Startup Survival: How to Get Past the 3-Year Hump

Crumbs Bake Shop -- No. 422 on the 2010 Inc. 500 list of the fastest growing companies in the U.S. -- charges $4.50 for a single Peanut Butter Cup Signature cupcake. What do you think the bakery pays for the flour, sugar and Skippy?

In an environment where most businesses never see their third birthday, Crumbs is thriving in part because of its fat gross margin. Whether you're starting a lemonade stand or the next Groupon, arguably the single most important predictor of your future success is what you pay for the stuff you need to make your final product.

Here's why gross margin is the key to surviving your first three years in business:

1. Cash preservation
When you're bootstrapping a start-up, cash is oxygen, and if you're spending all your money on buying what you sell, you increase the odds that you'll run out of cash before your business gets off the ground. I try to avoid businesses where what they sell costs more than 30 percent of what they end up charging for it.

2. More money for sales and marketing
Having a fat margin gives you more money to invest in acquiring customers. Whatever I think it will cost me to get a new customer, I now triple it. I learned this the hard way. When I first left college, I had an idea for a new magazine. I had saved up $17,000 through various business endeavours growing up, and I blew $10,000 on producing the first issue. I was left with only $7,000 to get subscribers. I thought if I made a great product, people would flock to it. My goal was to get 10,000 subscribers in the first year. I blew through my last $7,000 and amassed a grand total of 112 subscribers.

If you're spending all of your cash on raw material, you won't have enough left to spend on marketing.

3. More profits
The bigger your gross margin is, the more of it will flow to the bottom line. The more profit you make, the more money you'll have to reinvest in people, rent, etc., further separating you from your competitors.

4. Wiggle room
I'm not big on estimating jobs to the penny, enforcing rigid employee expense policies and imposing two-drink maximums at holiday parties. I prefer to keep things a little more fluid so I don't have to obsess over where every penny is in my business. If you have a healthy gross margin, you'll have plenty of padding in your financials, allowing you to focus on building a great company instead of expending your energy nitpicking.

Now, here's how to increase your gross margin:
The secret to fattening your gross margin is differentiating your product so it doesn't become a commodity. There is an expensive way and a cheap way to differentiate your brand.

The expensive way is to slug it out through advertising in a Coke vs. Pepsi-like battle for the mind of the consumer. If you win, you can charge obscene margins. Tiffany's pays about the same for its diamonds as your local jeweller does but charges you three times as much for the privilege of presenting your gift in the little blue box.

The cheap way of raising your gross margin is to differentiate your business by redefining your company as the only player in a specific niche instead of a small fish in an ocean of larger competitors.

For example, when Crumbs Bake Shop started out on the Upper West Side of Manhattan, it was just another generic bake shop destined for a business life of mediocrity punctuated by peddling undifferentiated bread products and realizing skinny margins.

Then it found cupcakes.

Now it distinguishes itself by selling the world's best cupcake. It leads with cupcakes, reserves the best merchandising space for cupcakes and displays cupcakes above the fold on its website. Ten years ago, nobody would have dared start an entire company around cupcakes, but having the best cupcakes in the world made Crumbs a unique bakery, and it was rewarded by raving customer evangelists and the right to charge a premium. Charging $4.50 for flour, water, and a wad of peanut butter gives Crumbs the extra money to invest in people, real estate and marketing, which all serve to grow and differentiate the company further. It's a virtuous cycle that starts with a healthy gross margin.

Are you paying too much to make what you sell?

(photo courtesy of Flickr/soapylovedeb)
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