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Gross Margins and Markets that Scale

I'm writing this post to those who aren't founders or business strategists and just getting started in their careers.

Why is software such a great business? It's all about the margins. Really gross margin.

First, what are margins? Margins are basically the revenue you make less the costs to achieve those revenues. There are two important margins in business: Gross Margin and Profit Margin.

Gross Margin is the direct costs to produce and sell a product. Usually it is revenue minus either or both cost of goods sold and cost of sales. In software, Cost of Sales is usually the larger of the two.

Profit Margin is revenue minus all expenses tied to the business, including operating expenses and research and development. Most software companies have substantial development costs.

In software, Gross Margins are often great whereas Profit Margins are typically negative as the company continually invests in product development. Large and mature software companies have positive profit margins and generate free cash flows used to buy back stock or pay dividends to reward shareholders.

In software, if you are selling a product that is truly software and not tied to a service, the gross margins are great. Why? Software has a unique characteristic whereby you can write one piece of useful software and sell it many times at low marginal cost. Take Microsoft in the 80's and 90's. Why did that company grow to be one of the largest in the world? Sure, they were able to capture a market, but that isn't enough. The underlying economics of the business were astounding. While it takes a team to make great software, once the software is written it can be sold infinite times at merely the cost of distribution. The cost of making the software is fixed but the gross margin of the software (the amount you sell each license minus the cost of producing each copy) is large, and can quickly cover the development costs and then generate free cash flows.  Those large cash flows make the business successful, allows for further development of new product and returns value to the investors.

Way back, the first such business with low marginal costs was printing or publishing. After the printing press was developed and economies industrialized, publishing became a dominant business. While there were many successful business during the period of industrialization, few had the economics of publishing, making that industry the software industry equivalent of yesteryear.

Today, there are many other businesses that operate this way.  The entertainment industry, including movies, music and, yes, still publishing (though this industry is changing rapidly) have similar economics. Pharmaceuticals also have the same property of low marginal costs.

Software has been a more attractive and lucrative sector due to its versatility and predictability. Making software and developing a go to market for selling that software is more programmatic and predictable than Pharma or Entertainment.

In the next decade look for the Entertainment industry and Pharmaceutical industry to get more programmatic. When there are fewer failures, profits in these sectors will sky rocket. Perhaps, not as emphatically as software, but dramatically none-the-less. It will ultimately besoftware, though, that will enable this transformation.

Pharmaceuticals will have a broader, more lucrative sector than entertainment, which will be a pro when new treatments can be developed predictably. The Entertainment sector's IP has longer longevity, both due to copyright law but also due to the timeless nature of some content. An entertainment company that has dialed in content generation and has created enduring content will have a slow but monumental build to long term profits, whereas software must constantly iterate it's IP to fend of obsolescence, eating into long term proifit margin (Profit Margin, distinct from Gross Margin, being the take home cash less all production and operating costs).

Make it once, sell it at low cost lots of times is a great business to be in.

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