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Negative Gross Margins - Fred Wilson, Union Square Ventures

With concerns growing in Silicon Valley about a potential tech bubble among highly-valued startups, there has been increased focus on profit margins and cash flows. Fred Wilson, a prominent VC with Union Square Ventures, recently penned a post on his great blog which should be required reading for tech entrepreneurs about the dangers of negative Gross Margins.

His concerns echoes what we advise with our clients who are Owners / Founders / CEOs of small companies. Often, the first area we analyze and emphasize with the companies we work with is to significantly improve Gross Margins. Without the appropriate level of Gross Margins, no company (no matter how lean it is) can afford its overhead or its necessary growth investments in product development and marketing.

“We have seen a tremendous number of high growth companies raising money this year with negative gross margins. Which means they sell something for less than it costs them to make it.

"It can be an “on-demand” service provider that subsidizes the cost of the workers on its platform so that the service seems like it costs less than it actually does. Why would an on-demand startup take this approach? To build demand for the service, of course. The idea is get users hooked on a home cleaning service, a ridesharing service, a food delivery service, or a gym roaming service by bringing it to market at a price point that is highly attractive and then, once the users are truly hooked, take the price up.”

Wilson goes on to point out the flaw with this strategy:

“The thing that is wrong with this strategy is that taking prices up, or using your volume to drive costs down, in order to get to positive gross margins is a lot harder than most people think. If there are other startups competing with you and offering a similar service, you aren’t going to be able to take prices up without losing customers to a similar competitor, unless your service truly has 'lock in.' And most don’t. Using volume to drive costs down can work, but if there are similar services out there, the provider who is being asked to take a cut by you might just move their supply over to another competitor offering a higher price.”

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