Some thoughts on the topic du jour in tech right now -- the sudden reappraisal of tech-enabled businesses based on gross margins/unit economics. Here's what founders need to know.
The Gross Margin Problem: Lessons for Tech-Enabled Startups link.medium.com/Q6FMwpLZ90
The Gross Margin Problem: Lessons for Tech-Enabled Startups link.medium.com/Q6FMwpLZ90
1/ How did we get here? The truth is that software startups never had to worry about gross margins until software started eating the world. Gross margins only became a concern once software blended with physical-world products to create new “tech-enabled” business models.
2/ Historically, pure software businesses had perfect gross margins. All the expense was in creating the first copy; subsequent copies were free. Realizing that he could sell cheap mass-market software and make it up in volume made Bill Gates the richest man in the world.
3/ When software moved to the cloud, this dynamic didn’t change. Almost all of the production cost is in creating the product for the first user. Aside from hosting, it’s almost free (on an incremental basis) to provision additional users.
4/ As a result, early-stage software startups never needed to have much proficiency in cost accounting. They didn’t really need to know which expenses were overhead versus COGS. They just needed to know their burn and runway.
5/ But when software started eating the world, everything changed. Software was just one component of the service being offered. Software might be the disruptive element but it wasn’t the source of unit economics.
6/ These new “tech-enabled” businesses had major COGS (e.g. leases at WeWork; drivers at Uber) and cost structures more similar to the companies they were disrupting (e.g. commercial landlords; the taxicab industry).
7/ But they still thought like software companies. Good for innovation, not so good for operational efficiency.
8/ Although growth solves many problems at startups, unit economics is not one of them. When you’re losing money on every transaction, you can’t make it up in volume. In fact, the more revenue that a business with negative unit economics generates, the more money it loses.
9/ As a result, there is now a painful readjustment happening as many of these companies try to fix unit economics and bring their cost structures in line. Valuations are similarly being reappraised for growth that was achieved at the expense of negative unit economics.
10/ So what are the lessons if you’re a tech-enabled startup? First, you’re going to need a proficiency in cost attribution from the beginning. You’ll need to know your unit costs at a much more detailed level than a typical SaaS startup (which doesn’t have meaningful COGS).
11/ Attribution can be harder than it sounds in the early days of a startup when the finance function is immature. COGS are not typically purchased in units; they’re often bought in larger chunks and unitized based on assumptions that must be verified.
12/ Which costs are one-time and which are ongoing, which are temporarily inflated and which can be brought down with scale, are important to understand. Insights about improvements must be operationalized and measured.
13/ Second, you’re going to have to pay a lot more attention to pricing. In a typical SaaS startup, the goal is just to get over the “penny gap” — prove that there is willingness to pay for the new product and then increase pricing over time.
14/ But with a physical-world product, an artificially low price point means that product-market fit could be an illusion. This is the old problem of selling dollar bills for 90 cents — you will appear to have a thriving business. Raise the price to $1.10 — no business.
15/ Startups that are “temporarily” using VC money to subsidize negative contribution margins must always have anxiety about the true quality of their product-market fit and eventual market size. Would they still have a big business if they raised prices to a sustainable level?
16/ Third, you should prioritize 0 to 1 problems like positive unit economics and a culture of operational excellence before going from 1 to N. Get the operation working at small scale, in one geo, with the right teamwork and culture, before expanding into lots of markets.
17/ Trying to re-engineer the unit economics or culture of a business that is already operating at massive scale is brutally hard. Searching for the scalable model when you’re already at scale is a contradiction in terms.
18/ Note that it's not unusual for startups to lose a lot of money in the early days. But the question is what kind of money are they losing? Losing money at the corporate level is ok (all startups do); losing money at the unit level is not.
19/ Founders should plan to be unit-economic positive by the time they raise growth capital. Founders can no longer depend on an endless spigot of funding to defer tough business decisions.
20/ It should go without saying that tech-enabled startups can still be fantastic businesses -- if they get the unit economics right. //
