we occasionally see SaaS businesses incorporating on-going services into their business models. While this causes us to look deeper into the company’s scalability, we often see a favorable tradeoff resulting in exceptionally strong gross retention and net retention.
As expected, public SaaS companies in our SEG SaaS Index with higher gross margins continue to be well rewarded by investors (see page 22). See SEG’s 2021 Annual SaaS Report for additional detail.
Gross Margin and Valuation
When assessing a SaaS company’s value, investors often talk in multiples of ARR or multiples of revenue. These investors are also likely assuming a gross margin in the range of 75% to 80%. What happens if an investor compares two similar businesses, except one has an 80% gross margin and the other a 60% gross margin? Hopefully, the investors toss the ARR or revenue multiple into the trash and focus on a gross profit multiple. Consider the two SaaS companies below. Assuming all else equal, what is gross margin’s impact on valuation?
|Company A||Company B|
|Gross Profit Margin||80%||60%|
|Enterprise Value (EV)/Gross Profit||9.0x||9.0x|
|Enterprise Value (EV)||$72M||$54M|
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 along comes Company B. Because Company B has the same revenue, the belief is the 7.2x comparable multiple is appropriate, and therefore Company B is also worth $72M.
Not so fast! Company B has significantly less gross profit. For every dollar of revenue Company A generates, 80 cents are available for operating expenses. In contrast, only 60 cents per dollar of revenue generated by Company B is available for operating expenses. Because these are materially different, the better comparable for Company B to use is Company A’s 9.0x gross profit multiple. Doing such yields Company B a valuation of $54M. Not what the shareholders of Company B want to hear! However, if Company B had a gross margin of 95%, it’s likely these shareholders would be more than happy to use a gross profit multiple.
For more on the importance of COGS and ways to improve it, check out our virtual coffee with SEG Senior Analyst Austin Hammer and Jonathan Christie, Manager in Transaction Services at Grant Thornton.
If you have any questions about your SaaS business’ gross margin or COGS, please don’t hesitate to reach out.