I’ve argued that Gross Margin Dollars is more important than Gross Margin percent. Most business school grads are focused on the percent because it’s good for the stock price, when it’s the gross margin dollars which pays the light bill.
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.
The argument would be that the $75mm deployed towards creating the $100mm could probably be better used elsewhere.
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.
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....
Nothing in my MBA curriculum has taught me that low margins are bad, just that low margins with high capital intensity is bad. At the same time, absolute numbers are critical and should be analyzed independently from margin.
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.
You’re talking like a rational actor. However there is a lot of irrational behavior caused by principal agent problems in investing. If a trade goes belly up the boss or client is going to ask why you bought a company doing 36 points of gross margin in an industry where the average is 60. In many cases, to preserve competitive advantage, the company doesn’t want to disclose the mix of revenue and profit margins of its business units, so investors don’t even have any way to evaluate why the company is doing only 36 points. So in many cases it can be “rational” to shut down a business unit making $25 million of gross profit.
I think I don't understand what capital intensity means here. If the margin is low, doesn't it mean that it's capital intensive? In the example, $75M is required to get $25M. Isn't that intensive?
Capital intensity has to do with net operating assets (PP&E, working capital). It’s capital intensive if you have to build a $1B plant in order to make a 1% margin.
I worked on a project that made over $100M for my employer and then got axed. (Or technically, it got axed by my department after 2 years and then was picked up by another department because it was still making money, and then got axed again 2 years later in some priorities reshuffle.)
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.
The only sensible answer is opportunity cost. I’ve worked with a few startups that have axed entirely profitable products because they could get a better ROI by defunding those products, and directing that investment into their core competency. In the cases of this that I’ve been involved with, it’s always turned out to be a very good decision.
Why would you not spin off the product as a separate company? I can't think of a single situation where "having X" is better than "having X and also $25mil/year".
Because opportunity cost means you don’t get to “and also”. In the cases that I’ve been involved with personally, spinning off another company hasn’t been feasible. To put it a bit more explicitly, say you have a product that generates $25mil/year, and runs about $10mil/year expenses. But, you also have a different product that for every $10mil that you invest into it generates $50mil/year in revenue. The opportunity cost isn’t that you’re spending $10mil to generate $15mil in profit, it’s that you’re spending $10mil to lose $25mil in profit.
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.
If your all-star engineering team is tied up by the 25mil/year business, you may need their attention urgently refocused on the core product. In theory they could recruit a replacement team and hand off the business, but that also takes time and attention.
Agreed, and just to expand, not only the engineers, but ops, infrastructure maintenance, customer support, sales, rent, HR, legal, recruiters, translators, the IT guy that keeps the TVs with Zoom working, and the list goes on and on and on. Some of these people are full time on the project, some are part-time, some are shared costs, some are not, but sometimes it's totally worth to shed the $25mil/year and re-focus on something else.
You axe it if you can use the same resources (people, capital, time) to produce something with a higher absolute margin (or better, future cash stream, which is the real measure of value for a company). So you don't axe it but keep the costs in, idle. You could even discontinue the product, restructure the company to fit, and give back the cash to shareholders if the contribution that product was giving is less that they can make elsewhere (on a risk adjested basis). At least in theory... in practice cutting the costs to fit is very difficult...
I am not sure that the article argues against that, but it does explain why your revenue multiple based valuation will end up being lower than if you had not taken on that additional business, even if the valuation is ultimately higher.
Understanding percentage of GM allows you to set the allowable percentage of all the overhead expenses below the GM line. It matters not of you have high gross margin dollars but spend it it all and your net is zero.
Yet another article that loves to talk about how important gross margin in SaaS is, but tip toes around its definition.
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:
I was totally confused in that whole article about what they were talking about when they said Gross Margin.
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).
It took me a moment to realize that the plot showing current market capitalization multiples versus gross margin for SaaS companies is not showing earnings multiples, nor EBITDA multiples, nor gross margin multiples for that matter.
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...
The pertinent question would be: why would you exclude sales and marketing from the gross margin, but include support costs. Ostensibly you are able to scale back sales and marketing without alienating your existing customers, but realistically optimizing for GM then potentially leads to an organization that oversells (high sales and marketing costs) and underdelivers (low value of what's actually in the product)
The example is so skewed in favor of the article. Why on earth would you spend fixed % of revenues on sales, marketing, R&D, G&A? They add up to 57% of revenues. So, the conclusion of the example could equally be that a SaaS company has to generate 43% gross margins or there is NO WAY for it to make a profit. Come on.. What about Square that is working with 41% gross margins according to the chart above it?
So we o my simple mind Gross Margin is the Expected Annual Revenue from a customer, minus "everything but the price paid for acquisition (ie google ads)" - leaving the per customer acquisition cost as the point the article is making.
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.
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.