An interesting trend in the SaaS industry is that the most successful startups aren’t always profitable at the earliest stages. At first glance, this approach to measuring performance may seem counterintuitive. After all, don’t businesses need to be profitable to sustain their operations?
The short answer: yes and no. There’s a lot of nuance to the discussion, since there are at least four different ways for SaaS companies to calculate profitability metrics from an accounting standpoint.
This article provides a look into two common approaches, along with foundational takeaways for founders. You’ll gain an understanding of two common metrics, gross margin and net profit.
There are multiple ways to measure profitability in a SaaS business. The technique that you use will depend on the requirements of your audience and the situation in which you’re reporting the metric.
In the accounting industry, there are best practices for financial reporting, to ensure compliance, a high standard of ethics, and good financial hygiene. These standards, known as generally accepted accounting principles (GAAP) include established rules and procedures. It’s this reason why, when you work with a CFO or accountant, what you report upon in your financial statements may be different from what you share with a financing partner.
In the venture capital (VC) community, SaaS startups are considered profitable when customer lifetime values (LTVs) are high enough to cover customer acquisition costs (CAC) and other business expenses.
It takes time, sometimes years, for a business to become profitable. In some cases, such as when the desired outcome is an acquisition, the startup may never reach profitability.
Regardless of the specific situation and chosen technique for measuring profitability, a startup’s metrics need to demonstrate that the core business model is sustainable. That’s where gross margin and net profits enter the equation.
Gross margin and net profit share in common that they are both profitability metrics. Each communicates a different story, however. Net profit describes whether a business is profitable, overall. Gross margin provides insight into individual revenue streams.
All profit metrics evaluate revenues and expenses in their formulas. While gross margin takes a partial view of expenses, net profit takes into account a complete picture of the business overall.
During a startup’s growth stages, financing partners and VCs will typically prioritize gross margin above net profits when making a funding decision. Here’s a calculation-informed look into why.
Gross margin provides a look into a business model’s viability.
It’s calculated as your total revenue minus cost of goods sold (COGS), which are the direct costs involved with. Gross margin percent is expressed as a percentage of your total revenue and represents the profit that you have to reinvest back into your business.
Gross margin % formula
(Net Revenue) - (Cost of Goods Sold)
Revenues can come from multiple lines of business including software subscriptions, consulting services, or hardware purchases rated to your business. COGS include but are not limited to support, customer success, marketing expenses, server costs (i.e. AWS, Microsoft Azure, etc.). COGS typically do not include salaries, commissions, and rent.
When determining gross margin, you’ll want to calculate a number for your entire business, in addition to a number for each revenue stream. As an example, let’s say that your SaaS startup sells subscriptions at $10 MRR, at a customer acquisition cost (CAC) of $3. The gross margin would be ($10-$3)/$10 = 70%.
So what’s considered good?
The median performance is at 75%, and the top-quartile margin is 82%. Gross margins vary based on your startup’s business model — for instance, whether you have an integration ecosystem, offer professional services, or maintain a line of business around course sales.
Gross margin can also be calculated as recurring gross margin, on a monthly basis, to monitor ongoing performance and make financial projections in your business.
Net profits measure how much of your total revenue is profit. It’s similar to gross margin, which also calculates profitability, with one subtle difference.
Where gross margin accounts for COGS only — direct costs involved in making a sale — net profits include all expenses in a business. For this reason, net profit is a more precise measure than gross margin of a business’s profitability overall.
You can calculate your startup’s net profit percent by subtracting the total expenses from revenue and then dividing that value by revenue.
Net profit % formula
(Net Revenue) - (Expenses)
Most businesses will have a net profit that’s lower than gross profit. That’s because net profits account for all expenses, rather than just direct costs (COGS). Net profits include COGS in addition to fixed costs such as salaries, rent, utilities, and equipment.
Net profit provides a lens into the performance of a startup overall. So, you wouldn’t use this formula to examine individual lines of business. Instead, you would use gross margin to evaluate specific revenue streams.
Every startup needs to keep track of both metrics as lenses into profitability. Gross margin is how you optimize key revenue streams within your business, as you can make changes to COGS in near real-time. Your net profit helps you keep your overall operations running.
When evaluating funding options, you may find that some potential financing partners prioritize gross margin above profitability during due diligence phases. A stable gross margin indicates that a startup has created a sustainable, predictable business model.
A SaaS startup with a high gross margin even with a negative net profit is still a viable acquisition target, with the potential to be a high-performing line of business. That’s because net profits account for employee salaries, while gross margins do not. In some situations, an acquirer may want to purchase a line of business but not bring on the startup’s entire workforce.
Financing partners may also choose to prioritize gross margin above net profit for a number of reasons. If you’re not sure about the scenario specific rationale, be sure to ask.
Remember that every company is different, and there are many different factors that have the potential to impact your profit metrics. External market forces will always be out of your control.
In addition to knowing your profitability metrics, it’s important to know the stories behind the numbers. That way, you can take steps to ensure stable performance, should the underlying assumptions for your business change.
Ultimately, financing partners are looking for signs of long-term stability and predictability. Your profitability metrics are key to establishing this picture.
This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal, or tax advice.