“Gross margins are key to a business, more so for those that are looking for investors. Have a good portion of your revenues in gross margins and you will be able to fund growth and make it appealing to investors and marketing partners while also being able to pay for the evolution of your business towards your Vision and to your planned Exit Strategy”
When considering an investment on a business one of the main factors considered by investors is Gross Margins; why is it that important? Let’s see.
Gross Margins are the amount that’s left after the business pays for all the direct costs of producing a good or service. Let’s say for instance that you manufacture purses. The direct cost of producing the purses is the sum of everything that you need to manufacture them including the cost of the fabrics, the threads, the latches, the cost of the labor used directly to sew them. If those costs were $12.93 per purse and you sold them for $45 a piece your gross margin is $45 – $12.93 = $32.07. This margin can also be expressed as a percentage or the ratio of gross margin to direct costs in this case $32.07 / $12.93 = 248%.
Now, if you run a business you know that the gross margins are not what’s left in your pocket after selling a purse. There are additional costs that are not directly used to produce the product or service but that are necessary for the operation of your business including office lease, administration, accounting, sales & marketing. The sum of these expenses are called Indirect Costs and they have to be taken off from the gross margins before you can have any profits.
So, why are gross margins so important to investors? There are several ways in which they are crucial to an investable business and here are a few of them.
- Returns to Investor: When someone considers investing in your business they will want to get money out of it. In the case of your purse manufacturing business investors will consider if your gross margins have room left for generating profits to them and how big can they be so there is an actual potential for them to make money. If your selling price, instead of the $45 was for instance $15, with the $2.07 left after direct costs you would need to cover the indirect costs and leave a profit for you, the current owner of the business. This margin is too low and most investors would see too little a potential for them to make money out of such venture, espe
- cially if the capital will be used to increase production or to fund marketing and distribution so the deal for them loses attractiveness
- Funding marketing channels: For our hypothetical purses business let’s assume that you are currently selling them
nline through your own website. Now imagine an investor that has access to a major retailer, for instance Target, and is looking to invest in your business so that you can increase production to satisfy the demand generated by the big store. Because your purses leave a gross margin of $32.07 your capitalist friend may consider this to be an investable margin as there would be enough room for all the parties to make money. The selling price to the red giant could be $25 leaving $12.07 for you and your new partner while Target would get $20 per piece, margin that may give you a good chance of having your purse using their shelf space. Yes you would lose an important margin when selling to the retailer but presumably sales would grow dramatically and you and your investing partner would potentially make big bucks. Also consider that with increased production you may get better prices on y
- our raw materials based on volume pricing so your direct costs may be reduced leaving better gross margins
- Product Development: Investable businesses usually have a path to growth, a plan to go from their current state to bigger sales and in most cases this plan includes the development of new or improved products. In your purses business maybe you are considering a newer version of the bags that will include a location system so that owners can always find their purse if they leave it somewhere. Or perhaps you want to develop a new latch that will open faster or more easily and make it a unique purse. Product development needs to be funded to guarantee the evolution of the business and most of the times you want those funds to come from the gross margins as they represent the cheapest cash you can get
- Market Penetration: Every new product or service needs to penetrate markets to grow and one effective strategy is to offer promotions to capture new clients. What sort of effective promotion do you think you could offer for your purses business if the selling price was $15 and you were making $2.07 in gross profits per unit? Even a 10% discount would let you at a loss! If you don’t have cash left on your gross margin to pay for mar
keting and promotions no matter how good your product is; if you can’t find new clients to buy your product you will eventually be out of business
In summary, gross margins are key to a business, more so for those that are looking for investors. Have a good portion of your revenues in gross margins and you will be able to fund growth and make it appealing to investors and marketing partners while also being able to pay for the evolution of your business towards your Vision and to your planned Exit Strategy.