We Need to Talk About Those 50% Profit Margins

If you’re projecting more than 30% profits, you’re missing most of your costs

A real US $100,000 bill. Image from National Museum of American History via Wikipedia.

When looking at financial projections of early-stage startups, it’s not unusual to see expected profit margins of 40% or more, often 50% or sometimes even 60%.

Last week I had the honor of reviewing a pitch deck with a profit ratio of 95%. Wow! How do I invest in that?

By profit ratio, we mean the net profit after all operating expenses. EBITDA divided by revenues. This is very different from the gross profit margin which subtracts only the cost of goods sold, which for a software company with almost no production costs, should be close to 100%.

The attraction of software startups is that revenues can grow exponentially while costs grow linearly. With no cost of goods other than cloud hosting, profits seem limitless.

Except they aren’t.

The net profit for the S&P 500 averages around 12%. These are the most successful companies in the country. If we narrow the list to only software companies, the profit ratio is close to 25%.

You probably think that once software development is done, other than customer support and a few developers to add an occasional new feature, and perhaps an extra…