Last week, we dissected popular financial metrics and wrote about how they apply – or rather don’t apply – to most startup investments. This week, we look at Gross Margins and what startup investors should really look for, especially in a service-based model.
As seasoned venture capitalist Tomasz Tunguz says, not all revenue dollars are created equal, but all gross profit dollars are. As a refresher, gross profit is a company’s total revenue minus the costs associated with making and selling its products, or the costs associated with providing its services. For well-established companies, gross profit margins should be as high as possible, pretty stable and in an ideal world, increase steadily.
The same applies to startups (finally, some common ground!). The higher the gross margin, the more the startup will generate value as it scales and the more revenue can be reinvested in growth without raising additional money and diluting actual shareholders.
However, more and more startups operate under a service-basis model, hence the software-as-a-service (SaaS) concept. What the service-basis model entails on a financial perspective is that revenues are recognized as the software service is delivered. For example, a B2B SaaS startup sells $5,000 contracts to small and medium-sized businesses (SMBs) for the use of its software over a 5-year timeframe. The startup has to book revenues of $83.33 per month for 60 months, instead of booking $5,000 when the contract is signed, even if the SMB paid the full amount upfront.
The startup most likely have sweated blood, deployed manpower, and spent significant cash to acquire a SMB as a customer. Many of these up-front customer acquisitions costs can’t be recognized over time in the income statement. The timing of revenue and expenses are misaligned - affecting negatively the startup’s gross margin during its early life. In fact, at first, the faster the startup is acquiring customers, the more its gross margin is negative.
The beauty of the service-basis model is that once the company acquires customers, they stay for a long time and generate high profit in the long run - creating a J-curve for gross profit. As a venture capital investor evaluating a potential investment in a SaaS startup, we have to get past the current gross margin to fully see a businesses’ potential.
First, we’ll want to see that the gross margin is increasing over time, or that it will be increasing in the projections.
Second, we compare what we call the average customer Lifetime Value (LVT) with the average Customer Acquisition Cost (CAC) as a guidepost. Simply put, the customer LVT is the sum of all revenues a customer will bring to the company. The CAC is the sum of all sales and marketing expenses spent to acquire a customer.
Going back to our example, let’s say the startup spends the equivalent (CAC) of $1,000 to acquire a SMB as a customer and that an average SMB is a loyal customer for 10 years. The customer LTV is 83.33 x 12 months x 10 years = $10,000. The LVT:CAC ratio is 10 - which is really good. Most experts will say that your ratio should be at least 3 as a rule of thumb. You can adapt the ratio to particularities of different business models. For certain startups, you might want to calculate and consider how many months of revenue it takes to recover the CAC.
When looking at a startup gross and operating margins, remember the J-curve.
The bottom line is that venture capital is a different beast than other asset classes. Even the most knowledgeable investors new to venture capital start by not knowing much and making mistakes. Financial information about a startup can be misleading if you don’t understand the specific attributes of that company and that market. My biggest advice is to learn alongside experienced people that know what they’re doing. Startup investing can’t be mastered by reading books - your best bet is to lean on partners who have the trophies, the scars, and the baggage to fund, build, and exit legendary companies.
A great way to get started is to join Brightspark’s network of investors. It’s completely free, and you’ll get access to a deal flow of exceptional early-stage companies, as well as receive more tips and educational content.