Negative Gross Margins
Gross margin is one of the simplest and most important concepts in business.
If you sell something for more than it costs you to produce, you make a profit on the sale. Sell enough units, and you can cover your overheads to produce a profit as a business overall.
The alternative is no muy bueno.
Negative gross margins means that as you scale your business, your cash burn goes up. In other words, the more you sell, the worse off you are. It’s clear that in the long run, that cannot go on.
What we’re seeing in AI land is a new tolerance for negative gross margins. Sometimes that can be justified, sometimes it can’t.
To summarise the situations where negative gross margins are acceptable:
- Your costs per unit reduce materially with scale: Sometimes this is because you have large component of fixed costs, sometimes it’s because absolute scale provides economies of scale for negotiating better terms with your suppliers. Sometimes both. Netflix was probably gross margin negative for a while given the cost of licensing/producing content amortised over a relatively small user base. But now, at scale, that problem goes away - and in fact serves as a massive moat vs. new entrants trying to do the same thing.
- Your business has network effects: Some businesses only have value as a function of the number of other users on the platform. A phone is useless if nobody else has a phone. So when you’re in the mode of building distribution, you can stomach the gross margin hit in the short-term. You’ll monetise the network further down the line once the value is actually created. Facebook is the obvious example. They didn't monetise for years and even though small, there was obviously a cost to serve their early user base. But once the network was established, they could begin extracting value. And a tonne of it, too.
- Your beachhead product is deliberately a loss leader: We'll call this the Revolut strategy. Effectively, you're happy to accept gross margins on the first product that you launch to a customer on the logic that you can then upsell and cross-sell additional monetisation over time to that same customer. So really, the gross margin is not negative when looked over the course of the customer lifetime, but might be in the short term.
- You have a shitload of capital and can force others out of the market: Let's call this the Uber strategy. Effectively, you raise a shitload of money and smash that into low pricing, with the hope that you can flood the market, kill your competitors, and then ultimately over time raise prices. The embedded assumption here is that in the long run, you have pricing power relative to a customer's next best alternative. Otherwise, you may just be overstating the TAM to begin with. That's an entirely different question for another blog post at some point.
If none of the above are true and your gross margins remain negative: simply, stop. By definition, you aren’t creating value. Go back to the drawing board and find true value that your customers are willing to pay for. There’s no point scaling a model that doesn’t work. Rethink.
And of course, even if these are true, the embedded assumption is that you can raise enough capital to keep the show on the road on your journey to positive gross margins. In a bull market, that's very plausible and there are plenty of examples of people having done so. When the market turns, though, you might find that the paper value you thought you had evaporates quickly, and you're no longer the master of your own destiny.
Either way, spend time getting bloody good at fundraising and articulating the long-term vision for how you're going to create value, even if in the short term you're ploughing cash into the ground.