The Importance of Gross Margins

We're going to start with a first driver, which is just simply gross margins. Gross margins is just the revenue minus the gross costs of producing an item. So let's say that I am selling a cookie, and it costs me 50 cents to make a cookie. And I know all those ETL students are really hungry after they hear those lectures. And so I camp out outside of class, outside of Huang. And my intention is to sell you a cookie. And if I sell you that cookie for $1, my gross margins are 50 cents. I sell you the cookie for a dollar, it costs me 50 cents to make. I make 50 cents of profit, which means that how many cookies can I make next? One cookie, I sell that other cookie for a dollar, I make 50 cents of profit, and I can make one more cookie. So at 50 cents or a 50% margin, my slope is zero. Does that make sense? I am basically just making one cookie every cycle. If I have the insight to say, you know what? I'm not going to target the Stanford students. I'm going to go to the faculty club. That's where they have the money. And I'm going to charge $1.50 for that cookie. Suddenly, just by shifting the price up to $1.50, my margins go from 50% to 67%. But I sell that cookie for $1.50 at the Faculty Club, it cost me 50 cents to make. I make $1 of profit, which means how many cookies can I make? I can make two cookies. And if I sell both of those two cookies for $1.50 each, it's $3. It costs me a dollar to make. I have $2 in profit, which means I can make four cookies. So just by doing that subtle shift of having the gross margins go from 50% to 67%, I'm suddenly on a multiplicative path. Does that make sense? And at 75, and let's say if you're like, it's not the faculty club, it's the Stanford Mall. That's where the real money is. All the venture capitalists go and they shop there. I'm going to go to the Stanford Mall and sell that cookie for $2, and it only cost me 50 cents. Suddenly, I make 75% margins, or a buck 50. I sell one cookie for 50 cents. For $2, I make $1.50 of profit. I can then produce three cookies. If I sell those three cookies for $2 each, that's $6. It costs me $2. I make $4 of profit. And then I keep going up. And so 75% then gets us at this magic growth clip of 3x, I can start growing 3x at 75%. And so one of the golden rules, by the way, is that if you do not want to raise venture capital, but you're like, I do want to build a billion dollar business, if you can have your margins be 75% or higher, and if you can bill up front, if you can have people pay you before you have to build the product. So if you can have people prepay for a year of Spotify before you deliver the service or prepay for a magazine, then you can be customer funded and put yourself on that 3x growth curve to keep hitting things. This is why venture capitalists love software. Because the costs, as we increase these margins, our growth rates become even more absurd. And if you think about with software, the cost of doing a Google search, the gross costs are just the energy of that server. It's basically nothing. And this is why VCs hate hardware. I mean, just to oversimplify, I don't want to speak for all of venture capitalists, but hardware requires capital. You have to put in money. Your gross margins are lower, you need to worry about distribution and all these other things. And so these are some questions that I would ask if I was a venture capitalist and that I would also want to arm you to understand. If you're a founder building a business that's seeking venture capital or just trying to build a big business is understand what your gross margins are. If you're building hardware, understand what your bill of materials are. And if you are building something that's going to be hardware like, then you need to be able to answer the question of how do you finance the business to cover your cost of goods. And that's a separate discussion that we can have later. Does that make sense? So that's lesson one is gross margins.