SaaS gross margins have been getting attention lately as investors dig into SaaS cost structures and revenue growth rates going into 2020.
Gross margin is simply revenue minus cost of revenue, expressed as a percent. Gross margin shows what is left over after you deliver your products and services. SaaS cost of revenue is comprised primarily of hosting and network costs, plus any professional services, implementation, training and other services. SaaS vendors with no professional services have the highest gross margins, typically above 80%. SaaS vendors delivering subscriptions as well as professional services typically have gross margins between 60-70%.In a recurring revenue business, the more you can increase gross margin over time, the more revenue dollars you retain per customer. High gross margins together with high customer retention rates for a SaaS company at scale contribute to higher valuations, up to 20X or even 30X revenues in today's market.
Have SaaS Gross Margins Improved Over Time?
Cost of Revenue (COR) has come down for pure recurring revenue SaaS companies over the past 10 years, resulting in higher average gross margins for public companies. The main drivers of the cost reductions are:
- Hosting expense, the primary component of COR, has become more competitive, with extensive use of AWS and other hosting and network services
- Better cost management of professional services for companies selling services alongside subscriptions.
In the following chart for SaaS companies in 2008, you can see average COR as a percentage of Revenue at 40.4%, and average Gross Margins at 59.6%. The average revenue for this group was $171M.
Source: OPEXEngine 2019
A good example of a SaaS company from that period with a strong recurring model enabled by professional services is Netsuite; here's a chart before and after IPO in 2007.
Source: OPEXEngine 2019
Now looking at average COR and Gross Margins for SaaS companies in 2018, and normalizing revenue to compare against the 2008 companies, Gross Margin on average has increased almost 10 points, with more companies over 80% gross margin, while Cost of Revenue ranges from 15% at the low end to 46% at the high end, averaging 31%, almost 10 points as well below the average for 2008.
Source: OPEXEngine 2019
Early-stage SaaS companies typically are not as concerned about Gross Margin as companies at scale. In early years, many companies use Professional Services for customer acquisition and retention, giving away services at cost or even below cost. In these early years, companies typically are laser-focused on finding a scaleable sales model while Cost of Revenue is an after-thought. As companies scale, best in class SaaS companies have gotten a lot better at delivering services at cost or above cost, and to productize services into recurring revenue product expansions.Hitting 50-60% gross margins for companies with professional services, and 70-80% gross margins for pure recurring revenue companies within 5 years, with continued slight improvements in following years is considered ideal.
Conclusion
High gross margins are seen as a strong barrier to competition and significant risk mitigation if revenue growth slows. Heading into 2020, the SaaS market is expected to continue with strong growth. But with over 60 public SaaS vendors in the market today and thousands of private SaaS companies competing for customers, healthy cost structures will increasingly be looked at by investors when evaluating where to place bets.
