SaaS Margins in 2024


Andrew Ishimaru

Low-code tools are going mainstream

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Multilingual NLP will grow

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Combining supervised and unsupervised machine learning methods

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Automating customer service: Tagging tickets and new era of chatbots

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Detecting fake news and cyber-bullying

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The days of easy high margin software are coming to an end.

We've already seen this pressure in the post-2021 downturn as VC investments slowed way down and companies flipped focus from growth at all costs to profitable growth and extended financial runway.

But there are still defensible strategies to secure & keep high margins.

Let's talk about it.

In the new world of SaaS, companies must fight to build a moat in the market if they want to be more than a commodity.

Where previously, many SaaS companies could grow rapidly from market expansion due to rapid adoption of the internet, now the world's population is online, and already knows what software is.

The capital cost of building software falls more and more every day.

Monthly subscriptions to billion dollar SaaS platforms keeps increasing every year.

And it's apparent that margin headwinds are multiplicative and only picking up.

Things like:

  • AI tools that let anyone build software or 10x the output of an individual engineer
  • Cloud services reducing the capex cost of starting a new software company
  • Orders of magnitude more trained software engineers at all levels from fresh grads to seasoned executives
  • Many of the obvious ideas have already been built, and are now highly competitive verticals
  • High churn as customers actually use the "month to month, cancel any time" to switch to cheaper or better software platforms. Year to year for B2B on annual contracts.

So the software landscape today is insanely competitive.

There are a ton of software companies out there competing on every little niche, and all the big industries.

And it's never been easier for new challengers to enter the market.

This presents difficulties to all players in the software game, especially if we think about software as not an industry in itself, but rather a value-add layer on top of the world's existing industries that extracts a tax for this value in the form of pay-per-use at the platform layer, MRR in the SMB layer, and line item in the annual budget for F1000 enterprises.

As software matures, it crosses the chasm from eating the world to becoming a rent-seeking middleman between enterprises and the nerds.

So how should we think about the market landscape?

New SaaS companies (startups) most likely fall into three categories:

  • 'Micro SaaS' / 'Indiehacker' / 'Build in Public'
  • SMB SaaS
  • Moonshots (VC backed)

Established SaaS companies fall into a few categories:

  • Category winners
  • Category challengers
  • Dying moonshots
  • SMB SaaS
  • Mature Micro SaaS
  • Dead & gone

New startups must grow or die.

Micro SaaS companies leverage some strength of the founder to have a competitive edge; a founder-developer, a bucket of personal capital to invest, some unique insight on the market, or distribution to market.

SMB SaaS is launched the same as other non-SaaS businesses. Without VC backing but a larger effort than a solo founder. Possibly spun out of an existing company, or vertically focused.

Moonshots take the VC backed, grow-at-all-costs route.

Established companies are a little different. This represents the current state of the last 20-30 years of change in software businesses.

Category winners have greater market share and a superior product, but face pressure from shareholders to either keep growing quickly or maximize free cash flow. Some are publicly traded. Some are owned by PE firms & VC firms whose bets paid off. Others simply won the battle to the top and now reap the rewards.

Category challengers need to fight for market share, thereby requiring investment in product, marketing, and sales. There is a growth capital investment needed to breach the product & brand moats set by the category winners.

Dying moonshots raised a lot of VC money, but failed to become a winner or even a real contender for their category. Some have great products and known brands. Many are unknown with mediocre products.

SMB SaaS represents the middle of the market. These are regular business that happen to be software companies, who have carved out a niche in the market for themselves. SMB SaaS founders necessarily run a competent business. But there are risks are on all sides from Micro SaaS moving up-market, to category leaders building their product as a new feature, buying a competitor, or simply entering their corner of the market.

Some were built from the ground up and sit today as nice small & medium-sized businesses.

Other times, this represents the endgame for different types of SaaS companies.

Dying moonshots that can restructure their cap table and cut costs to flip to profitability can laterally transition into an SMB SaaS.

Matured micro SaaS can move up-market to become a stronger enterprise beyond the core product.

And failed category contenders can seek to carve out a new niche in the market to stay alive vs. the winners & challengers.

Mature Micro SaaS is then the final type of established SaaS company. This company hasn't grown enough to move into the SMB SaaS category. But it is profitable and defensible, and is a nice little business in itself. Some of these companies print huge amounts of free cash flow. Others eke by.

P&L tools for SaaS CEOs & Founders

So how should founders & CEOs running SaaS companies think about this today?

Disciplined structuring of budgets across the business, intentionally broken out into unit economics, operating costs, variable costs, and product development.

At a high level, something like this:

  1. COGS for platform costs
  2. Operating costs for back office & core maintenance
  3. Variable costs for sales & marketing and generally gaining market share
  4. R&D for development costs of building new features, either straight-lined or as capex

Like so in this simple P&L example.

Startups operate in their own lane to grow

Micro SaaS founders need to think most about funding operating costs to get off the ground, sales & marketing costs to gain customers, and R&D to build a strong product. COGS can be optimized later, provided it's not ludicrously high from inception. If the founder writes code, then sales & marketing is the main thing. If the founder has distribution to market, R&D is the main thing.

SMB SaaS most likely has some capital or resources to deploy. They need to think about leveraging their insights on the market & distribution to the market to make best use of investments in each category. COGS can probably be optimized later.

Moonshots will have a lot of capital, so they can focus on everything at once. It's critical not to lose sight of core unit economics. But rapid market growth is the name of the game.

In all cases, the main drivers are still pretty much the same as they have been for the past two decades. Maximizing growth and minimizing churn.

Established software looks to the bottom line

Category winners can enjoy the juice from their now-plentiful orchard of customers. However, the danger for category winners is twofold. One, getting complacent with bloated opex, sales & marketing, and R&D budgets from the growth phase, and two, losing their advantage & customer base to poor service, expensive pricing, and feature parity with category challengers.

Category challengers essentially have two choices. Invest in growth & product to reach #1 in their category, or become an SMB SaaS company by either optimizing their cost structure across the entire stack, or moving laterally to a niche in the market that is more defensible. This could take the form of internal investment or strategic acquisitions to grow through M&A.

Dying moonshots should seek cost discipline and building a moat in their strongest customer segment to transition into an SMB SaaS company. A cap table restructuring may be required. An exit to a better company is always an option, but of course not preferred for equity holders.

Lastly, SMB SaaS founders sit in a nice place. They don't have the pressure of category contenders, and have a capital runway that is not afforded to dying moonshots. These companies have the luxury of time on their side for strategic decision making, relatively speaking.

That could take the form of driving down COGS to improve gross margins. Reducing opex spend through efficient operations. Deciding to either invest more in sales & marketing and R&D to move into new market segments, or keep costs low to generate more cash. And lastly, make strategic acquisitions to grow through M&A, especially if cash is available.

The end game of software

One of the original software investment value theses was that customers would rather stop paying their rent than their software bills. And PE made billions off the back of this thesis in the form of durable cashflow and rising valuations as the market caught up.

But we live in a different world today.

Businesses don't even need to pay rent in a world of remote work.

Switching costs are falling.

And there are more competitors to switch to than ever before, so feature moats are eroding.

In this world, free cash flow and moat defensibility is king and markets don't have an endless supply of new customers (ie users) who are choosing between nothing, the status quo before you built your software, and your software.

So eventually SaaS CEOs will need to navigate this handful of choices about how to run their business.

  1. Decide how long to keep investing in new features to take market share or expand the product's offerings in the market
  2. Be more strategic about calculating expected returns of launching new features as a capital expense rather than an ongoing cost (accounting preferences aside as a different topic for discussion)
  3. Optimize sales & marketing spend for free cash flow rather than growth, or making calculated decisions on investing capital in sales & marketing to build a moat around a market niche or take down a serious competitor.
  4. Restructure their operating expenses to a light back office / admin cost, and reduce platform costs as much as possible to raise gross margins.
  5. Consider strategic M&A to acquire feature sets and brands that help build a moat or take down competitors in their category.

The end game in software was always to grow quickly, decide to become profitable, and spit off free cashflow. It just got covered up with other narratives throughout the decades.

In this way a software company running at negative margins can quite literally jump to 50%+ margins overnight.

The whole game becomes, secure a core cohort of strong customers, support them well, and protect your corner of the market.

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