One important aspect of Software-as-a-Service (SaaS) that isn’t well understood to first-time entrepreneurs is the role gross margin plays into the business. Gross margin is defined as the percent of revenue left over after the cost of servicing that revenue is taken into account (see SaaS cost of goods sold). For example, with a SaaS company, things like application hosting costs, customer on-boarding costs, customer service costs, and any third-party fees like software licenses or data fees that are required to use the product are included in the calculation.
Gross margin is also a reflection of how valuable a dollar of revenue is to the business. If the company is an ecommerce business with 20% gross margins (commodity products) vs a SaaS business with 80% gross margins, every additional dollar of revenue for the SaaS business is equivalent to four dollars in the ecommerce business (due to the much higher contribution margin). Margin is one of the main reasons a $10 million revenue company can be more valuable than a $100 million revenue company.
Early on, a startup shouldn’t worry too much about gross margin. It’s most important to find product/market fit and build a repeatable customer acquisition process. Over time, economies of scale will start to kick in and most SaaS companies will be able to achieve gross margins in the 70-80% range, if not higher. Gross margin, subscription revenue, and great growth opportunities all come together to drive high valuations for SaaS companies.
Pay attention to gross margin in SaaS companies and understand why it is so important.
What else? What are some more thoughts on gross margin and SaaS?