Negative gross margins can bury your startup

In my last blog on gross margins, I had written about the importance of gross profits for a startup to survive in any business environment – especially black swan events like COVID. It did not end there. Throughout my 5+ month WFH stint, a question keeps me obsessed, i.e., what matters most growth or gross margins?

There are (expectedly) a range of suggestions on this topic. David George and Alex Immerman laid out a convincing argument that as an investor, there are 4 metrics that trump gross margins when valuing a business.

  • Economies of scale
  • Meaningfully differentiated technology
  • Network effects; and
  • Direct brand power

It is important to note that while David & Alex endorse moats before margins, they do not encourage that strategy at the cost of degrading unit economics. In a clear message to founders, they state that in the quest for high volume and scale benefits, you cannot make your unit economics become unprofitable.

However, you would be incorrect to assume that your startup can throw caution to the wind in the quest to build a moat filled with investor money.

Two Sigma Ventures’ Villi Iltchev in Why Gross Margins Matter writes that [founders] often naively assume that with scale, gross margin will improve, and are surprised a few years later when they realize there is very little in their control to move margins. Even public companies have a hard time growing their gross margins, a fact that Villi corroborates.

Villi’s blog focussed on sticky gross margins of SaaS companies, but Fred Wilson saw this behavior in on-demand service providers and B2B service providers. Still, it was way-way back in 2015 when he wrote about Negative Gross Margins — criticizing on-demand service providers who aggregated supply at a higher price than they sold it. Uber, Ola, Urban Clap, WeWork, DoorDash, Swiggy, OYO, and a plethora of on-demand startups indulged in this behavior – to build demand for [their] service.

Founders assumed that at a particular scale, they would hold a monopolistic position that would give them pricing power – to decrease payouts to suppliers and increase realizations from customers. Therefore, raising a ton of money to operate a scorched earth strategy and force your competitors out of the market was the accepted business practice of that day. The approach found takers in VC funds, and they raised mega funding rounds, raising these startups to unicorn or decacorn status.

A group of founders took inspiration from this growth hack and adopted the negative gross margin strategy for direct to consumer brands, aka D2C brands. Why did they do it? Because it made sense!

Most mass-market consumer brands (like HUL, P&G, Marico, etc.) do not manufacture what they sell. Instead, most of their goods are contract made, letting the brands concentrate on quality control, distribution, marketing, and brand building.

The spare capacity with contract manufacturers became the targets of the D2C brand founders. They aggregated the distributed supply and sold it under their brand name. To quickly get to a leadership position in their category, the founders applied the same negative gross margin strategy as the players identified above. Projecting that at a particular level of sales, their startup would possess the pricing power to reduce costs and increase prices and creating a viable business these founders asked for stacks of money today to burn their way to a monopoly.

However, their monopolistic apple cart got upset as challenger brands quickly propped up, ironically supported by the same contract manufacturers that backed the challenger brand. The competition put the contract manufacturer and the customer in the driver’s seat. Either (or both) of them could switch their loyalties to another competitor that would offer better terms if a startup negotiated lower prices with suppliers or increased rates on their customers.

Achieving the monopolistic scale became a long shot for most of these brands. COVID just buried them.

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