As more tech IPO’s tank, it’s clear that public market investors are not reacting well to the potential of the hottest companies in tech today. They want real margins that can sustain businesses in the long run.

Fred Wilson wrote an excellent piece on this recently, and cited a post I’ve seen referred to often, All Revenue is Not Created Equal. From the post is an excellent description of how valuation should differ based on the margins in a business:

There is a huge difference between companies with high gross margins and those with lower gross margins. Using the DCF framework, you cannot generate much cash from a revenue stream that is saddled with large, variable costs. As a result, lower gross margin companies will trade a highly discounted price/revenue multiples. All things being equal, gross margin percentage should have a direct impact on price/revenue multiple, as there will obviously be more gross margin dollars to contribute to free cash flow. Journalists who quickly apply 10x multiples to all private companies should at the very least consider gross margin levels in their analysis.”

Another great post on this topic, that I’ve referred to in the past as well, is Tren Wilson’s post, Gross Margin for Fun and Profit.