Your Customer to Account Ratio Doesn't Matter - Your Gross Margin Does

A few years ago, I met with a SaaS startup who was looking for someone to lead their customer success team.  Interesting product, good funding, early traction, 50-70 clients - everything sounded great.  But as I dug into their customer success model, I saw a big problem - their customer success ratios. They were charging $30,000 yearly on average and their customer success managers (CSMs) were managing on average 7 accounts - meaning each CSM was managing $210,000 yearly and spending 18.5 hours per month per client.  

We've reviewed what the experts recommend before (and one that doesn't recommend the recommendations), but one thing people tend to forget when they are obsessing about the simplicity of the ratios:  gross margin.

But first, a gross margin primer

Gross margin is the amount of revenue minus the cost of goods sold, usually described as a percentage. So, if you sold a pen for $10 and it costs $5, your gross margin is $5, or 50%.

In SaaS companies, gross margin is a less obvious - it's not a hard good you are creating or buying, so what makes up the gross margin calculation?  

For SaaS companies, gross margin is generally made up of:

• Hosting costs - what it takes to provide your software
• Third party applications embedded in your software - fees and dollars to provide your software

But also:

• Support costs - the human cost of the team to support your software
• Customer success costs - the human costs to serve your software

Every person you hire to serve your software hits your gross margin calculation.  And generally speaking, your support and customer success costs are directly related to the number of clients you have - as you continue to get more clients, you'll need more support and more customer success managers.

The SaaS Gross Margin Goal

In my experience, the majority of the startups I've worked for are looking to achieve a gross margin around 70-80%.  And the experts back this up - David Cummings states that "most SaaS companies will be able to achieve gross margins in the 70-80% range".    SaaS Capital aims even higher, stating, "For SaaS revenue streams, (excluding professional services), gross margins are typically 85% to 95%".  Lead Edge Capital begins by stating on the low end, that "gross margins typically range from 60% to more than 80% " but later comes back to say, "as the customer base matures and the company reaches scale, most SaaS companies should achieve gross margins in the 75%–80% range".

And this is what makes the rule of  "1 CSM for every $2M in ARR" so compelling -- if your CSMs are making an average of $67,000 (as according to Glassdoor), each CSM is contributing about -3.5% to your gross margin.

The Red Flag

Even with no other information, I knew there was a problem with the startup's business model.  If the average CSM makes $67,000, each client is paying $30,000, and each client is 1/7 of the CSM's time (or $9,571 of the CSM's salary), we are looking at about a 68% gross margin without adding in any other costs.  Assuming hosting, support, and third party applications were about 5% of the $30,000 price tag, we're looking at an estimated 63% gross margin.  

Even more concerning, as I started talking about how I could help scale the team for the long term, the CEO of the company told me that I didn't understand their business model and that this high touch approach was key to their success.  In the early days, I totally support this - you don't know what you don't know, and oftentimes, throwing money at people is cheaper than developing software, or cheaper than developing the wrong software.  With SaaS products, getting a client set up and adopting the software early is a key to being successful for the long term, and if it's a significant investment in Year 1 that gets you set up for an easy renewal in Years 2 and beyond, you should totally do that.  

But - if you have a high touch model, you need to price your software high enough to cover the gross margins for a high touch model -  raising the price of the software 30% would have propelled the gross margin to over 70%.   If you have lower priced software, you need to think about scaling back your customer success model to be a lower touch model - changing the ratio of accounts to 9 accounts per CSM or 14.5 hours per month per client would have also increased the ratio to just at 70%.  

You need to have gross margins that are in line with a strong SaaS business, and you need to have an eye towards getting there.