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5 Drivers of SaaS Valuation #4 – GROSS MARGINS

September 3, 2013

Given your revenue, how much money can you make?

The SaaS Capital team has looked at the financials of literally hundreds of businesses over the years. Almost all these businesses were either SaaS companies or had a very similar recurring revenue business model. Drawing from these experiences, we have put together a list of value drivers every seller should pay attention to as they go about preparing for the sale of their company or their company’s stock (an equity raise). Other nuances of your business will undoubtedly impact valuation, but theses are the broad-based value drivers.

Listed in order of importance, they are:

  1. Growth
  2. Addressable Market Size
  3. Customer Retention
  4. Gross Margins
  5. Customer Acquisition Costs

In this fourth in a series of blog posts are going to take a deeper look at GROSS MARGINS as a valuation driver.

While it’s true net income and EBITDA are not direct valuation drivers for growing SaaS businesses, gross margins are relevant. Gross margins strongly indicate the profitability of your business when it reaches a more mature phase. Gross margins also determine how much revenue your business can channel back into sales, marketing, and product development and therefore, how capital efficient the business will be. For these reasons, the less direct costs required to deliver your SaaS revenue, the more valuable that revenue is.

SaaS businesses must be able to clearly identify costs associated with professional services versus the costs associated with the product itself. Those two revenue streams are typically valued separately. It does not matter as much what margins you are earning on services; although losing money is always a drain on cash and not ideal. Buyers are more interested in the gross margin you are earning on the core product.

Of note here is the question of revenue mix between professional services and the SaaS product itself. While it is true that “given a specific level of revenue”, the less it is professional services revenue, the greater the valuation. In the real world, though, no one ever “gives” you a level of revenue. The bottom line is this; if you can make money on professional services and it helps solidify or grow your SaaS license revenue, more services revenue is a good thing and it does add incremental value.

Gross margins for SaaS businesses are measured many different ways. There are no standards.

We recommend including all direct hosting and customer support costs in SaaS license COGS as the best “operational” number that provides the proper visibility into the business’ actual operating leverage. Including sales commissions and allocated overhead in COGS clouds the number, reduces its usefulness, and is an unnecessary negative in a valuation discussion.

For SaaS revenue streams, (excluding professional services), gross margins are typically 85% to 95% and a SaaS business can increase its valuation by intentionally focusing on improving its gross margin. For professional services, we now see the vast majority of SaaS businesses making some money on this activity and not providing it as a loss leader as they commonly did 5 years ago.

To learn more, download our white paper “What’s Your SaaS Company Worth?” for an in-depth look at all five valuation drivers and other considerations when conducting a valuation exercise.

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