Gross Margin Is Sexy Again
What do WeWork, Uber and Blue Apron all have in common?
Two things actually.
First, their investors have taken a beating in the past year. WeWork just pulled it's IPO, and might become the fastest company to ever fall from a $47 billion valuation to zero. Uber, which went public in May at $45 a share, has seen it's stock fall by 35% since the IPO. I don't think the floor is yet in sight. Blue Apron went public in June 2017 at $10 a share, which was much lower than investors had hoped. Earlier this year, Blue Apron's shares fell below $1, and the company had to execute a 1-for-15 reverse stock split to avoid being delisted.
The other thing they have in common? Terrible gross margins.
First, it's worth noting that both Uber and WeWork have made it incredibly difficult to calculate their gross margins. The way they report financial results is designed to make analysis of their financial reporting much more difficult than it should be. Never a good sign.
But when you dig into their financial statement footnotes, you realize that WeWork had gross margins that were less than 20% in the first half of 2019.
Uber calls its gross margin "Core Platform Contribution Margin". Whatever. Their gross margins were 9% in 2018, which is up from zero in 2017.
Blue Apron is the shining star of this group, with Gross Margins that are still under 40%.
For comparison, one of the best IPO's of 2019 is Zoom. Zoom makes a great video conference solution, went public in April at $36 a share, and today Zoom trades at $75 a share. Zoom has Gross Margins of over 80%.
I'll do a separate post digging into the calculation of Gross Profit and Gross Margin. But for now, suffice to say, they are the two most important numbers on your P&L.
Gross Profit is calculated by subtracting your cost of sales from your net revenue. Cost of Sales holds all of the variable costs directly related to the revenue you generate. The fully loaded cost of the product you sell and the cost of delivering that product to your customers. Your Gross Margin is calculated by simply dividing your Gross Profit by your Net Revenue.
The reason this number is so important is that your Gross Profit represents all of the money you have left to invest in sales & marketing, new product development, and the investment in the leadership team and operations of your company. These expenses are typically called Operating Expenses, and the difference between Gross Profit and your Operating Expenses represents your profitability.
In the past few years, we've seen companies like WeWork, Uber and Blue Apron deal with low Gross Margins by losing billions of dollars, funded by Venture Capital investors betting that the company would find a path to profitability somewhere down the road. Investors are starting to wake up from a state of delusion, and they are realizing Gross Margin is important again.
Why does this matter to the entrepreneur at the start of their journey in building their company?
A couple of reasons.
First, macro trends in the investing environment matter. Investor sentiment tends to move in waves. If you were following the playbook that dominated the press around startup unicorns over the past couple of years, you might be fooled into believing that Gross Margins don't matter. You may have built a financial projection that shows mounting loses in your early years, as growing marketing spend overwhelms your meager Gross Margins. You believed that your story of market domination and the fuzzy math of future profitability would save the day.
That's no longer going to be the case. The emperor has been revealed to have no clothes. Most VC's are refocusing on businesses with strong fundamentals that lead to real valuations. It doesn't mean that they won't fund high growth, high cash burn businesses. But if Gross Margins of the company as it scales are below 50% - 60%, many investors are going to shy away from the potential of a crash and burn like WeWork, Uber and Blue Apron. Billions in value have been lost. Investors are paying attention.
More importantly for you, strong Gross Margins are the key to being able to control your own destiny. They give you the power to find off-ramps from the VC fundraising hamster wheel. You'll have room to invest in customer acquisition, your team and product innovation while minimizing EBITDA losses and cash burn.
Strong Gross Margins are the path to profitability, cash flow, and building real value in the company. As you grow, you'll be building leverage over your Operating Expenses below Gross Profit, and that's where you'll drive margin expansion.
When you have low Gross Margins, every dollar below the Gross Profit line gets squeezed when your cash runs low. You'll find bank financing harder to get. You'll have to pull back on marketing spend, which will slow revenue growth, which will accelerate losses and cash burn. The slowing revenue growth will make you less interesting to venture investors, closing off paths to new funding. It's a downward spiral that can be hard to stop once it starts.
Focus on Gross Profit from day 1. Understand how much it costs for you to generate $1 of revenue. Understand your path to increasing your Gross Margins, and focus your early investment in product development on getting down that path as quickly as possible.
When you put your pitch deck together and meet with investors, make it clear that you understand your Gross Margins, that you care about them, and that you understand the leverage in your business and the path to profitable scalable growth.
Because Gross Margin is sexy again. And it's about time.
