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The Margin Question

While I’ve never been told this directly, I’m sure that a lot of startups I meet are a little put off as to why I oftentimes ask so many questions about their margins. As a brief refresher, margins are the % of sales that a company gets to pocket, after accounting for the cost of production. So, if it costs Acme Co. $5 to make a shirt that it sells for $10, their (in this case gross) margin is 50%.

Generally, the entrepreneurs are miffed at me because – well, they’re working in startups. They’re too busy trying to build out their product to work on financial forecasts which are likely inaccurate. The savvier entrepreneurs will sometimes throw back some variant of the point I made a while back about how the goal (for a venture-backed startup) is not profitability, but growth. The numbers themselves are also kind of a trap: if they are too high, it makes the entrepreneur seem naïve. If they are too low, it makes the business seem uninteresting.

But, the real reason I ask about margins is not necessarily to get at the precise number, but so that I understand how the management team thinks about their business and how it will grow. I’ve been in many meetings where management teams present a fantastic revenue growth story which relies on expanding product lines with lower margins. The idea here is two-fold: first, products with lower margins are easier to sell (since you’re marking them up less) and, second, as long as you are making money on each incremental sale, why not push lower margin products when venture-backed acquisitions and IPOs are oftentimes mainly evaluated on sales growth?

I tend to view that type of reasoning as a poor rationalization of opportunity costs. Whereas an entrepreneur might see “profitable growth opportunity,” my first instinct is that if a business is forced to turn to lower margin products to grow the business, then they should spend more time building a better product (to get those margins back up) or trying to find markets where the company’s innovations are more highly valued. As is oftentimes said, the most important assets that any startup has are time and money – and every second and every dollar spent chasing a lower-margin sale is a second and a dollar that is not being spent improving one’s products or chasing a higher-margin sale. When you combine that with the fact that lower margin businesses tend to be that way because there is more competition, the idea of pursuing lower margin growth opportunities becomes a lot less appealing.

Now, this isn’t to say that pursuing a lower-margin market is fundamentally a bad thing. Companies like Amazon and Samsung have built impressive businesses going after barely profitable markets (i.e., many types of online retail for Amazon and memory chips & TVs for Samsung). But, its only after a careful consideration of opportunity costs and strategy that such a choice should be made.

Published in Blog

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