Sure . . . VCs and investment bankers will talk to you about your gross margins. And it makes sense. It is one of many factors to consider during fundraising or negotiating your exit. But don’t let them steer you in the wrong direction — the importance of “industry-leading” gross margins is usually overemphasized.

So how should you be looking at your gross margins?

First, here is a short accounting review.

Gross Profits = Revenues – Cost of Goods Sold (COGS)
Gross Margins = Gross Profits / Revenues

Here are 3 lessons you can incorporate into your operational planning and your business reviews:

Lesson 1: Gross margins can provide some insight into your PRICING POWER

If your gross margins are jumping up and down from quarter to quarter, you haven’t demonstrated that you have pricing power. When your pricing is more consistent across your customer base, you have a higher degree of confidence about the VALUE you are providing to your customers. Even when you have high gross margins, high variability over time might indicate a lack of pricing power. This not only makes fundraising more challenging, but it also slows your revenue growth (because every contract becomes customizable).

Lesson 2: Gross margins can provide some insight into your controllable COGS.

I have worked at a couple of fintech companies, and I’ve seen firsthand that non-controllable input costs often limit the financial scale of the business. For example, many financial data companies selling into startups may provide attractive entry-level pricing. The resulting gross margins for your startup end up declining as your company gets bigger and the vendor exerts their supplier power over you.

Lesson 3: Higher gross margins aren’t always better.

You have to have a strong understanding of your competitive differentiation. In some instances, you may believe that delighting your customers and gaining customer insights is your competitive differentiator. Your long-term strategy and financial model should account for higher ROI in the long run (considering retention, pricing power, brand reputation, and customer insights), so you have the confidence to invest heavily in customer support (which increases your COGS).

ASIDE
Gross margins aren’t profits. Gross margins aren’t cash flows. Companies with higher gross margins don’t necessarily get higher valuations, even in the public markets. This is only one piece of the puzzle.