In addition to gross margin, several other profitability metrics are critical in a SaaS business. These metrics provide insights into the overall financial performance, efficiency, and profitability of the company. Here are some key profitability metrics, and we will explore them in this article:
Let’s now dive deeper into how to measure profitability of a SaaS business.
The Rule of 40 is calculated by adding the company’s growth rate (typically measured as revenue growth rate) and its profitability margin (usually represented by EBITDA margin or operating margin). If the sum of these two metrics is equal to or greater than 40%, the company is considered to be in a healthy position.
Mathematically, the Rule of 40 can be represented as:
For example, if a SaaS company has a revenue growth rate of 30% and an EBITDA margin of 15%, their combined score would be 30% + 15% = 45%, indicating that they meet or exceed the Rule of 40.
An important question to consider when calculating the Rule of 40 is whether to calculate it based on recurring revenue or total revenue. If your business model is such that you have 80% of revenue streams recurring then you should use this revenue in the calculation. If, however, you have a large portion of variable revenue in your overall sales mix, it is probably better to use total revenue.
Here is an example of how the Rule of 40 metric might look like:
The Rule of 40 helps strike a balance between investing in growth and maintaining profitability. It acknowledges that while high-growth companies may prioritize scaling and market capture over profitability in their early stages, they should still aim to achieve a certain level of profitability relative to their growth rate to ensure sustainability.
If you are in an early stage of life as a business, the Rule of 40 may not be the right metric to focus on. As a rule of thumb, it is a metric suitable for SaaS business that generate at least $3M in revenues.
In a SaaS business, the OPEX (or operating expense) profile refers to the breakdown and analysis of the company’s operating expenses. It provides insights into how the company allocates its resources and incurs costs across various categories to support its operations and deliver its SaaS product or service.
The OPEX profile typically includes expenses related to:
Analysing the OPEX profile is important for controlling and optimizing the cost, but also for explaining to investors how resources are allocated and how the company manages its operational expenses. OPEX profile also allows for benchmarking with industry peers and competitors enables businesses to assess their cost efficiency and identify areas for improvement. Obviously, OPEX profit is essential to making the right decisions about the business strategy, including resource allocation, pricing, product development, and sales and marketing strategies. It helps in determining investment priorities, cost reduction initiatives, and growth strategies. Last but not least, it is significant for financial forecasting and budgeting, so a business can project future cost and profits, and model out the business performance in response to its strategic initiatives.
It is important to point that each OPEX department should have its department leader who resides in his/her respective department, and not in one department housing all executives.
And with COGS, all OPEX departments should be fully burdened, to include taxes, benefits, travel, training, but also shared facility cost and depreciation of shared business’ assets.
Here is how both the COGS and OPEX expenses appear in an income statement:
To calculate correct gross margins for a SaaS business, it is essential to code expenses to the right buckets. More specifically, it is essential to bear in mind that variable expenses in a SaaS business are not the same as in a traditional brick business since they include costs such as customer success and development operations which in traditional business fall into OPEX category, or indirect cost located in the middle of the income statement. To remind, the decision about where to put your customer success cost depends on the following factors:
CS belongs in COGSPutting cost in the right section of the income statement is not only important for the gross margin calculation but also for the operating margin calculation. Knowing how much a SaaS business invests in OPEX as % of revenue is a critical piece of information as it allows for understanding where we are investing our money in future growth and if this investment is working to produce extra revenue. Just to be clear, OPEX are the expenses below gross margin (or profit) that support the infrastructure, growth, and continued development of our SaaS business model. They do NOT vary much overtime and thus can be considered as overheads or “stepped” overheads (i.e. increase in stepped stages, as the business growth.
Not included in the ACS on the COGS are cost associated with onboarding, training, configuration as these are one-time in nature.
There is no standard ACS metric, and it can range from a few hundred dollars to several thousand dollars per customer, or even more for enterprise-level sales.
When calculating ACS, it is thus critical to separate ongoing/existing business and customers from acquiring the new business/customers, particularly in the OPEX line where expenses are often co-mingled. Here is the general logic to follow to allocate OPEX between new and existing.
To think about it differently, if we stopped acquiring new logo business, what resources would be required to maintain our existing customers. I do admit that including our account management might be debatable. They generate incremental revenue for our business.
Understanding ACS is critical to not only calculation of ARPA/ARPU but also the operating leverage of the SaaS business and its potential to scale up. Ideally, we see ARPA and ACS expansion over time as we scale and become more efficient in supporting our customer base. This can be presented with the following illustrative graphic:
Understanding the spread between ARPA, new deal pricing, and ACS is thus critical. To successfully scale your SaaS business, you must understand these unit economics.
If you serve enterprise customers, for example, and now want to offer an SMB plan (lower price point), how does this impact your delivery of revenue and resources required?
Or maybe you still land enterprise customers but are experimenting with more affordable pricing entry points. Do you have any ARPA/ACS spread, or will you have to make it in volume over time to lower your unit cost structure?
Will adding 100 customers drive down your unit costs significantly? Or will it take 1,000 customers? Calculating economies of scale helps answer these questions and educate the leadership team about our cost structure and the impact of customer growth on our unit costs.
Interest, tax, and depreciation are not the only add-backs to EBITDA. If your business has significant non-recurring (or transitory) expenses in its income statement, such as material executive recruiting fees, M&A fees, one-time consulting projects, these can be added back to come up with a “normalized” EBITDA.
Furthermore, SaaS businesses, because of the very nature of their business model, have large deferred revenues in their balance sheet. Deferred revenue refers to the unearned revenue that has been collected from customers who signed contracts or took subscriptions, and the revenue from these contracts or subscriptions has been “deferred” in the companies balance sheet in accordance with the accounting policies. Because these contracts and subscriptions are like “money in the bank”, i.e. they will flow through generating cash flows to the company, it is imperative to show not just EBITDA but also Cash-Adjusted EBITDA, one that includes the period-over-period growth in deferred revenue balance that sits in the balance sheet.
If a SaaS business has large and growing deferred revenues sitting in its balance sheet, it is also very likely to have capitalized commissions sitting there as well. Capitalized commissions refer to the practice of treating sales commissions as an asset on the company’s balance sheet rather than as an immediate expense on the income statement. It involves capitalizing the costs associated with acquiring new customers (typically incentives payable to the sales team) or renewing existing contracts and amortizing them over a period of time. Such commissions should be included in the Cash-Adjusted EBITDA to ensure that one does not compare apples with pears.
Operating leverage in a SaaS business refers to the degree to which fixed costs and variable costs are present in the company’s cost structure. It measures the impact of changes in revenue on the company’s operating income or profitability. More specifically, operating leverage represents the amount by which a business can increase its EBITDA by increasing its gross profit. Or put differently, operating leverage tells us how much money a business keeps for every dollar of gross profit increase, after deducting its COGS and fixed-liked OPEX items. A business that generates revenue with a high gross margin while minimizing operating expenses has high operating leverage.
Operating leverage is important to measure because it provides insights into the scalability and profitability dynamics of a SaaS business. It helps assess the company’s ability to generate higher profits as revenue increases and understand the potential risks and benefits associated with changes in the business’s cost structure. Ultimately, operating leverage helps avoid the growth trap, or a situation when money is being poured into a SaaS business without increasing operating profitability, and thus cash flows and value of the business.
As the business scales up, one would expect the gross profits to drop to the bottom line, helping recover the fixed-like OPEX expenses even if the company continues investing in R&D or sales capabilities. As has been pointed out, it is easy to get caught in a “growth trap” whereby gross margins increase, but a business spends at the same pace on OPEX which is not a smart thing.
Here’s why measuring operating leverage is important in a SaaS business:
As a SaaS business, it is almost impossible to get ahead financially if the business suffers from low gross margins. High margins are essential to pay for the money invested in the business and to leave some profit to the investors or owners of the business.
The formula for calculating operating leverage in a SaaS business is as follows:
Operating leverage is typically expressed as a ratio or a multiple. A higher operating leverage indicates that a relatively small change in revenue will result in a proportionally larger change in operating income, implying a higher level of scalability and potential profitability. Conversely, a lower operating leverage suggests a smaller impact of revenue changes on operating income.
Here is an example of operating leverage calculation:
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