The 6 Margins/Ratios you need to define your Moat

Most Startup projections I have seen are both too detailed and not detailed enough. They contain a Balance Sheet, Cash Flow Statement, and Profit and Loss Statement and describe in detail what the income and costs will be in the next three to five years. These models are complicated to fill out and prone to errors. Far too often, there is an underestimation of overhead costs, resulting in unrealistic cash flow streams.

For me, there are two financial models for start-ups. The first is for the first 12 to 24 months and should be detailed. Most start-ups have a runway of 12-24 months with fairly predictable costs and unpredictable income streams. This model is used to determine if and when the money runs out. These models should be relatively detailed and help the users understand how much and when they need to raise.

For investment purposes, it is far more relevant to understand the value drivers of the company. What is the gross margin when the company produces at scale, and do you need cash to grow, or will your customers fund your business? You only need a simple model to describe the key value drivers, along with a rough revenue estimate (sanity-checked against the Market size) to see if something is investable.

My financial model accommodates a simplified, detailed, or hybrid approach, as every investor is unique.

The Moat to defend profitability

Every startup needs to decide how they are going to differentiate itself from its competitors and create an "Economic Moat". This metaphor is from Medieval times, where moats were used to protect castles from invaders. There are different kinds of Moats. Below are three that are most relevant to start-ups.

• Low cost. The Startup has found a clever way to be more cost-effective than the competition.

• Intellectual Property. The company has invented something new that is difficult for competitors to replicate.

• Brand. The founders have found a way to create loyalty from their customers. This will buy the Startup's product instead of a similar product from a competitor.

Other Moats, such as network effects and capital expenditure intensity, may come into play once the company is able to attract significant funding or shows strong organic growth.

Six key ratios that describe a company

There are six key margins and ratios that are highly relevant in helping to understand how the startup will defend its moat and create a return for investors.

▪️ Gross Margin. The higher the better. The fewer competitors, the less pressure on the Gross Margin. In a highly competitive market, there will be significant pressure on the gross margin. In competitive markets, the companies with the lowest cost base will be the winners.

▪️ Research & Development/Sales. A high ratio will allow start-ups to create an R&D moat. This is normally the easiest way for a Startup to grow into a profitable company.

▪️ SG&A (Selling, General, and Administrative)/Sales. Companies competing on brand/selling to B2C must spend on marketing to create a brand Moat. A Startup does not want to spend massive amounts of money to kick-start sales, so the product and/or marketing strategy need to be something fresh, unique and or exciting to create Hype.

▪️ Net Capex/Sales. Capital-intensive businesses require capital to expand (e.g., new shops, factories). The lower the better, although it does provide a certain Moat.

▪️ Non-Cash Working Capital/Sales. The lower, the better. If negative, customers and/or suppliers fund the company's growth. However, it does make the company slightly riskier, as it can also be a sign of distress. 

▪️ Free cash Flow Margin. For an investor, this is the most relevant margin as it indicates the amount of excess cash available. This is the cash not needed by the company to grow and can be returned to the investors. It enables the calculation of a company's value and determines whether an investment is viable or not.

Why do moats matter?

My model helps founders calculate the margins and ratios based on the products/services they sell. It also allows for sanity checking the Startups' assumptions versus industry and peer group averages. If your moat is your Brand, but you only spend 10% of your revenue on sales and marketing, the investment proposal is on shaky ground, especially if competitors spend 20-30% of their revenue.

In large and rapidly growing markets, competition will also increase rapidly, creating margin pressure, especially for companies with narrow economic moats. Every startup should have a good understanding of

• What is the Moat?

• How do you defend the Moat?

• How much money do I expect to have left over after I spend enough to defend my Moat?

• Does this excess cash create a high enough risk-adjusted return for an investor?

Most VCs only invest in large, growing markets. Several investors made the mistake of investing in companies with too narrow a Moat; it is unlikely that they will repeat this error in the coming years. Startups that were easily funded a few years ago will struggle even if money gets less tight.

For angel investors, investing in niche markets with less competition may be an attractive option. There will be less competition, and therefore less defending of the Moat is needed.