In today’s macroeconomic environment, top-line revenue growth is no longer enough for startup founders seeking investment. ‘Quality of revenue’ has become heavily scrutinized by investors, who are seeking companies with a pathway to future profitability. Given these concerns, investors are looking more closely at startups with wide gross margins, which have higher-quality revenue and are more likely to find a sustainable business model. Techstars co-founder and VC Brad Feld considers gross profit growth a more important metric than revenue growth and claims that it is the first line item he looks at on a company’s Profit & Loss statement. Understanding the relationship of cost of goods sold (COGS) to this metric and how to calculate it is critical to accurately representing your margins.

 

Gross Profit & Perceived Value

Gross profit is defined simply as [Revenue] – [Cost of Goods Sold], so in order to calculate gross profit, a startup founder needs to have an accurate measure of their company’s COGS. COGS is a simple but important calculation: “the direct costs of producing the goods sold by a company”, including materials and labor but excluding indirect costs like distribution. 

Unfortunately, the COGS calculation is often poorly understood by founders and there is no clear set of rules for which expenses should be included. Based on our experiences working with over 100 startups, we advise founders to define their COGS using the following rules:

  • Included: Hosting expenses and other software required for keeping production environment running; employee expenses associated with retaining customers (customer support and customer success); DevOps (though this is a bit of a grey area)
  • Excluded: Commissions and other customer acquisition costs; account management expenses, especially if they are oriented around upselling (as opposed to retention)

Once a founder has a defensible COGS calculation in place, how does she gauge whether her startup’s gross margins are up to par? Gross margin benchmarks vary by industry, but when investors talk about “software margins” they are often looking for a gross margin of 80% and up. If you are still in the early stages and your margins aren’t quite so high, that’s OK! However, you should be able to show that you’ll be able to achieve these margins in the future by growing revenues faster than COGS.

 

Implementing COGS to Your Advantage

Understanding what metrics are desirable and what your goals should be can make a substantial difference in receiving funding, and ultimately, your startup’s survival. Hopefully this article gives you a solid understanding of how your startup should be calculating Cost of Goods Sold. If you have additional questions about your startup’s financials, feel free to reach out to set up a call.