Staying capital-efficient within hardware
Background: Almost three years ago I wrote about a thesis I was exploring around hardware. The TL;DR version — 1) despite the terrific set of new resources and accelerants that have simplified the hardware business building process, it is still terrifically difficult 2) hardware is still capital-intensive and arguably a less efficient place for venture capital dollars 3) there is a growing set of software businesses being built in and around hardware businesses to enable the overall ecosystem that is perhaps a better risk-adjusted investment strategy. This essay reframes these ideas and highlights a few cos in the category that have surfaced.
Startups are often synonymous with risk. They’re started by founders with sometimes unrealistic expectations of positive outcomes and who have little desire or ability to weigh true probabilities of failure. If they did, they would likely be deterred from the visions they’ve laid out. By sharp contrast, the professional investors who examine whether to come along for the ride stay keenly aware of downside. Different sectors and models are subject to varying types of risk and in some cases form the basis by which certain investors choose to participate. For example, some risks are more intrinsic to the nature of the model, as seen in online marketplaces, where a network effect is your worst enemy long before it can be your best friend. Some investors find this or other specific styles of risk to be too large a threat and look elsewhere for outsized opportunities. One constraint and risk relevant to all businesses, however, is capital-efficiency.
In short, capital-efficiency is a relative measure of the capital required to initially build and scale a business. If a business can create an initial working prototype that secures a level of market validation for a relatively small sum, the business can be considered capital-efficient. The more capital required to build and sustain a business, the more risky it becomes to support such a venture (as its evidence of success can only be determined after significant capital has already been spent). Conventional wisdom dictates that if the upside achievable in any given venture is similar, better to invest a smaller allocation of your investment pool and thereby minimize your exposure.
What’s changed?
Given the precipitous (and well-documented) fall of traditional startup costs over the last few years, the issue of capital-efficiency has become a smaller slice of investment committee discussions. It’s not that the cost structure of portfolio companies isn’t a very serious consideration, but more the idea that “software” businesses are generally considered quite cheap relative to their “hardware” counterparts. But.. capital-efficiency is an investor term, not a founder term. Chris Dixon illustrated this dichotomy well by contrasting the “finance lens” from the “product lens”. VCs must look through the finance lens, while entrepreneurs, though they can’t completely ignore the finance lens, need mostly be concerned with product.
So while the costs around building a hardware business are still considerable (but falling), “makers” everywhere, are now empowered. A powerful confluence of factors (also now well-documented) have given the space resurgence and fed founders a resolve around pursuing these paths over the next web or app phenomenon. Everything from open-source hardware initiatives and communities like Arduino, Raspberry Pi, Sparkfun, Adafruit to crowdfunding platforms affording hardware tinkerers the ability to assess demand and raise proof-of-concept-money (that professional investors may still be reticent to deploy) to specialized accelerator programs (Bolt, Lemnos Labs, Haxlr8r).
For the most part, this entire backdrop has been covered many times. What I’ve found most interesting among the debates is that it has been a fairly binary discussion around whether we can rely on true, consistent growth in the category — you either accept hardware in all of its capital inefficiencies (to say nothing of the operational complexity) and believe that today’s climate is different OR you continue to believe that you’re better off focusing on software’s feasting of the world (“Hardware is hard”). While I agree with the former, I also see a significant and largely under-discussed category of businesses that is being formed — around — hardware. These are mostly software businesses: marketplaces, tools/services, curated commerce, infrastructure — that are all flourishing to support this maker movement.
This pocket of opportunity is unique in that it satisfies capital efficiency requirements of most investors under the traditional software paradigm, but also provides a meaningful way to participate in the growing hardware revival. Kickstarter in some ways satisfies this definition, though it certainly has not made hardware its exclusive focus (in fact, it has imposed changes over the yrs making it harder for product concepts to raise). Investors in Kickstarter will benefit to a small extent from successful hardware ideas without having to invest directly into the businesses themselves. There are also growing software platforms that sit at the front and back of the Kickstarter life-cycle participating in a similar way. There are those that enable founders to build the prototype that get them Kickstarter-ready, and those that help fuel manufacturing and sales once they’ve achieved success post-Kickstarter. Not to mention the tools and services that will surely surface to allow all of these disparate devices to seamlessly communicate, finally creating the online-to-offline bridge we’ve heard so much about. My sense is that these areas — infrastructure tools that help hardware founders operate and platforms that help them reach targeted customers — will become a more distinct category of focus going forward.
The hardware products themselves are rightfully getting the most attention. These tangible experiences are clearly the most exciting fruits of the movement. Though equally as important will be the market that will be built around and in service of them. From an investor perspective, it may just be where the best risk-adjusted returns lie.
Cos. that fall within the thesis —
- Ayla Networks — cloud-based application enablement platform for IoT
- TicTrac — digital health and insights platform for wearables
- Upverter — EDA software technology
- IFTTT — digital switchboard to automate actions across services
- Tindie — hardware / maker marketplace + community
- Shapeways — 3D printing service and marketplace
- ShopLocket (acq by PCH) — payment service for hardware pre-orders
- Noam — hardware messaging protocol and prototyping framework
- Inventables — hardware storefront for designers
- Maker’s Row — marketplace connecting makers with factories
- Buddy — cloud data management system for IoT
- Grand St (Acq by Etsy) — curated hardware marketplace
- Electric Imp — smart device services platform
- Canopy — open-source cloud platform for IoT
- ShipWire (Acq by Ingram Micro)— enterprise logistics / fulfillment
- Plethora — automated CNC services
- Transfix — automated logistics technology for freight shipping
- Interface.io — authoring tool to enable non-programmers to custom experiences for IoT
- Octopart — search engine for electronic components and industrial parts
- BackerKit — fulfillment service of crowdfunding platforms
- Spark.io — IoT dev tools and cloud software
