You Need to Lose Money, But A Negative Gross Margin Is A Really Bad Idea

It’s easy to grow fast: just get a negative gross margin.
If you’re selling a $10 note for $1 you will have a ton of growth.

But nobody would do such a stupid thing, don’t you think?

Well, in fact Paypal did something very close to that.
At their early days, they gave $10 to every new user and an additional $10 everytime they referred a friend. That gave them hundreds of thousands of new customers and an exponential growth rate. Peter Thiel commented:

Of course, this customer acquisition strategy was unsustainable on its own — when you pay people to be your customers, exponential growth means an exponentially growing cost structure.

And such a method didn’t stop in 1999.

Negative Gross Margin Today

Not having enough cash to cover all the startup’s expenses is natural. This is just saying that your gross profit should cover all your operating expenses (wages, it costs, advertising, office expenses, etc.)

The shortcoming is when you have a negative gross margin. (Reminder: gross profit = net sales — cost of goods sold / growth margin = gross profit / net sales (net sales = revenue — discounts)) When gross margin is negative, you basically lose money on every transaction.

Fred Wilson recently wrote that we still witness a lot of startups raising money with negative gross margins:

We have seen a tremendous number of high growth companies raising money this year with negative gross margins. Which means they sell something for less than it costs them to make it.

It can be an “on-demand” service provider that subsidizes the cost of the workers on its platform so that the service seems like it costs less than it actually does. Why would an on-demand startup take this approach? To build demand for the service, of course. The idea is getting users hooked on a home cleaning service, a ridesharing service, a food delivery service, or a gym roaming service by bringing it to market at a price point that is highly attractive and then, once the users are truly hooked, take the price up.

It can be a service provided to startups, like the ability to ship via an API, or the ability to process payments via an API, or the ability to pay your employees or give them benefits. All of these examples have a real cost component to them. They are not pure software. And there are providers in the market who are not passing through the true cost, in effect subsidizing the cost of the service, to gain market share. This results in fast growth but negative gross margins. Again, the companies that are doing this are hoping that once they get to scale and users are “locked in”, they can raise prices.

The thing that is wrong with this strategy is that taking prices up, or using your volume to drive costs down, in order to get to positive gross margins is a lot harder than most people think. If there are other startups competing with you and offering a similar service, you aren’t going to be able to take prices up without losing customers, unless your service truly has “lock in.” Bottom line: this strategy works only if you obtain a monopoly position in your market and you are the only game in town for your customers and suppliers (or there are very high switching costs).

Negative gross margin might be voluntary: either you believe the margin structure will evolve for your benefit (as explained by Fred Wilson), or you believe the switch costs are high enough and you want to lock as many users as possible.

But as a Fernando Suarez & Gianvito Lanzolla showed, in their amazing piece The Half Truth of the First Mover Advantage, it is very difficult to really lock users in rough waters, where technology and market structure are evolving at very fast paces.

Negative gross margin is more often involuntary, startups make mistakes with their unit economics: they underestimate some costs (or hope that price can go up or costs down), when they measure their transactions (such as discounts, transportation, returns, non-payment) or when they make their assumption (such as a churn too low or an average lifespan too long).

Bottom line: Some people argue that profit is just an opinion in the short term: you can try to have a positive net income asap (like most of traditional business) or just focus on growth, but cash (revenue over all and gross margin especially) is a fact.

But let’s dig into three important considerations:
(1) why gross margin is eventually a competitive advantage between two competitors,
(2) it is a bit more than gross margin and a bit less than contribution margin,
(3) why units economics are an never-ending debate in the quest of maximizing shareholder value.

Gross Margin = growth

Why is gross margin that important? Because growth margin represent the percentage of money a business can invest into growth.

Tomasz Tunguz, from redpoint, compiled the gross margins of publicly traded companies:

He adds:

Using real examples, BenefitFocus must sell twice as many $50k contracts as Tableau to invest the same amount in Sales and Marketing. For two directly competitive companies, Gross Margin improvements translate into a competitive advantage [because it can use the additional margin to acquire new customers and build new products]

Gross Margin Or Contribution Margin Ratio

Gross Margin = gross profits / net sales
Contribution Margin Ratio = variable costs (product costs & period expenses) / net sales

The Paypal history was about contribution margin, not gross profits.
What you need to keep positive is a bit more than your gross profits, it is your gross profits AND the variables costs that can’t be decreased (like the human cost if the transaction is a service, or the delivery price you will have at scale (eg: the one that your biggest competitor already have)).

Maximizing Shareholder Value, You Say?

This is the core of the discussion about maximizing shareholder value: it is very hard to determine what’s best for the company, especially when every shareholders don’t have the same timeframe.
Even for long-term investors (like founders or VCs), the consensus is hard, it depends a lot in the shareholder view about the present (macro-environment variables such as interest rates* or micro-environment variable such as the current valuation of the company) and the future (evolution of interest rates, company’s market, competition, etc.).

As a rule of thumb, the lower the interest rates are and the better the future appears, the less people tend to be disciplined about prices. This can lead to incredible stories (Facebook) or to incredible fails (Webvan in the 2000s or recently Homejoy to a lesser extent).
Prices are nothing but bets on the future. And players (founders, VCs and other investors) can’t always win.

Now we have emphasis that negative gross margin is a bad idea, how can we navigate in the rough waters having in mind the trade-off between growth and profitability? Let’s focus on transactional models first and see how to go beyond the tradeoff.

* interest rates makes money abundant, which has an effect on the capacity of the fund to invest (positive for VC), on competition (negative for VC) and expected growth (positive for VC)

Want to know more about startup funding? Read our articles:

Part 1 — Startup Funding: Growth Is The Only Way
Part 2 — The Jedi Trick: You Have to Choose Between Growth And Profits
Part 3 — If Growth Was Easy To Forecast, There Would Be Only One VC fund: Nostradamus Partners
Part 4 — You Need to Lose Money, But Some Loss Are A Really Bad Idea
Part 5 — How To Have Growth AND Profits? (Part1: Transactional models)
Part 6 — How To Have Growth AND Profits? (Part2: Non-Transactional Models)
Part 7 — What About Valuation For Late Stage Startups?
Part 8 — Fail Often, Fail Fast. Investors Do Half of That
Part 9 — What daphni will not invest in
Reminder: daphni investment thesis