The success of a SaaS company depends not only on its customers and revenue, but also on particular financial metrics that drive sustainable growth. One key profitability metric is gross margin: the total revenue left after deducting the costs of goods sold (COGS) in a given period.
Gross margin is important for several reasons:
It puts your startup on the path to profitability,
It’s a good indicator of scalability; and
Investors use it to evaluate and value your startup.
Revenue might be the lifeblood of your business, but it’s never the sole determining factor in whether your startup can survive and thrive, because cash inflow alone does not guarantee profits. As the SaaS industry expands, you’ll need a solid grasp on your startup’s gross margin and SaaS margin benchmarks so you can steer your business toward a profitable exit.
What gross margin says about your SaaS startup
A measure of your company’s financial health and growth potential, gross margin provides actionable insights for important business decisions. A low gross margin typically indicates low operational efficiency, which creates challenges for scaling your startup. A high gross margin means your business is generating more revenue than it’s spending, so you’ll have money left over to invest in growing the company.
To find your gross margin percentage, you need your revenue and cost of goods sold (COGS).
Typically a 12-month period is used in calculating gross margin, but it’s also common for SaaS startups to track gross margin semi-annually or even quarterly.
SaaS Gross Margin Benchmarks
Depending on lifecycle stage, SaaS gross profit margin benchmarks can range from 50% to 95%. Early-stage SaaS startups are likely to have lower gross profit margins, because they aren’t yet benefitting from the economies of scale that later-stage SaaS businesses enjoy.
Early-stage SaaS startups should aim for a gross profit margin of at least 50%.
A true SaaS business with mature operations will typically have gross margins from 70% to 95%.
What’s a good gross margin for SaaS?
Managing gross margin is a balancing act. If you keep costs too low or increase prices too soon, you risk selling a product that doesn’t align with the value you can deliver, and that in turn will make it harder to expand your customer base.
So, a good gross margin depends on your business, and it should always be looked at in conjunction with other financial metrics. To offer some perspective, the weighted average of gross margins across Lighter Capital’s portfolio of 150+ SaaS startups is 72%.
SaaS businesses with a gross margin well below the 50% threshold might want to dig into their COGS calculation. Not only do SaaS startups often struggle with what to include in their COGS, or cost of revenue, but some tech businesses have a substantial service component with direct labor costs. If that sounds like your startup, then increasing revenue won’t necessarily improve your margins.
If you’re aiming for a gross margin within typical SaaS industry benchmarks, there are several tactics to consider.
4 Effective Strategies for Improving SaaS Gross Margins
SaaS businesses can reduce their COGS and/or increase revenue to improve gross margin. Seek opportunities to raise revenue and lower COGS so you can augment your gross margin early.
With that in mind, consider these four methods:
1. Increase prices
If your prices rise without hurting sales and your COGS stay relatively the same, you’ll see a strong improvement in your gross margin. You will, however, need a diverse customer base that sees the value in your solution and won’t be easily poached by your competitors.
GO DEEPER: When and How Often to Raise SaaS Prices
2. Acquire more customers
The more customers you acquire, the more revenue will flow into the business. If your COGS stay the same and your prices don’t change, you’ll need more customers to improve your gross margin. Before you charge ahead with this strategy, you’ll want to dig into your customer acquisition costs (CAC) and CAC efficiency. If you have high CAC or low CAC efficiency, you might burn up your cash before you get new revenue.
3. Upsell existing customers
Less expensive than acquiring new customers and often less risky than increasing prices, upselling is a strategy for inducing established customers to buy an enhanced version of the product or service you’re delivering to them. If your pricing is based on the number of users or licenses, you can also upsell customers by encouraging them to expand their use. Successful upselling increases revenue, which will improve your gross margin.
4. Reduce COGS
Reducing your COGS while holding prices steady is another way to improve your gross margins. Two good strategies for reducing your cost of goods sold include:
Audit your solution stack
For a SaaS company, reducing expenses from hosting applications, data warehouse fees, and other third-party software applications helps you lower COGS and improve gross margin. First, identify your primary operating expenses so you can prioritize and focus your cost-cutting.
Look for licenses you can eliminate or reduce, as well as applications with overlapping functions that can be consolidated, and always negotiate contracts when it’s time for renewal.
Take advantage of products and service discounts
Using free or discounted solutions to reduce costs can quickly shrink your COGS. At Lighter Capital, we offer client perks that include over $100,000 in discounts for a wide variety of products and services. Taking advantage of discounts, freebies, or other similar benefits can give SaaS startups an advantage early on to scale efficiently with minimal costs.
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