Nick Mehta

AI Turns SaaS Margins Into Growth Opportunity

Some are saying “AI killed SaaS.” Maybe the truth is closer to (paraphrasing Bezos): “SaaS’ margins are AI’s opportunity.” And the opportunity may be to embrace the new business model of lower margins and larger markets. Let me explain. Software companies have historically commanded the highest gross margins* of any industry. As an example, see the below chart sourced from the incredible @AswathDamodaran dataset, with a ChatGPT plot assist. High gross margins exist for countless reasons in business; economics professors could run circles around me in terms of the general logic. In business software, the relative lack of customer power, in the form of low alternatives and high switching costs, certainly played a factor. While SaaS improved customer choice, SaaS companies still command superior gross margins at 78% median, per the marvelous @MeritechCapital benchmarking tool. How will AI affect this? Well, I'm not a believer that end customers desire to build every application themselves. Expertise and focus are still valuable. But the threat that customers can build custom tools - along with the lower barrier to entry for direct competitors - means customers in the AI era have more negotiating power with vendors. Negotiating power could pull vendor margins down over time. What can existing and new vendors do in response to this? Altman recently said it well - margins will be lower but agentic TAMs will be larger (particularly through capture of labor spend). Meritech's dataset shows combined revenues in pureplay SaaS companies of $270B. If margins compress and topline stays the same, the industry is in trouble. But even 50% GM% at trillions of spend could lead to a boom in companies that embrace agentic models. Now not all will make the turn. And some businesses or spaces aren't built for this TAM capture. But those that do could find margin DOLLARS (not %) are higher on the other side. *A logical question is what about Operating Margins? I didn't have time to look into this in detail, but there is often a strong correlation at an industry level between GM and OM.