US tech leaders, including Apple, release quarterly reports in the next two weeks. Private market investors will look enviously at their earnings. Tolerance for never-for-profit start-up models is less than it was, following the downbeat market reaction to hyped tech start-ups last year. Badly behaved founders, pumped up private valuations and shares sold without voting rights all played a part. But poor gross margins are a reason too.
High gross margins, revenue minus the cost of goods or services produced, are back in vogue. Large start-ups must suggest more convincing plans for profitability than taxi app Uber and office rental company WeWork were able to muster. Losing money may be par for the course in new companies but not all losses are equal. Software companies spend large sums upfront to create the first version of a product, then sell it to more users at little or no extra cost — opting to spend heavily on marketing. Software-backed companies such as Uber and WeWork have to keep on paying out as they add users. Property and driver costs cannot be eliminated. Losses rise with revenue growth.
Gross margins can demarcate between winner and loser start-ups in 2019. Cloud-based video app Zoom had gross profit of $136m on $167m of revenue in the last quarter, an 83 per cent gross profit margin. Data monitoring company Datadog has a 78 per cent margin. Shares in both companies have climbed since listing. But even though Uber’s gross margin is 51 per cent, other costs, such as heavy insurance expenses, are difficult to reduce.
Start-up investors want it all, the promised growth by founders and the presence of a healthy profit margin buffer. Proving a market exists is becoming less important than demonstrating it exists without investor-led subsidy. Lossmaking companies in search of multibillion-dollar valuations need to show they will not inhale cash forever. The most successful tech IPOs in 2020 will be those that offer high gross profit margins.
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