Gross margins and SaaS companies
twosigmaventures.com
twosigmaventures.com
I worked an account where we made 60 points of margin on our base product, which we sold $50M/year. We then sold $100M of an add-on product at 25 points of margin. There were people arguing that we should stop selling the add-on product, until I pointed out that it contributed almost as much margin dollars as our primary, with almost no engineering effort.
Slightly less cynical reply... it will lead to someone’s promotion by writing something like “doubled gross margin percentage by streamlining product lines to focus on core competencies” in an annual review. Sad to say that this happens all the time.
My theory is that it was partially our MBAs and partially the stock analysts MBAs. In our industry, normal margins were 60 points, so when our company was generating 36 points, it looked wrong to the analysts, so it needed to be fixed....
Unfortunately a lot of people forget that caveat.
They also forget that in an environment where capital is fairly cheap (which hasn’t been the case in human history until extremely recently) the margins shouldn’t be compared against other industry players, etc, but rather against the overall cost of capital on the market.
Comparing margins across industry is useful because if your margins are lower than your competitors then it could indicate inefficiencies or mistakes you might be making. But one needs to understand why those margins are lower. Apple, for example, can enjoy much higher margins than Dell, because although they are in the same industry, the brand and value proposition Apple brings is very different from Dell’s. Dell could try and chase the margins Apple has, but it would have to then become a very different company from what it currently is.
The real answer has to do with org charts and executive attention. If your VP is told that anything less than a billion dollars doesn't matter, he's not going to want to be distracted by anything that you know is going to be worth less than a billion dollars, and is going to want to focus 100% on those opportunities that could be worth more than a billion dollars (even if they have a low chance of success and an expected value much less than $100M). It's possible that some other VP might be interested in it - for example, if you have a product that's made $100M and has a decent chance of growing 2x and another department has a mandate to make $100M this year, it could be an easy win to adopt the $100M project off the $1B department and take credit for its continued growth. But then next year your growth target is $200M and the project may only have $50M worth of growth left in it, so your incentive is to axe it and concentrate on newer initiatives.
Same reason that VCs only fund companies that have a potential to single-handedly return the fund, or that hedge funds & private equity will drive well-known brands like Sears into the ground so they can strip the assets and sell them off to more productive companies. Manager attention is worth something, usually in proportion to the amount of capital they're already managing, and so it may not be worth spending the attention needed to make $25M when the resources you have at your disposal are expected to make $250M. That same opportunity could be very attractive to a team of 3 with no outside funding, though, and that's why we have the full-employment theorem for entrepreneurs.
In reality everything will be a lot more complex than this. But having the discipline to focus on your core competency, especially in situations like this, is a common trait I’ve seen in many successful start-ups.
https://www.investopedia.com/terms/c/contributionmargin.asp
Essentially, how much did that add-on ($100m) service “contribute” to the companies overall margin ... which obviously factors in absolute dollars
Edit: fixed typo
If deployed towards something that would have a 33% margin, you would be making about $38mm instead of $25mm.
Of course, the argument sucks because it ignores the fact that there are massive risks and therefore discounting associated with an unproven revenue stream. And if it is proven, then there should be absolutely no difficulty in getting financing for it with a 33% margin, and that financing would be much cheaper than the cost of shifting the money used to drive the 25% margin earner. Shifting this money means you’re basically paying for the new 33% margin product with money that has been borrowed at a cost of 33% itself...25mm profit on 75mm investment. You can get money from the market at a small fraction of that cost. Borrowing 75mm in the US should not cost more than 7-8mm per Anjum if you have such an obvious opportunity that you were willing to forsake 25mm of earnings for it. And if you’re unable to borrow at a reasonable cost for that project maybe it indicates that the project isn’t as much of a sureshot as you think it is and therefore the 33% margin that is being projected needs to be steeply discounted due to the risk factor.
Unfortunately I’ve seen a lot of people learn the metrics, and the ratios but never really understand what they mean and what information they provide, and therefore, what they are useful for.
Out of curiosity - how does this audience calculate what is included in the 'cost' / 'cogs' part of the equation?
My take - if the cost is required to maintain the continued ability for the customer to meaningfully use the SaaS application, then it's a COGS. This would mean the following should be typically COGS:
- Fully loaded infrastructure costs (Hosting / Web Services / sys admin personnel)
- Support personnel (fully loaded personnel costs)
Also, GM for professional services and SaaS subscriptions should be maintained separately.
If you calculate GM for subscriptions appropriately, you can tell A LOT about profitability or potential for profitability of a SaaS company.
We recently learned that’s not quite right and added in salaries for our support team and site reliability engineers and it’s 75% gross margin.
The definition absolutely matters and it would have been great if they stated an opinion.
How can professional services be included in Gross Margin?
What are they including in COGS?
Traditionally, any direct sales costs are included in COGS, but that doesn't seem to be the case here.
My take:
- Fully loaded infrastructure (as parent) including bandwidth costs
- The entire support department (management and office expenses included)
- Maintenance coding (if possible to split out from feature coding)
I'm assuming all revenue is subscription-based. I agree that any other revenue should be split out and calculated separately.
Again, I'd be really tempted to include at least some Sales and Marketing costs in there, too. If you couldn't get the sale without the advert, then technically the cost of the advert is a COGS item. But I get that this is debatable (half of your marketing spend is wasted, etc).
That plot is showing revenue multiples ranging from 10x to 50x. In other words, for every dollar of revenues today, it seems shareholders expect many dollars of actual honest-to-good net profits in the future. Alas, many companies on that plot, in fact, reported net losses over the past 12 months.
Let's hope for the sake of these companies, and for the sake of their shareholders, that aggressive spending to fuel growth today ultimately produces future profits that justify those revenue multiples.
While not an expert, I've tried the regression the author has done with CapitalIQ before. There's a third hidden axis which is whatever you want to define size/maturity/runway to be. That potentially explains some of the lift in multiple as well.
Similarly his example of investors not paying attention to gross margin seems a bit stretched. While I've never personally participated in a venture deal, pre-public private equity investors scrutinize gross margin a lot, and so does equity research converign listed firms.
While conceptually interesting, saying that a 30% EBITDA company that adds 1500 basis points of COGS goes to 15% margins and therefore ROIC falls (or valuation) is relatively boring. But his point about margins persevering post IPO was super interesting. I wonder if for the existing incumbents, after entry of one of these sexy unicorns, gross margin goes down after...
I hope not. If you sell it for less than it costs you to make it, eventually you're gonna have a bad time.
I mean, if you have high gross margins then you have low per customer acquisition costs - which has been the whole point of most articles on Saas Slow ramp of death for the last decade.