May 11, 2022

When Gross Margins Matter

00:36:17

Summary

Main Topic: Gross Margins in Business

Key Points:

Gross margins are a critical metric in business, representing the revenue minus the cost of goods sold.
Calculating and defining gross margins can be complex, especially in early-stage companies.
As companies mature, their gross margins can change dramatically, and it's essential to understand the underlying drivers.
Modern software business models and technology shifts have changed the way we think about gross margins.
Subscription-based revenue models add predictability to revenue streams, making it easier to optimize for margins.
Companies with high gross margins may not always have the same valuation multiples as those with lower gross margins.
Marketplaces have different cost centers and considerations for long-term margin structure.
Founders should focus on building a durable competitive advantage and return on invested capital rather than solely on gross margins.

Participants:

Martin Casado, General Partner at A16Z

Gross margins are a critical metric, but they can be complex to calculate and define, especially in early-stage companies.
Companies should focus on building a durable competitive advantage and return on invested capital rather than solely on gross margins.
Subscription-based revenue models can add predictability to revenue streams, making it easier to optimize for margins.
Marketplaces have different cost centers and considerations for long-term margin structure.
Founders should be aware of the pitfalls of over-optimizing for gross margins in early stages and focus on building a repeatable business model.
Companies should have open discussions with their technical and business teams about structuring costs and margins.
Gross margins can change dramatically as companies mature, and it's essential to understand the underlying drivers.

Focus on building a durable competitive advantage and return on invested capital rather than solely on gross margins.
Don't obsess over gross margins in early stages, as it can be unknowable.
Have open discussions with your technical and business teams about structuring costs and margins.
Be aware of the pitfalls of over-optimizing for gross margins in early stages and focus on building a repeatable business model.
Focus on building a business that works rather than over-optimizing for gross margins.

Show Notes

Gross margins–which are essentially a company’s revenue from products and services minus the costs to deliver those products and services to customers–are one of the most important financial metrics for any startup and growing business. And yet, figuring out what goes into the “cost” for delivering products and services is not as simple as it may sound, particularly for high-growth software businesses that might use emerging business models or be leveraging new technology.

In this episode from June 2020, a16z general partners Martin Casado, David George, and Sarah Wang talk all things gross margins, from early to late stage. Why do gross margins matter? When do they matter during a company’s growth? And how do you use them to plan for the future? The conversation ranges from the nuances of and strategy for calculating margins with things like cloud costs, freemium users, or implementation costs, to the impact margins can have on valuations.

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Transcript

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**A16Z Podcast: Understanding Gross Margins**

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**Amelia:** Welcome to the A16Z Podcast. I'm your host, Amelia. Today, we're discussing gross margins—a critical metric for understanding how a business operates, especially during turbulent times. Joining me are A16Z General Partners Martin Cassato, David George, and Sarah Wang. Let's dive in.

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**David George:** For a later-stage company, we're assessing execution risk, not whether the product works. We ask: Can we estimate the long-term margin structure? Do we understand the market dynamics and competitive landscape? Can we guess the growth rate's persistence? If a company can grow at high rates for 10 years, that excites us.

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**Amelia:** Why do high gross margins matter?

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**David George:** High margins mean more cash flow. For software companies, we look at cash flow margins. With more mature public companies, it's easier to benchmark. Typically, software companies have 70-80% gross margins. Below that, costs are split into sales and marketing, R&D, and G&A. As companies mature, R&D and G&A typically stabilize at 15% and 10%, respectively. Sales and marketing depend on growth and retention rates.

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**Martin Cassato:** It's not that precise. Early on, it's hard to know what's fixed vs. variable. For example, software licenses might be incorrectly categorized as R&D, affecting gross margins and profitability models. This can lead to overestimating mid-term profitability.

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**Sarah Wang:** Gross margins change over a company's lifecycle. Early on, low margins don't mean they'll stay low. Workday had 40% margins before going public but now has over 70%. It's about understanding what it costs to deliver revenue.

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**Martin Cassato:** R&D is tricky. It's not fixed; it grows with the company. Cloud costs are variable and significant, especially with AI and ML. Engineers optimize for feature velocity, not efficiency, leading to technical debt. This makes understanding COGS difficult until later stages.

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**David George:** As companies mature, they transition from "tell" to "show." Founders must demonstrate margin expansion and a credible path to steady-state margins. This includes cloud cost optimization and economies of scale.

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**Sarah Wang:** For companies with freemium models, we advise treating the cost of serving non-monetized users as sales and marketing, not COGS. Slack does this, maintaining high gross margins. Dropbox included it in COGS, confusing investors.

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**David George:** Implementation costs can drag down margins. Early-stage companies often undercharge for implementation to keep customers happy. As they scale, it's crucial to charge appropriately, making implementation part of the business model.

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**Martin Cassato:** AI and ML companies may have different margin structures due to high computational costs. Accuracy improvements require more data, increasing costs. These companies might have lower margins than traditional software firms.

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**Sarah Wang:** Valuation isn't just about gross margins but return on invested capital. High margins can facilitate reinvestment, but low-margin businesses with strong moats can also generate high returns. Pricing power and competitive advantage are key.

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**David George:** Marketplace businesses often have lower margins early on, using scale to build moats. They may underprice to gain market share, but as they become dominant, margins improve. Investors look for network effects and defensibility.

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**Martin Cassato:** Founders should focus on product-market fit and repeatable sales before optimizing margins. Once mature, margins become crucial. Discuss margin implications with your team early to avoid pitfalls.

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**Amelia:** Thank you, Martin, David, and Sarah, for your insights.

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**Martin Cassato:** Thanks for having us.

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**David George:** Great discussion.

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**Sarah Wang:** Enjoyed it.

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**Amelia:** Tune in next time for more on tech and culture. Visit a16z.com for more content.