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Importance of Gross Margins in the Due Diligence of Target Companies

SaaS - software as a service. Internet and technology concept.By Brandon Lamb, CPA, Transaction Services Partner

Gross margin measures the percentage of revenues left over after subtracting the costs to service those revenues.[1]  Gross margin is an important, yet often overlooked measure of a company’s financial health.

Changes in gross margin over time may reveal underlying concerns about a company’s management team, market or industry.  For example, deteriorating margins may indicate an inability of a company to increase prices in an inflationary environment.  Decreasing margins may also reveal an inattentive management team, increased competition, or an inferior product.[2]

Large gross margin fluctuations may also signal poor management practices or unusual market conditions.  On the other hand, historical margin volatility may be justified when a company has made significant operational changes to its business model.[3]

In any case, understanding margin trends and the key drivers affecting margin fluctuations is vital to helping an investor develop a financial model and accurately assess valuation.

Published industry benchmarks may provide a baseline from which to measure a company’s historical gross margin performance.  However, investors should ensure the calculation of gross margins is consistent when comparing within markets and industries.[4]  Accounting policies and procedures (and management’s efforts to use those policies to manipulate margins) may impact the expenses classified as cost of sales or overhead.[5]

Margins in the software-as-a-service (“SaaS”) space are particularly important to software investors looking to quickly grow the business or make it cash flow positive in the near term.  Because SaaS companies are traditionally high-margin businesses (typically greater than 70%), sellers may feel pressure to inflate or manipulate margins to put the target company in the best light prior to sale.

For that reason, SaaS investors must ensure a target company’s cost of revenues includes all personnel and other costs required to implement and service the company’s existing customer base.  These costs typically include the following:

  • Support – personnel responsible for servicing current customers on a day-to-day basis.
  • Customer success – personnel focused on implementation and retention of the customer base; and
  • Development operations – development personnel focused on bug fixes and platform maintenance, hosting costs, and royalties. Development personnel responsible for R&D and development of new functionalities should be classified below the gross margin line in operating expenses.

SaaS businesses often include a services component billed separate and apart from the SaaS subscription.  Where possible, the services component should be bifurcated from recurring revenue gross margins to provide a more accurate view of a company’s ability to scale its SaaS platform.

ML&R Due Diligence Team here for you

The due diligence team at Maxwell Locke & Ritter has performed over a hundred Quality of Earnings (“QoE”) engagements on SaaS and other recurring revenue companies.  Please reach out to let us know how we can help you.

Brandon Lamb, CPA, Transaction Services Partnerblamb@mlrpc.com

Lathrop Smith, CFA, Transaction Services Partnerlsmith@mlrpc.com

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