2 min read

The Gross Margin Secret

Almost 15 years ago, cloud computing changed the software industry forever. Gross margin became the gatekeeper financial metric for startups looking to raise venture capital - too low and your chances of raising fall faster than Dogecoin during Elon's appearance on SNL.

The reasoning behind this framework is sound. High gross margins are a reflection of a business's ability to invest in sales and marketing or product development (R&D).

However, 80%+ gross margins aren't as common as we are led to believe.

Only 20 of the Bessemer Emerging Cloud Index companies achieve this benchmark. Among those who don't: Okta, Datadog, Salesforce, Veeva, and ZScaler - businesses we'd all be proud to back.

So what about the businesses with "lower" gross margins?

As David George and Alex Immerman of a16z wrote, "business quality is about defensibility and defensibility comes from moats".  Lower gross margins are acceptable when they are being sacrificed for defensibility.

This tradeoff happens frequently within sectors like energy and industrials that are undergoing significant digital transformation. There are three primary culprits for gross margin suppression:

  1. Services - implementation and customer success
  2. Hardware - assets often need sensors or some form of modernizations
  3. Edge cases - initial customers often have problems that have never been solved before

Net, customers adopting new technology or within digitally nascent industries are often lower gross margin at first.

C3.ai is a great example of a startup that successfully navigated the transition from low to high gross margins. In the years leading up to their IPO, their gross margins were in the mid-60% range instead of 75% where they sit today.

Why? Implementation work to ensure data fidelity for machine learning and the occasional edge case (especially for first-in-vertical customers) increases onboarding costs.

Post-implementation, customer success, a service product with lower GM, proves critical for adoption and eventually customer stickiness.

These processes are measured in months not weeks so the early unit economics look less than promising.

However, all of this extra work also creates long-term customers with obscenely high annual contract values. These industries do not change vendors often, but when they do they are extremely low churn due to the implementation costs and mission-critical nature of the systems they run.

Reliability and relationships matter and great service is one of the best building blocks of trust rendering it essential even if it makes the P&L look subpar by some measures.

On one of the last episodes of Power Down (reunion tour coming soon), John explained this from the investor lens:

"As an investor, you want to know a secret and win deals based on that secret. But, you eventually want the market to pay a higher price even if they don't know your secret.

Anticipating when the unit economics will flip to the 75%+ gross margins most investors expect is one of those secrets.

Gross margins are one of the gatekeepers of venture capital for good reason - they indicate operating cash for the business. But, when it comes to energy and industrial tech, investing in the processes that create short-term lower gross margins creates higher quality long-term economics.

In a world of increasing competition and valuations, we can't forget quality matters too.