Ask any great investor or entrepreneur in branded consumer products what the most important success factor in selling a branded product is, and she will almost certainly tell you the brand itself is most critical to the company/product's success. While there are many different theories on what makes a brand great, there's one common factor: they require capital. Capital to invest in sales people, in marketing personnel, trade shows, sampling, advertisements, slotting costs, consumer surveys and the list goes on.
When CPGs are out raising money from investors, long before a brand has legs, investors will turn to one number in your pitch deck and will send you home empty-handed if it is out of order: gross margin. So why is gross margin so important? You never hear of a company selling for a multiple of gross profit right? It's always 2x revenue or 8x EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization).
Here are 5 reasons you need to be laser focused on gross margin for your CPG company:
1. It's how you build your brand.
Gross margin, which is your gross profit/net sales, is basically a measure of how much money your company has left over after all the fixed and variable costs of production (e.g. materials costs, production labor, fixed plant overhead, etc.) are subtracted from your net sales. In a branded CPG company, these dollars are absolutely essential because gross profit is what you have left to invest in your brand—new packaging, marketing, couponing programs, that awesome spokesperson you want. If you don't have gross profit, you simply cannot invest in brand-building activities. And if brand is the most important thing for a successful CPG, no gross profit=no success.
2. Small changes have big impacts.
Razor-thin gross margins just don't leave much room for error. For example, if a company has $10 million in revenue, 20 percent gross margins and its COGS (Cost Of Goods Sold, previously $8 million) increases 30 percent, it would go from $2 million in gross profit to losing $400,000. As an investor who knows your company will need gross profit dollars to invest in brand-building activities, gross margins that are so thin that a 30 percent swing in COGS puts the company underwater just don't meet my sniff test. With unprecedented volatility in commodity costs over the last six or seven years, 30 percent COGS swings have become the norm, and there's nothing an investor hates more than pouring equity capital into a company to fund losses at the gross margin level. Why? Funding gross profit holes does not build a brand!
3. Gross margin is really hard to change (but make sure you show me how!).
I've sat through countless management presentations where companies with 2 percent gross margins tell me how their gross margins will be 45 percent next year but then brush over the "how." Mix shift, price increases, economies of scale, commodity cost declines, changing co-packers, new plant, etc. are all great reasons for gross margins to improve; however, these changes are much easier said than done. If you do tell investors that your gross margin will increase from 2 to 45 percent, make sure you build a bridge of the how (i.e. the key drivers and impact of each). Perhaps 10 bps of the increase is due to a new corn contract you are buying on; 20 bps from a price increase already agreed to by customers. These are tangible reasons for the increase that investors can underwrite.
4. Strategics care.
Oftentimes, when Pepsi, Kraft, Nestle, P&G or any large CPG company buys a smaller company, they look first at gross profit and not EBITDA, EBIT or net income (actually, they look at contribution margin, but gross margin is close enough). These companies will often plug your company's products into their sales force and use their administrative functions, thereby eliminating all your costs below the gross profit line.
5. It's all relative.
Medical device gross margins are >80 percent. Private label manufacturers are lucky to get 25 percent. Your absolute gross margin level is less important than your level relative to your category. Personal care companies have 65 percent margins because they need to invest a ton of dollars in sampling. Ice cream companies' gross margins are in the 30–40 percent range due to their expensive frozen distribution. Investors understand that categories are not comparable—what matters is how you perform within your category, because that's what your marketing dollars are competing against.
At CircleUp, we look for high-growth companies that have strong brands, great management teams, reasonable valuations, a path to exiting to a strategic and that have gross margins at least as strong as their peers.