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Calculating and Framing SaaS Gross Margin for M&A

Summary
  • How to calculate gross margin for SaaS
  • Why COGS plays an important role in calculating gross margin
  • How to properly position gross margin for M&A buyers

In contrast with other sectors where valuations are often based on multiples of EBITDA, SaaS companies are often valued on multiples of revenue.

What sets best-in-class SaaS companies apart are exceptionally high gross margins in the realm of 80-90+%. Acquirers and investors care deeply about gross margin, since the metric signals whether the SaaS company they invest in will have the ability to scale immensely.

In light of the importance of gross margin for SaaS, discussions around this metric play an important role in any M&A or capital raise transaction. As such, founders should ensure they’re correctly reporting this metric according to the expectations of their buyers while ensuring it is positioned in the best possible light.

Based on our experience advising 75+ SaaS founders through successful M&A and capital raise transactions, here are our thoughts about how to correctly classify costs and calculate gross margin for the M&A discussion.

Correctly Calculating Gross Margin

While the calculation for gross margin is fairly straightforward (i.e. Net Revenue minus Cost of Goods Sold over Net Revenue), the output of the metric is dependent on which costs a SaaS company chooses to classify as a Cost of Goods Sold (COGS), as opposed to an operational expense.

In many cases, a SaaS company’s definition of COGS will vary from that of the average acquirer, and these disparate definitions can result in misalignment between the buyer and seller, leading to suboptimal outcomes.

Incorrect definitions of what to include in COGS can artificially push gross margin up or down. Most often, SaaS companies unintentionally inflate their gross margin by under-burdening COGS. In other words, SaaS companies often unknowingly classify costs that should be included in COGS as operational costs.

Below is an example P&L showing a company under-burdening COGS, resulting in a higher reported gross margin.


Example P&L with Under-Burdened COGS

Net Revenue $100
Cost of Goods Sold (COGS) ($5)
Gross Profit $95
Operating Costs ($50)
...

Reported Gross Margin: 95%

Included in COGS

  • Third-party fees
  • Payment processing fees
  • Revenue share/royalty fees

Included in Operating Costs (but should be in COGS)

  • Hosting costs
  • % of customer support personnel cost dedicated to onboarding and ongoing support
  • Implementation and data migration costs
  • Platform troubleshooting and break-fix personnel (DevOps, SysAdmin, Support)

While a high gross margin might look good at the get-go, misclassifying costs and thereby inflating gross margin doesn’t lead to good transaction outcomes. When a buyer diligences the SaaS company and discovers a strong discrepancy between the purported gross margin and their own diligenced metrics, the tone of the transaction can turn.

At a minimum, the buyer will present a change in price or deal structure. Depending on the magnitude of the discrepancy, the buyer may back out of the deal altogether.

In light of these issues, founders should take a conservative view of gross margin while also positioning this metric in the best light.

Calculating an accurate gross margin based on COGS

Some of the costs to include in COGS are more intuitive than others. As a general rule, any cost incurred to deliver the product to a customer should be included in COGS.

Below is a list of some of the most common items we advise our clients to include in their calculation of COGS and gross margin:

  • Web hosting costs
  • Fees for third-party software integrated into the company’s platforms (e.g. Google Maps, third-party data, etc.)
  • Merchant payment processing costs (i.e. costs to process customer credit cards—generally ~2%)
  • The cost of platform troubleshooting and break-fix personnel (typically the customer support or operations team)
  • Costs of implementation/data migration (typically mostly headcount associated)

By including these costs in COGS, you will enter a transaction with a more accurate view of your gross margin, which will align better with the diligenced metrics of buyers and help maintain a positive tone in the deal as you approach closing.

Positioning gross margin in the best light

While ensuring the calculation of COGS for buyers is fully burdened, you need to keep in mind what the output of that calculation says about the business. The size of your gross margin will affect a buyer’s perception of whether to classify your company’s revenue as that of a recurring software business or as that of a services business. A buyer’s perception of how revenue is earned strongly influences valuation.

In many cases, especially for young and growing companies, the aggregate gross margin is often over-burdened by one-time implementation costs with thinner margin profiles. In reality, the company’s margins on its recurring revenue (the revenue buyers really care about) could be much higher. By segmenting the revenue and costs associated with recurring vs. one-time business, the SaaS company can paint a more favorable picture of long-term gross margin.

See the below example:


Overall P&L

Net Revenue $100
COGS ($30)
Gross Profit $70
Gross Margin 70%

P&L for Recurring Revenue

Net Revenue $80
COGS ($12)
Gross Profit $68
Gross Margin 85%

P&L for One-Time Revenue

Net Revenue $20
COGS ($18)
Gross Profit $2
Gross Margin 10%

Overall, this company’s gross margin doesn’t clear the 80% threshold most buyers look for to justify a valuation at a revenue multiple. But by segmenting the revenue and costs between recurring and one-time business, a different story becomes apparent.

In this case, recurring business shows an attractive gross margin of 85%. This makes the asset more attractive to buyers, because as the company retains customers, this high-margin recurring revenue will make up a larger percentage of the company’s overall revenue.

Of course the above example is contrived—dividing revenue and costs between repeat and one-time business can be a difficult process. Further complicating the process, many SaaS companies don’t break out one-time costs like implementation costs as specific line items, but instead lump them in with overall recurring costs.

In cases where the SaaS company can’t easily separate one-time and repeat business, a different frame through which to present this story is the time frame. Comparing the margins of new customers vs. renewal customers can expose that same story of long-term profitability. See the below example:


Overall P&L

Net Revenue $100
COGS ($23.5)
Gross Profit $76.5
Gross Margin 76.5%

P&L for New Customers

Net Revenue $40
COGS ($16)
Gross Profit $24
Gross Margin 60%

P&L for Renewals

Net Revenue $60
COGS ($7.5)
Gross Profit $52.5
Gross Margin 87.5%

Don’t Take SaaS Metrics as a Given

For any SaaS metric, be it gross margin, retention, growth rate, or another, don’t take the metric at face value. If you’re looking to go through an M&A or capital raise transaction, you will want to make sure that each metric is calculated according to the expectations of the buyer. See our article about key SaaS metrics to learn more.

At the same time, top-level metrics alone, even when aligned with buyers’ expectations, rarely tell the full story. In most cases, a SaaS company has to dig into the data to uncover the most compelling frame to market the business. To learn more about how an investment bank can help with this process, see our article about appropriately positioning a business.

Modified on Jun 04, 2021