Margins matter

February 25, 2020

Start-ups consistently want to give their product away for free, sometimes investors encourage them to charge for their product instead of trying to go for an “eyeball grab.” Margins are important. Start-ups should charge customers unless they have a justifiable reason not to.

The reasons are two-fold: 1) Margins signal about the difficulty of the problem that the business is solving, and 2) Cash generated by sales, will enable the start-up to bootstrap their efforts, leaving them less reliant on external funding.

Start-ups should charge for their product as quickly as possible. If they’re solving a difficult problem and creating value for their clients, then this shouldn’t be an issue.

Why wouldn’t you charge?

Start-ups don’t want to charge because they believe that it’s easier to get customers when they don’t need to pay. The frictions that used to exist in getting people to sign up for services online don’t really exist anymore. It could make sense to offer a freemium service if it’s necessary to get a meaningful amount of customers before the platform is able to be successful (i.e. network effect exist) or if the company needs to prove out a number of hypothesis, which requires a certain scale. Beyond that, if people aren’t paying for the service, it’s difficult to prove that there is value being created.

Margins are a function of quality

The margins that a business is able to generate are a function of the quality of the business and the difficulty of the problem that it is solving. If it’s a little problem, it’s likely that people will only want to pay a little for the solution. This would result in a low margin business.

If it’s a big problem, then customers would likely be willing to pay a lot for the potential solution. However, if the business is low quality (poor people, processes or priorities) then it’s likely that the margins will be eroded by a high cost structure.

A good business that’s solving a difficult problem will have high margins. The higher the margins, the higher the cashflows, and the more that that business will be worth in the long-term.

Summing up

A business that’s able to generate high margins will benefit from the phenomenon of increasing returns. That business will be able to raise additional investor funds, generate higher free cash flows (once it’s operating at scale), and higher the best people. The best people like to solve hard problems. If margins indicate the difficulty of a problem, then it’s likely that businesses with high margins will attract the best people.