What Investors Want

Last week, we said that a high gross margin is the most important quality of a successful business. Indeed, most venture capitalists’ first question is about the gross margin. I have had venture capitalists summarily end the conversation if the answer is insufficient. Let’s unpack and discuss this. Let’s define a few terms first. Please note that these definitions do not necessarily agree with standard accounting definitions.

Sales is defined as the amounts that customers are invoiced. Again, please note that an accountant would not accept this definition, and would instead insist that sales is defined as what customers pay, which may be quite different if there are returns and allowances. However, most business owners like to think of sales as what they invoice, so we’ll use that here.

Trade Spend These are generally amounts that brands are forced to pay in order to continue doing business with a retailer or distributor. They may include slotting fees, promotional fees, demo fees, spoilage allowances, and so on. Even if you feel that you have voluntarily agreed to a promotional fee rather than being forced into it, we are including it in Trade Spend. The idea here is that they are costs of doing business and reduce the profitability of your business.

Cost of Goods Sold (COGS): This is the amount you pay for the product you delivered to the customer. Please note that this includes freight to the customer, freight from your production facility to your warehouse, and warehouse fees. Venture capitalists call this a fully loaded cost of goods. Standard accounting practice is a bit more lenient, which is why the VCs insist on a different treatment.

Gross Profit is Sales less Trade Spend and COGS This is the amount you make in profit after paying for promotions you were forced into, (even if you don’t think you were forced into them), and after paying for and delivering your product to your customer.

Gross Margin is the Gross Profit divided by Sales, or more accurately Gross Profit divided by Sales less Trade Spend. For our purposes here, it doesn’t make too much difference.

With that out of the way, let’s first say that Gross Profit pays for everything. Your salaries, office, and shareholder returns come out of it. If you cannot generate gross profit, you have no business.

But what Gross Margin is required in a growing, healthy business? The answer depends on the type of business. An interesting starting point for this discussion is this Investopedia article, which further links to CSIMarket, an amazing source of information about profitability of various industries.

Memorably, Coca-Cola’s gross profit margin is 55%, which is typical for the beverage industry in general. Food companies have lower gross margins, around 22%, because of the higher volumes. Overall, the Food & Beverage industry has a gross margin of about 50%.

For a small CPG company, the minimum gross margin is 40%, preferably 45%. This is not only a requirement of venture capitalists, but also a requirement to have a healthy, growing business. This gross profit pays for salaries, product development, interest costs, and marketing. Typically, after these so-called fixed expenses, there will not be any taxable net income to report.

Typically, brokers ask for trade spend of 20-25%. I would advise that trade spend including slotting fees be kept under 25%. It is important to monitor and plan your trade spend. Uncontrolled trade spend kills companies.

If you find that maintaining a gross margin of 40-45% leaves your prices too high relative to the competition, that is a good sign that the competition is too strong.

In conclusion, gross margin is a fundamental indicator of a company’s health and viability. It is a key determinant of whether a business can sustain its operations and grow. By effectively managing gross margins and related expenses, businesses can position themselves for success in competitive markets.