The gross margin imperative in the age of AI

Higher gross margins are still key to long-term sustainable growth. AI-driven automation can help SaaS companies get there.

This is undoubtedly one of the most exciting times to start a company. We’re living through a unique moment in technology, and the optimism is truly palpable across the ecosystem. We’ve been incredibly excited at Lightspeed about the impact AI will have on application software, and we’ve shared our thoughts on how we see the next generation of software companies building end-to-end automation as part of our SaaS 4.0 framework.

Today we want to highlight the importance of something that can seem quite mundane but is critical to the long-term viability of companies building right now. And that’s the topic of gross margins. It turns out margins still matter a lot.

The advent of LLMs has meant that software today can do a lot more than ever before. As a result, some of the most disruptive companies at the application layer are offering “work as a service” and even charging on a success basis for the job to be done, as opposed to static per seat pricing. The impact of this will be profound long-term.

This approach however is either computationally complex and requires a lot of spend on LLMs and the underlying infrastructure, or sometimes involves human-in-the-loop workflows to fine tune the accuracy of the model.

As a result, we’ve noticed that gross margins in the early days for a lot of companies are lower than what would traditionally be considered software gross margins at the 60-70%+ level. Because of the automation potential over time, VCs have also been more open to investing in businesses where gross margins are lower at the start – even sometimes hovering around the 10-20% mark in the early years.

So how important is it to improve gross margins? Or can top-line revenue growth make up for lower margins? To illustrate the long-term impact of gross margins, we’ve shown below 4 hypothetical companies. Each company has the same growth rate and spends the same on S&M, R&D and G&A. The only difference between them is their gross margin.

This chart shows the power of compounding over time. Over a 5 year period, all four companies scale from $10M to $150M+ in ARR (given same growth rates). However, because of the gross margin differential, Company A (20% gross margins) burns a cumulative $160M, whereas company D (80% gross margins) turns cash flow positive and generates $27M in cash flow. That’s nearly a $200M burn differential between these two businesses.

The bottom line is that in the age of AI, gross margins still matter a lot to the business fundamentals and actually provide a structural advantage over time.

The AI paradigm shift

The good news is that gross margins are not written in stone. You can increase effective margins by reducing operating expenditures through automation. A wide range of formerly manual tasks are now automatable, thanks to the advent of large language models and generative AI. There also tends to be a lot of low-hanging fruit for eng teams to automate parts of the stack, and the prioritization depends a lot on how much focus there is on gross margin as a KPI.

Companies whose gross margins are still in the 20% to 40% range should be looking hard at how they can use AI and automation to increase their efficiency over time, as it will have a big impact on funding requirements, overall burn and as a result founder ownership.

We’re really excited about companies that are implementing end-to-end automation using these amazing new capabilities. And if you’re one of them, we’d like to hear from you.

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