Gross Margins Don’t Matter
How overusing heuristics can lead to missing emerging opportunities
A company could have 10% gross margins and I wouldn’t care.
A VC saying this is blasphemy, I am aware. But it feels great to get my view out in public.
The last two decades of software made investors lazy. 80% gross margins meant “this is investable.” There was no need to do the harder underwriting of balance sheets, return on capital, and how nascent markets would evolve.
But in this new venture era where investing in hardware is back in vogue and balance sheets are getting bigger, we need to primarily care about two things:
1) Aggregate profit DOLLARS (“Contribution Margin”); and
2) Total capital invested to get there
Profit dollars fuel continued R&D, which deepens the moat and increases enterprise value. And the more profit dollars we generate, the fewer equity dollars we need.
The optimization should always be for the most DURABLE profit dollars generated as QUICKLY as possible with the LEAST about of capital required.
High gross margin (%) is just a proxy for doing that well, but focusing just on that will cause one to miss great opportunities.
interesting take. it's so true that high gross margins can sometimes obfuscate the hidden cogs of running companies - I think of saas companies that have to invest massively in R&D and sales and marketing to keep building new features and win/retain customers. there's often less operating leverage than some would want to believe. I'm trying to think of low gross margin companies that end up delivering great returns on capital. I guess it boils down to owning a category or a choke point that becomes super sticky / hard to compete with.