Most companies assume that revenue is the most important financial metric. While revenue is important, it isn’t the most important metric. The most important metric is gross margin.
Gross margin matters more than just strictly revenue because gross margin allows us to understand a company’s ability to spend money and grow.
Let’s create a fake real world scenario to help paint a picture of why gross margin is so vital…
If there are two startups selling products that cost $1M, and the first company has a 10% gross margin and the second has a 90% gross margin, the first company will be able to spend just $100,000 per sale on marketing, research, and other costs. The second company will be able to spend $900,000 per sale on those same departments.
Because the second business is able to spend $800,000 more on each department per sale, they can afford to pay significantly more to acquire each customer. Since the company can spend more money to acquire customers, it’s likely that it will grow much more rapidly.
Before we continue, let’s define how to calculate grow revenue…
Gross margin = (Revenue - Cost of Goods Sold) / Revenue
Typically, companies that produce their own products will have higher gross margins than companies that don’t produce their own products. This is because companies that don’t create their own products need to pay somebody else for the goods that they sell. For example, Target will have a lower gross margin than Tesla because Target has to buy the goods that they sell, while Tesla produces their own goods.
Investors love SaaS companies.
SaaS companies are typically loved by investors because they often have very low costs of operation, which means they can have high gross margins. To bring this notion to life, we can look at the median gross margin for a publicly traded SaaS company. The median gross margin for a publicly traded SaaS company typically grows from 50% to 75% in year four to year five.
The three main reasons that SaaS gross margins typically rise are:
- SaaS companies reduce hosting costs as the amount of customers they have increases.
- Customer success and marketing teams typically become more efficient with their time and scope of activities as the company scales.
- As a SaaS startup grows, it can typically attract larger customers that have much higher willingness to pay for a product.
When a company is just starting out, it can be very difficult to correctly calculate what the gross margin is. However, when an early stage company creates a decent estimate of gross margin, it makes it easier to make smart choices about how to hire and focus time on engineering, marketing, sales, and other tasks.
It’s critical to know what your gross margin is. This number directly informs you as to how much you can spend to grow. It is, perhaps, the most important metric on the financial statement of a startup and it should be keenly watched.