Gross Margins and 2019 Tech IPOs
OCTOBER 21ST, 2019
2019 has seen a number of high-profile I.P.O. flameouts, with Uber, Lyft and the home-exercise bike maker Peloton dropping below their debut prices and WeWork not even making it to market. Late stage private market tech investors have long believed that nothing matters outside of growth, and that every tech company should be valued as a software company. We are witnessing the collapse of that narrative in the public markets.
The tech and VC industries have long awaited the first wave of the much-talked-about companies that were started in the last decade go public. Now we are seeing that, and the resounding feedback from public markets is .... wait for it .... margins matter!
If we look at the stock performance first wave of VC backed unicorn IPOs, the companies that have performed the best are software companies with traditional software gross margin structures.
PagerDuty: Gross margin 84.9%
Zoom: Gross margin 81%
Slack: Gross margin 78.5%
Cloudflare: Gross margin 77%
Conversely, many of the companies whose stock performance has struggled have low gross margins.
Uber: Gross margin 46%
Peloton: Gross margin 42%
Lyft: Gross margin 39%
Chewy: Gross margin 23.6%
Spotify: Gross margin 26%
WeWork: Gross margin 20%
Why do margins matter?
Traditionally, software companies achieve gross margins of around 75%. Why? Because the beauty of software is that once something is built, it can be resold over and over, and the marginal cost of getting a customer to use it diminishes with each new sign-up. Software companies, particularly those built on recurring revenues, should valued in a way that reflects this. If the product is something else (looking at you WeWork) and cannot produce software gross margins, then it needs to be valued like other similar businesses with similar margins. This is something late-stage private markets have not been doing.
As the tech IPO market picks back up at some point, gross margins will be even more important. Investment banks and sophisticated public market investors will have learnt from the IPO failures of the recent low margin unicorns. At Brightstone, as a matter of practice, we always check the gross margins of any business as soon as we can. Margins matter, even during the early stages of a company's life-cycle. This does not mean that an early stage startup should be turning a profit- net margin should be reinvested in growth. It does mean that we take a hard look at gross margins and operating margins excluding sales/marketing/growth budget. Margin is growth fuel. Companies with high gross margins and lean organizational operating structures produce a lot of growth fuel. This is important. It means we'll be diluted less as a company grows, because the company won't need to subsidise growth by relying on late stage capital markets. 2019 has taught us that it's also important because public markets will look for this type of margin structure in the future.
