Moats Before (Gross) Margins

In 2019, long before the outbreak of COVID-19, many lower gross margin tech companies were not being well-received by the public markets, and an excessive spotlight was cast by many on company gross margins. In the present moment, that attention has only grown for both public and private companies. We’ve observed a bifurcation in the market of “haves” and “have nots”: those companies that have high gross margins are worthy of investor attention, but those that do not are quickly dismissed. 

Of course, the focus on gross margins is understandable. A high gross margin is a preferred business feature. Higher gross margins allow for more percentage points of revenue to be spent on growth and product development. Higher gross margins also tend to translate to higher cash flow margin, and in a world where “how much runway do you have” has become a (if not, the) preeminent question, cash is paramount. For these reasons, high gross margin companies typically have higher revenue multiples than their low gross margin counterparts. 

But we risk losing sight of what truly drives business value. Yes, gross margins are important. But over-rotating on gross margins is myopic because business quality is driven by more than margins. 

Business quality is about defensibility. Defensibility comes from moats. And while high gross margins are often a reflection of moats, they are not a moat in and of themselves. And when faced with a low gross margin business, you need to focus even more on moats: without those extra points of revenue to invest in sales & marketing strategies or research & development, you need other ways to generate cash flow over time.

The markets will show you that companies with low gross margins can still be highly cash flow generative and highly defensible, and thus highly valuable. One of the highest valued companies in a major exchange, Apple, has a 38% gross margin, roughly half of that for many software businesses! In fact, many of the most valuable companies have low gross margins (as shown by Capital IQ, as of May 27, 2020): from Walmart and Home Depot to Disney and Netflix to Nike and Starbucks to Raytheon and Lockheed Martin. We believe the next generation of iconic companies like these will be more tech-enabled, but still likely have gross margins that are well below those seen in traditional software.

Over-rotating on gross margins is myopic. Why? Business quality is about defensibility. Defensibility comes from moats. And while high gross margins are often a reflection of moats, they are not a moat themselves, say @DavidGeorge83 & @aleximm

In the current crisis, many companies are (rightfully) focused on survival, but as we look toward the future, it’s critical to think about what your moat is or will be. For all entrepreneurs (but especially those building a low gross margins business), here are four examples of moats, as well as some metrics we look for that demonstrate the presence of that moat.

Economies of scale

Economies of scale refers to a cost advantage resulting from increased production. One of the most prominent examples in tech is Amazon’s distribution network, but they’re not the only one. For example, the scale of Carvana’s refurbishment network enables the company to care for vehicles at a lower cost than competitors. 

The simplest question for whether economies of scale are achieved is: are your per unit costs defensibly lower than your competitors’? It’s super-rare for early and growth stage startups to achieve such scale; assuming yours are not, the next question is: are your per unit costs improving while not degrading your unit economics? For example, you could push paid advertising to lead to high volume and scale benefits, but that paid advertising may be so excessive that your unit economics become unprofitable. 

Another sign of emerging economies of scale is if your business has a clear pathway to negotiating power over your suppliers and/or buyers. Again, Amazon is the classic example, but another interesting possibility is Spotify. Historically, music labels have commanded certain economics from streaming services, but if Spotify’s existing large user base continues to gain share, the negotiation could flip, allowing Spotify to achieve meaningfully differentiated economics relative to the competition.

Meaningfully differentiated technology

Most companies believe they have differentiated technology, and many do. Features, integrations, reportability … the list goes on. But when entrepreneurs look to distinguish their technology enough to make it a true moat, they should be focused on differentiating their product and service in a way that matters. Doing so enables companies to charge more (“premium” pricing) and spend less on sales & marketing (the product “sells itself”). Moreover, customer lock-in can be higher because there is a perceived switching cost of moving to an inferior tech solution. 

There’s no one clear metric that indicates this moat across all cases, but we tend to see it pop up in a few ways. One example is if your company has intellectual property (e.g. patents) that can protect your advantage for many years to come. In the absence of IP, the clearest measure of differentiated technology is pricing power. Are customers willing to pay a higher price for your product than others? If so, you are likely selling a differentiated offering. 

Another way we get at this question is talking to customers. If asked, do your customers claim no one else can match your offering today, and that they would be willing to pay a higher price? Do they say that no one else on the market has the capacity to continue building the way you do? Government officials select Anduril because its sensor fusion and machine vision platform is unlike the offerings of other defense contractors who are also unlikely to be able to recruit and retain talent capable of building similar technology in the coming years.

Network effects

It’s no secret that we at CFI love network effects, especially when it comes to marketplaces. Network effects happen when a product or service becomes more valuable to its users as more people use it, creating a flywheel effect on growth. Despite having low gross margins, many public company internet marketplaces, such as Lyft and Uber, have leveraged network effects to drive organic growth, increase switching costs, and build scaled businesses. 

We have published a lot about the metrics for and common leading indicators of network effects (to start, try here, here, and here), but there are a few rules of thumb for determining if you have network effects. One is measuring engagement: does engagement (e.g., DAU/MAU) improve as the number of users grows? Another way is to look at monetization: are you experiencing organic growth in wallet share for supply and demand? Across the many grocery and restaurant delivery startups, we’ve observed higher consumer engagement and dollar retention in denser markets. Ideally, for companies exhibiting network effects, we see increasing returns to engagement (e.g., revenue grows exponentially relative to time within a single metro).

Direct brand power

One way to combat having fewer percentage points of revenue to spend on strategies like outbound sales and paid marketing is to have built a killer brand. A strong brand commands word-of-mouth referrals, a cult following, and direct traffic. Those with LaCroix, Hint Water and increasingly Bevi in their office know that word spreads fast, and soon every office kitchen must have them in stock. 

Building a brand takes time and focus (and money!), but it’s ultimately valuable and can pay off well into the future. How do you know if you have a powerful brand? One metric we look for is increasing organic and direct traffic: do you have an increasing percentage of your traffic and revenue coming from organic or direct channels (vs. paid) over time? Leveraging unpaid channels can help ensure you’re not overly dependent on more expensive customer acquisition channels (i.e., are you beholden to Google and Facebook?).

Another metric we look at is decreasing customer acquisition costs (CAC): is your cost to acquire each customer falling or staying flat? Combined with growing organic traffic, flat to down paid CAC translates to declining blended CAC. While it is common for CAC to go up in the earlier days of a startup, as you build a strong brand that drives word-of-mouth, we look for CAC to come back down after you achieve product-market fit. 

[For a more in-depth discussion of the nuances of organic traffic and CAC, check out this podcast (with transcript) with our colleagues Jeff Jordan, Andrew Chen, and Sonal Chokshi on user acquisition and growth.]   

 

These four examples are far from the definitive list of moats, but they hopefully serve as a healthy reminder how startups can build enduring businesses, even without high gross margins. Still, the reality remains that if you don’t have high gross margins, you’ll often need two or more of these moats to become a highly valued company with meaningful cash flow. 

Ultimately, there is no one path to building a defensible and valuable company. Though some ways, like having high gross margins, might be easier than others, we work with founders every day who are forging the right path for their company.