Financial benchmarks are a controversial North Star in the tech space. Many operators argue that comparing too many of them is a short road to undermining the true value of your business; however, general guiding figures like SaaS gross margin benchmarks help you weave a story on the road to getting funded.
Proceed with caution, though. If you get too far into the weeds with your numbers, you can lose sight of what’s really happening in your business and start being more of a bean counter than a strategic CFO.
With those warnings out of the way, let’s see how your gross margin is faring, compared to other SaaS companies in 2023.
Gross Margin Definition
SaaS businesses consider gross margin to be a crucial tool for measuring success because it calculates gross profit as a percentage of total revenue.
Essentially, gross margin shows how much money can be used to pay for operating expenses and reinvestment in the business. It's a dependable way to measure your SaaS business' ability to grow and it’s a significant factor that most investors will look at when determining your business’ valuation.
How To Calculate Gross Margin
Gross margin is found by subtracting the Cost of Goods Sold (COGS) from net revenue. Take your total sales and subtract the costs of making and selling your product. For SaaS companies, COGS could be everything from web hosting costs and software to keeping the website up, as well as development costs, any direct costs, operating costs, and paying the customer success team.
The exact components will depend on your company's operations and business model. The rule of thumb is simple: without this person/process/technology, could the product be sold successfully? If yes, add it. If no, leave it out.
Here's how you figure out the percentage:
Gross Margin (%) = Gross Profit ÷ Sales
- Gross Profit = Sales – COGS
- Net Revenue = Gross Revenue – Returns – Discounts
For example, if you sell your product for $10 and it costs you $3, you're keeping 70% of what you earned. That means your gross profit margin is 70%.
To make these SaaS metrics calculations easier and devoid of any human errors, consider using one of these financial reporting solutions.
The Value Of A Gross Margin
Gross margin is a clear sign of a SaaS company's financial health and growth potential. When this margin grows, the company can reinvest more profits into operations.
According to Ben Murray from The SaaS CFO, SaaS business owners must understand how different revenue sources affect their gross margin. He emphasizes that “the mix of services, recurring revenue, and other income sources matters”.
But, like anything, it’s not a perfect metric. While high gross margin may indicate a company's overall profitability, it may not always paint the full picture for SaaS companies. Many of their costs occur in the early stages of research and development, so their net profit margin may not accurately reflect their scalability.
When evaluating a SaaS company, investors often consider annual recurring revenue (ARR) or total revenue, operating costs, and historical costs of development. Generally, they expect a gross margin of 75% to 80%.
SaaS Gross Margin Benchmarks
Over the past two decades, the evolution of SaaS has led to a mountain of information about financial and operational metrics and their reporting. Luckily, we’re avid hikers, so this poses more of an opportunity than a challenge. Due to the abundance of data, you can confidently evaluate your business' performance and establish a benchmark for your annual planning process, regardless of your business stage and industry.
However, while public company data is widely accessible, assessing what’s happening in the private markets can be challenging. As a result, most executives in the SaaS industry require a dependable method to measure their company's performance. Below are some SaaS gross margin benchmarks and market trends to consider when evaluating your business performance.
Growth Rates Decreased in 2022
If you want to get a realistic picture of your overall business growth, compare your company with others similar to you, not just your direct competitors. Look at businesses of the same size, with similar contract values, sales methods, and target audiences.
In 2022, the growth spurt from 2021 cooled down a bit, harking back to the slower 2020 vibes. On average, companies grew by 30% in 2022, down from the 42% growth in 2021.
Growth had briefly lost its spot as the leading valuation indicator to the Rule of 40 by the end of 2022 causing companies valued between $20M and $50M, despite being super-efficient in growth, to hit a few speed bumps. But by Q2 of 2023, growth rates climbed back up the leaderboard as the number one factor affecting enterprise value.
Here’s the breakdown, according to Benchmarkit:
- Growth's connection to company worth was 41% in Q2 ‘22 and 31% in Q2 ‘23.
- The Rule of 40's link to company worth was 44% in Q4 ‘22 but dipped to 17% in Q2 ‘23.
Looking through to the end of 2023 and beyond, companies are bracing for slower growth and trimming expenses to make their cash last longer.
The Rule of 40 Saw a Decrease in 2022
The Rule of 40 says a SaaS company's annual growth rate and profit margin should add up to 40%. Think of it as a quick health check for your company.
To get your Rule of 40 number, add your revenue growth percentage to your profit margin percentage. For instance, if you're growing at 10% and have a profit margin of 15%, your number is 25%.
If that sounds low, it's because it is. The “Rule of 40” means the target is 40%. To be in a good spot, your combined growth and profit should hit 40% or more.
In 2021, the Rule of 40 showed a strong increase, but it decreased in subsequent years due to slower growth rates in 2022 and a significant decrease in average EBITDA and operating income expected in the first half of 2023.
Benchmarkit also provided a snapshot of how the Rule of 40 shifted:
- January 2022: 14%
- July 2022: 38%
- January 2023: 44%
- June 2023: 17%
It's worth noting that the Rule of 40 can be artificially inflated by higher growth rates seen in companies with less than $5 million in annual recurring revenue (ARR). Therefore, it may not be a reliable metric for this cohort. Instead, they should focus on finding a strong product-market fit, consistently acquiring customers, and efficiently growing their revenue as they scale from $5M and beyond.
CAC Payback Period & CLTV: CAC Ratio Both Went Up
The CAC payback period focuses on acquiring new customers and is not affected by the expansion of existing customer ARR. It is a good indicator of how well your new customer sales and marketing strategies are working. In a report summarizing results from 2022 and the first half of 2023, we saw that the average CAC payback period went up in 2022 compared to 2021; however, it’s still shorter than it was in ‘19 and ‘20.
For companies earning between $5-20M in ARR, the average payback period was 17 months, but this number alone doesn’t tell us much. In order to properly compare to this benchmark, you need to take into account the average annual contract value (ACV) you’re selling. For example, if your contract’s lifetime value is between $5-10K, you should be earning that money back in an average of 10 months. If the value is $50-100K, you’re looking at an average of 19 months instead.
This payback period often experiences monthly fluctuations, especially for bigger businesses.
For example, landing a significant deal in one month can skew the results. To normalize any exceptional outliers, consider looking at this number over 3, 6, or 12 months for a clearer picture to base decisions on.
But what about customer lifetime value? In the last five to ten years, hitting a 3X result was the sweet spot for the lifetime value to acquisition cost (CLTV: CAC) ratio. However, over the past three years, yearly averages have increased to land between 3.6X and 4.2X. For companies earning $5-20M in ARR, the median CLTV: CAC is 4X.
The lesson? You need to take your buyers on more dates before you try to make things serious. But, when they like you, they’re in it for the long haul.
In less relationship-y language? Buyers are spending more time evaluating providers and want lower barriers to entry, as they need more proof before they commit to a specific solution. This is pretty well on the mark with what is to be expected in a market with less capital to throw around. When you prove your value to them, though? They’ll stay with you for longer, spending more money with you without requiring you to incur additional costs.
Pro tip: When exploring new markets, it’s best to break down the CAC Ratio by segments or cohorts, such as big enterprise clients versus smaller businesses. This can help you identify your most effective sectors in attracting new customers.
NRR Remained the Same, GRR Increased Slightly
Think of Net Revenue Retention (NRR) as a bucket of water for SaaS companies to measure success and growth potential. Now picture your subscriber revenue as water in this bucket. If there are holes in the bucket, you'll lose water over time, just as you’d lose customers to churn. Sure, you can expect a few drips because, let's face it, no business is leak-proof. But you can also fix the holes and keep more water in the bucket.
Ideally, gaining new customers and upselling will add more water than you lose, resulting in an overall retention of water in the bucket.
In 2022, everyone had their eyes on Net Revenue Retention rates. However, both new ARR and the expansion of existing Annual Recurring Revenue (ARR) slowed down a bit in the latter half of the year.
Over the last three years, Gross Revenue Retention (GRR) has been pretty steady. But in 2022, it bumped up by 2%, reaching 89%.
In North America, most SaaS businesses kept a consistent Net Revenue Retention (NRR) of 105%. But when you consider the global performance of tech companies this year, the average NRR sits at a median of 103%.
I looked specifically at bootstrapped SaaS companies with $3M to $20M in ARR - here are a few trends I picked up on:
- On average, companies are growing at a rate of 28.5%. But those in the 90th percentile are soaring with a 60% growth rate.
- As I mentioned, the average Net Revenue Retention (NRR) rate is 103%. However, the top performers in the 90th percentile have an impressive NRR of 122.1%.
- As for Gross Revenue Retention, while the typical rate is 90%, the 90th percentile boasts a solid 98%.
How To Improve Your Gross Margin
Here are some recommendations for crafting an upward charting path for your business.
- Lower your customer acquisition costs (CAC) by analyzing which platforms and campaigns give the best results and focusing on them.
- Think about implementing different pricing strategies, such as Buy Now Pay Later (BNPL), which lets customers pay in flexible installments.
- Look into new sources of funding and have a contingency plan, even if you don't think you need it right now.
- Don't offer discounts to increase Average Contract Value (ACV). While they may seem like an appealing strategy, discounts usually decrease customer lifetime value, affect the churn rate, and make renewals more difficult.
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