What are COGS in VC?

In venture capital (VC), the traditional financial metric of Cost of Goods Sold (COGS) plays a somewhat different role compared to its usage in established industries. COGS, commonly used in accounting and financial analysis, refers to the direct costs attributable to the production of goods sold by a company. This typically includes materials, labor, and manufacturing overhead directly tied to production. However, in the context of VC, startups, and high-growth companies, COGS serves as a key factor in understanding the business's unit economics, scalability, and profitability potential.

What is COGS?

COGS represents the direct costs associated with producing the products or services that a company sells. In an early-stage company, COGS may include the following:

• Raw materials for physical goods (e.g., components used in manufacturing).
• Direct labor costs, such as wages for workers assembling products or providing services.
• Production overhead, such as utilities and factory maintenance.
• For service-based or software companies, hosting costs, third-party software licenses, and certain operational support expenses may fall under COGS.

For SaaS or tech-enabled businesses, the specific components of COGS can vary significantly depending on the nature of the company.

COGS in Venture Capital Analysis

Venture capitalists focus on high-growth startups, which often prioritize market share, innovation, and customer acquisition over immediate profitability. As a result, while gross margin (Revenue - COGS) is important, startups in VC portfolios might have less mature financial metrics compared to established companies. However, understanding COGS in these early stages is critical for multiple reasons:

1. Assessing Unit Economics

COGS is essential in determining a company's unit economics, which refers to the revenue and costs associated with a single unit of a product or service. For example, in a SaaS startup, the unit could be a subscription sold to a customer. By understanding COGS, VCs can calculate gross margin per unit, which shows the profitability before other costs like marketing and R&D are considered.

• Gross margin = (Revenue - COGS) / Revenue
• A high gross margin signals strong potential for scaling, while a low margin indicates the need for optimization of costs or pricing adjustments.

2. Scalability

In VC, scalability is a primary concern. Startups with low COGS relative to revenue growth demonstrate the ability to improve profitability as they scale. For instance, software companies often have low variable COGS because the cost of delivering additional software licenses or cloud services is minimal. As such, their gross margins improve significantly as revenue grows, making them attractive to investors.

Conversely, a hardware startup with high COGS might struggle with margin improvement unless they find ways to optimize production or increase prices. VCs pay attention to whether the company's COGS will decline with economies of scale, which would indicate better long-term profitability.

3. Cash Flow Management

Early-stage companies often burn cash as they grow, and COGS plays a crucial role in understanding how quickly a company is consuming capital. A company with high COGS and negative gross margins may face significant challenges, requiring more capital infusions. Investors need to know how much runway a company has before it needs additional funding. By analyzing COGS, VCs can estimate how quickly the company can improve margins and become cash-flow positive.

4. Pricing and Market Positioning

Startups often experiment with pricing strategies to optimize growth and revenue. VCs use COGS data to evaluate whether a company’s pricing model is sustainable or if it’s overly dependent on low pricing to drive customer acquisition. A company with high COGS but low pricing will struggle to generate sufficient gross margin, whereas a company with a balance between its pricing and COGS is better positioned for long-term success.

COGS in Different Startup Sectors

COGS varies significantly across different industries, so VCs analyze it differently depending on the sector:

• Software and SaaS: Typically, these companies have low COGS, primarily comprising server hosting, third-party software licenses, and customer support. The focus here is on minimizing these costs while scaling subscriptions, driving high gross margins.
• E-commerce: For e-commerce startups, COGS includes procurement of goods, shipping, and warehousing costs. Margins are often thinner, so VCs closely scrutinize logistics and fulfillment efficiencies to understand how the startup can improve profitability as it scales.
• Hardware: Hardware startups have relatively high COGS due to the costs of raw materials and manufacturing. VCs look for companies with unique IP or manufacturing processes that can reduce production costs over time.
• Direct-to-Consumer (D2C): Like e-commerce, D2C startups face COGS challenges related to production and shipping. However, a strong brand or proprietary product can justify higher pricing and better margins. VCs evaluate how quickly these startups can optimize production to achieve sustainable unit economics.

Conclusion

COGS is a critical financial metric for venture capitalists when evaluating potential investments, even though it is often overshadowed by growth metrics and customer acquisition strategies. Understanding COGS allows VCs to assess a startup’s gross margins, scalability, and profitability potential, all of which are essential in determining whether the company can achieve sustainable long-term growth. For startups, keeping a close eye on COGS and working to optimize it is key to attracting VC investment and achieving lasting success in the market.