One of my partners often quotes Henry Truman: “There is nothing new in the world except the history you do not know.” And this quote is more true in the history of venture capital than perhaps anywhere else.
The year is 2013…and hardware is cool again. Software might be eating the world, but its finishing dessert. Creative entrepreneurs are flocking to the hardware sector en masse, with hardware accelerators and incubators popping up all over the country and overflowing with eager applicants. The mainstream media is brimming with videos of cool new gadgets, and VCs are taking off their hoodies to blog about hardware (myself included). Hipsters are now proud to show off not the coolest app they downloaded, but the latest gizmo they backed on Kickstarter, or the newest bracelet that emerged from a 3D printer.
But that’s just noise. Here’s what important: (a) solving most interesting problems is what drives the best entrepreneurs, (b) a hardware component is often the most important element to solving meaningful problems in the world, and (c) investors flock to sectors where the best entrepreneurs go. The emerging hardware revolution is partly based on a realization by entrepreneurs (not investors) that we can’t just tweet our way out of the important problems that face humanity (with all due respect to Twitter).
Having been involved in hardware startups as an entrepreneur and an investor for 10+ years, it is fantastic to see this attention return to the sector. VCs have made bushels of profits in the past from investing in hardware startups (from Apple to the semiconductor revolution and the telecom bubble of late ‘90s), and the future should not be any different. I welcome and love the focus on this sector and think it will result in major breakthroughs and great, lasting companies getting built over the next 5-10 years. This sector has felt a bit deprived of attention, especially since 2008. But now with some of the smartest people in the startup world focused on the space, many companies will reach bigger milestones faster.
Hardware startups can be both enterprise focused or consumer oriented. Major infrastructure, electromechanical tools, power generation/transmission/storage devices, robotics, medical devices, etc would all be classified as hardware companies. The renewed interest from today’s entrepreneurs comes from the belief that the confluence of distributed computing power, open source hardware and additive manufacturing have reduced the cost of building hardware so much that industrial grade solutions can now be built with consumer quality aesthetics and UI. What was once deemed possible only with expensive custom built machinery, can now be done with much simpler devices by taking advantage of the available computational resources. And not only that, when the hardware/software resurgence meets a socially connected and networked ecosystem, new solutions emerge that otherwise were not possible.
Excitement aside, in the world of building and backing companies, there is such a thing as being too early – or bringing too little to the party. Investors often want to be cheerleaders, but we can be more valuable pointing out challenges that others faced in advance so you can avoid them.
Below are some observations from my experience with hardware startups. Successful founders have been aware of that and managed through them artfully:
Teams – The heart and soul of any startup. Hardware startups tend to be highly interdisciplinary. A single MBA won’t cut it. More than likely you need to hire a mechanical engineer, an electrical engineer, a design engineer, and production specialist on your team to get even the most simple electromechanical devices off the ground. Hardware engineers don’t jump from firm to firm easily and hence top talent can be more difficult to recruit. The best teams I’ve seen in action usually had a handful of people with backgrounds in industry on the core team. Great CEOs surround themselves with amazing people, and that is especially true in hardware startups. It is a lesser known fact that scientific advisors can also play an important role in attracting strong talent. Entrepreneurs can use all the help they get. For example Naimish Patel at Gridco (disclosure: a Lux Capital portfolio company) has assembled a veteran team that boasts the credibility but not the culture from a multi-billion dollar electric grid industry that hasn’t changed much in 100 years.
Technologies – Hardware technologies are hard, interdisciplinary, and often filled with surprises. Hiccups, delays, and supply chain challenges are fairly common, and mistakes can be costly. Unless the hardware is really just a simple widget, an investor will be carrying technical risk in the company alongside any business vulnerabilities that always exist. New ventures need to remove technical risks upfront so the task of building a business becomes unhinged from “will this even work?”.
Design – People have come to expect brilliant and well thought through design not just in software, but also in hardware. Maybe Steve Jobs is to blame for raising the bar so high, but it’s a fantastic thing to have happened in the hardware world. Even a mass spectrometer designer now has to remember that the user is likely carrying a beautifully design smart phone in his/her pocket. Design philosophies can be fundamental to how a hardware product is engineered, built, manufactured, and expected to be used by customers. And design is very hard to get right, and extremely hard to change when the gears are already in motion. Design for the right customer, with the right usage patterns in mind, and plan refresh cycles that make sense for the industry. Tesla, Nest, Fitbit are some examples of hardware products where design was a key factor in early customer purchase decisions. For the upstarts, hardware accelerators like Lemnos Labs, GreenStart, Highway 1, Bolt.io, Lab IX, Y-Combinator and others are providing much needed design advice to hardware engineers.
Data – Barely a day goes by without meeting a hardware entrepreneur who is convinced they are building a big data company and the hardware is just necessary evil to be dealt with. While I could not emphasize the importance of data and analytics to drive actionable intelligence for long term value creation in a business, such a negative attitude towards hardware development can hurt the design and development of world class products. Hardware products tend to lead with one or a very select few killer apps, and data/analytics often enable evolution of a product into a platform for future revenue streams. Don’t try to be everything to everyone, but be a perfect solution for your target customer.
Incumbents – In many sectors, incumbents have deployed Porter’s Five Forces excessively to build fences to keep entrants out. Hardware incumbents move slowly, but are self-aware, often building protective provisions in customer engagements to also reduce the pace of change. Longer term contracts, supply chain bottlenecks, technology cross-licenses, and global salesforces allow them to “own” middle management in large corporations. In such situations, seek out customers looking for an edge to differentiate themselves in the field, and working with them to bring innovations to market faster. For example Toyota, Ford, GM may be big customers, but I would look towards smaller manufacturers from developing countries if I wanted to introduce new automotive-related technologies.
Intellectual property – Perhaps unlike software, hardware IP is not only easier to identify, but it’s built in multiple layers which can get quite confusing (often by design) quite fast. Large companies often cross-license hundreds (if not thousands) of patents and can frequently use IP to prevent innovation from taking their cheese. The best recourse is to take IP seriously, protect it aggressively, and to provide your customer with such a great and unique product that they are motivated to help protect you. For example Kymeta (disclosure: a Lux Capital portfolio company) is aggressively protecting its IP in novel satellite communications hardware because their technical innovation is a fundamental disruption in the market.
Regulatory barriers – Depending on the product, this could be a major issue to be dealt with even before your product’s beta-launch. I have seen at least one promising company’s life come to an early end because they mismanaged a nuanced regulatory landscape. Hire experts, drill them to get them outside of their comfort zone, and while remaining willing to bend rules, proceed with caution. Again, some of the most successful CEOs have always shown me a Plan B, C, and D when it came to regulatory matters. For example, as an investor Board member at UAV innovator CyPhy, I kept a very close eye on the regulatory changes affecting UAVs and flying robots, because they had a major impact on commercial opportunities available to the company. Of course, taking calculated risks on the regulatory landscape changing a particular way can sometimes be a very successful strategy. Or you can hope to be very lucky.
Manufacturing – A few decades ago the buzzword was “economies of scale”. You produced something once and replicated millions of times at scale to continuously squeeze inefficiencies out of the system and reduce costs. A former colleague termed the current phenomenon we see around us as “economies of un-scale”. Things can be produced at small quantities (using 3D printing for example) and then scaled in lower cost manufacturing centers. That said, manufacturing remains a major barrier to most hardware companies. Its expensive, mistakes are costly, doing it abroad could compromise technology and IP. While design cycles can be rapid, manufacturing supply chains are not as agile as we want them to be. I am not aware of successful hardware companies that did not have a credible plan of developing manufacturing capabilities close to home before embarking on a foreign adventure. Shapeways (disclosure: a Lux Capital portfolio company) is serving a global market for 3D printed products with distributed manufacturing centers. A single low-cost manufacturing plant wasn’t the right answer.
Value-chain/Distribution – Before making a hardware-related investment, I always lay out the value chain to understand who controls pinch points and can capture margin. In hardware startups, distribution is tricky and hard to do right when you have little leverage. Are there vendors in the supply chain who can truly obliterate a company’s best laid plans? One of my portfolio companies once burned through 3 months of cash (millions of dollars) because a certain specialized testing facility was just not available to test and certify their product. Whether the hardware is enterprise or consumer focused, direct marketing and direct contact with the end customer is incredibly important. A company must be able to identify exactly who benefits from their product and get buy-in at the highest levels. Fortunately for consumer devices, new channels are becoming available to provide initial customer feedback, quickly. Kickstarter, Indiegogo, Etsy, Ebay, others provide unique opportunities for early customer engagement that did not exist a few years ago.
Margins – Hardware margins are generally lower than those found in software. Sometimes these margins can be incredibly low, especially when producing in low volumes. Managing capital requirements through the optimal scale-up plans is critical to survive the growth phase. Not to mention the increased cash needs if you start getting returns and building up inventory. Hardware businesses must have strong VPs of Engineering and CFOs who are not just winging it.
Fundraising – Hardware startups may be in vogue now, but times and preferences change. Investors will need to have more patience and a stronger gut to deal with the ebbs and flows of the hardware business. These are not “bets” and “plays” – hardware startups need investors who understand why and how a company can manage through difficult circumstances, and bring strategic relationships to help in the process. VCs of all shape and sizes are right now seeding and investing hardware startups, but smart investors would be wise to partner with investors who live and breathe the hardware ecosystem. I advise hardware startups to always be ready to raise capital, if it is available at a good price – not only to prepare for hard times, but to also be prepared to run fast when opportunity presents itself. At Lux Capital, we focus primarily on hard technologies, but frequently partner with non-hardware firms that bring complimentary knowledge and networks to the table.
Exits – While entrepreneurs get teary-eyed thinking of the success Steve Jobs, Elon Musk and Tony Fadell have had in the hardware world, the cold, hard reality is that exits take longer, are more often evaluated on EBITDA multiples, and typical buyers lack the equity currency to pay Instagram-like premiums. Expect to hear the infamous “exit” question from investors. Even when they don’t ask, you should assume it’s something they’re considering. So you might as well give it some thought. Know the comps, understand what drove value creation, and be on top of relevant metrics that to your company. The upside? Because hardware startups in any space are harder to build, there is less competition and fewer me-too products. If your product solves a meaningful problem, expect a valuable return on time and capital for financial investors and entrepreneurs.
Looking at my notes from the last few weeks alone, I have met companies in following spaces: UAVs, satellites, high throughput DNA production, terrestrial robotics, hardware for retail analytics, personal health, quantified self, smart phone accessories, hardware/software toys for 21st century children, Internet of Things, computational imaging, 3D scanning and printing, virtual reality hardware, hardware for retail analytics, healthcare accessories, low cost diagnostics, remote sensing, portable medical devices/analyzers, open source hardware and others…this is just the beginning. The hardware tsunami is now upon us. My partners and I at Lux Capital are eager to help great entrepreneurs build their visions into successful companies.