Why razor-thin margins are going to
make life hard for startups like Instacart.
I recently watched a great episode of The Profit, this reality TV show where Marcus Lemonis, a razor sharp entrepreneur, invests in failing businesses and turns them around. The episode I watched was about a cupcake business run by a guy named Tony.
Early on, Marcus grilled Tony about what it cost him to make a cupcake. He quickly muttered some out-loud mental math and landed on 25 cents. But when Marcus crunched the numbers, it ended up costing more than double that. Tony didn’t know his numbers.
It turned out that after paying his rent, salaries, and other operating costs, Tony was actually losing money on every cupcake sold. And the strangest part: despite the fact that his business was costing him money to run, he had already signed a lease for a second location. He felt that scaling up would somehow make his business work.
The sad reality was that even if he expanded to hundreds of locations, he’d never make a dime, but lose more and more money.
This guy reminded me of a lot of some of the startup founders I’ve met over the years. Like most bootstrapped entrepreneurs, I’ve always had to know my numbers like the back of my hand. Not because I wanted to, but because I had to or my company would die.
Over the years, I’ve been surprised by how little many founders of venture-backed startups seem to understand basic accounting concepts like gross margin and net profit. The refrain I hear over and over again is that, once the business gets to scale, they’ll make up for razor-thin margins with big volume.
Some of the worst perpetrators of this “scale it then nail it” strategy are on-demand service and delivery businesses. While they are wonderful for consumers, and I personally love using them, any MBA will tell you that they have a Sisyphean business model with brutal margins.
While software companies are typically cheap to operate, have high margin, and scale almost infinitely, shit gets real when apps meet the real world. When some guy has to bike to Whole Foods to deliver Pepto and 3 apples to the Jones family in 20 minutes, margins and unit economics really start to matter. Unfortunately, these delivery services are unsustainable delivery businesses masquerading as (and being valued like) infinitely scalable software companies.
“Most companies in e-commerce right now are negative-gross-margin businesses. Amazon has such enormous scale, and they’re at about 13 or 14 percent gross margins, but on a huge number. In order to compete with Amazon, these businesses have to sell goods for less than what they cost. These companies are in the delivery businesses (Postmates, DoorDash, Instacart) and in the food business (SpoonRocket, Munchery). Basically, a lot of these new-generation, remote-control-type businesses — where the phone acts like a remote control to replace an offline experience — are generally, to date, highly, highly, highly unprofitable.
There’s a lot of what I call “venture philanthropy” to prop these businesses up. Time will tell whether any of those can become a real business. If a shoe costs $20, Nike doesn’t sell it for $14. They sell it for $400. We have to get back to this world of having pretty reasonable discipline on business models and understanding that many of these gross-margin businesses will never, never break even or become profitable.”
Good Low Margin vs. Bad Low Margin
Think of a business’s margins as the gears on a bike. The higher the gear, the less you have to pedal to move forward. With a high margin business, you get a bigger slice of each dollar you earn, whereas a low margin business often nets you a few pennies per dollar. Low margin businesses generally have less room for mistakes and are more challenging to execute because you only get to keep a few cents of every dollar you take in revenue to pay employees and keep things going.
Of course, not all companies with low margins are bad businesses. There are some very successful low margin businesses out there, including companies like Visa and Amazon. They can pull it off because they have economic moats that make it really difficult for anyone to compete with them:
Visa’s Moat: The Network Effect
Counter to what you might think, Visa isn’t responsible for issuing cards or providing their card holders with credit. They simply run one of the world’s largest payment networks and charge a small fee for every transaction (usually 1–2%).
Fifty years in, Visa has become the defacto credit card accepted virtually everywhere. There are a few secondary players like Mastercard and American Express, but so far nobody has been able to unseat Visa. Why? Building a credit card network is HARD. Nobody wants a credit card they can only use at a small number of places, so an encumbent would have to somehow convince the world’s merchants to accept their new Acme credit card. Good luck with that.
Visa and a lucky few own the only toll bridge into town, and they’re cashing in a couple basis points at a time.
Amazon’s Moat: The Low Cost Provider
Amazon, on the other hand, competes with prices so low that nobody can afford to compete with them. Originally, Amazon handily undercut its brick-and-mortar rivals by not having to operate expensive retail storefronts or charge sales tax. Their moat has continued to widened significantly with Prime, their customer loyalty program, amazing customer service, and ever-cheaper prices due to scale. Combined, these features have acted as a flywheel that drives more and more buyers to Amazon, and in turn more products and sellers.
The Next Generation
Let’s take a look at two next generation “unicorn” businesses. AirBnB, an example of what I believe is a good low margin business, and Instacart, a challenging low margin business.
AirBnB has proven that they can build a phenomenal business with low margins. Their marketplace connects guests to hosts, and facilitates the transaction, which they take a 12–15% fee off of. Unlike a hotel, they don’t employ the hosts, own any real estate, or take responsibility for the service delivered apart from insuring the hosts. They are similar to eBay: a marketplace connecting two parties so they can transact.
For every $1 of revenue earned, AirBnB keeps around 12¢ before expenses.
If AirBnB does $1 billion in revenue, they keep $120 million of it.
A company like Instacart, on the other hand, has to do a massive amount of work for a tiny slice of each transaction. They have to employ (or contract) a huge fleet of thousands of on-demand workers to deliver groceries and are 100% responsible for the customer experience end-to-end. The Wall Street Journal recently estimated that Instacart, like Tony’s cupcake shop, is likely losing money on most deliveries.
For every $1 of revenue earned, Instacart keeps just 2¢ before expenses.
If Instacart does $1 billion in revenue, they keep $20 million of it.
And that’s just the gross margin — the money from the trasaction that they get to keep to run their business. They still need to use all that money to fund their operations, pay their rent, and everything else aside from the cost of the delivery itself, before turning a profit. Ouch.
I hope I’m wrong. Seriously. I love using these delivery services. It feels like magic, and I’m their ideal customer: extremely lazy. But every time I do, I can’t help but feel that I’ve taken a couple bucks out of some VC firm’s pocket. Low margins are business kryptonite, and they catch up with just about everyone.
I’ll leave you with this Buffett quote…
“When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.” — Warren Buffett
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