During 2020, Tesla’s market cap increased by over $500 billion. That means it’s worth roughly as much as the combined market cap of the next nine largest car companies on the planet.
Also during 2020, Apple became the first American company to reach a market cap of $2 trillion. That means they’ve seen a two-fold increase in their valuation, having hit $1 trillion in 2018, in just over 24 months.
With two huge wins for industry-leading hardware companies, founders in the hardware space should be encouraged, right? In reality, startups that involve hardware can have the hardest time finding seed capital.
Hardware can be seen as a deterrent for venture capitalist, who might have already experienced its downfalls first hand. It can be frustrating as a founder to watch Tesla and Apple soar without seeing any VC interest in your own operation.
Here are some non-obvious factors that might be holding you back.
Due Diligence is Different
Over the last few years, new entrants have flocked to the hardware space. Alongside the newcomers, there are many zombie companies that are still in existence and impossible to liquidate. In order to gain a VC’s trust, you would need ample demonstration that your product stands out in a crowded industry. The only proof is thorough proof; proper due diligence in the hardware space requires prospective VCs to understand your manufacturing, production, and fulfillment processes.
It’s a huge time commitment (not to mention headache) for a VC to try to wrap their head around your entire supply chain. It makes due diligence nightmarish, and it’s one reason VCs might be more hesitant to engage.
Inflexibility is a COVID-Era No-Go
Compared to the flexibility of software, hardware makes pivots incredibly complicated. Mistakes are hard to fix, and development methods are hard to test. It’s therefore more difficult for startups to absorb feedback, recalibrate, and enact improvements. VCs can have the sense that once the founder pushes that big green button to start production, the rest is out of their hands. Not only does this stress the VC-founder relationship, it often constitutes a larger risk in the VCs mind, and adding a hardware company to their portfolio starts to seem all the more complicated.
The IP Quicksand
A lot of hardware companies experience the ‘IP Quicksand’ phase. Intellectual property can be hard to claim as a startup, and larger companies with more resources can levy frivolous lawsuits over patents, slowing down a founder’s journey or stopping it completely. Ideally, a VC would want a form of confidence in their due diligence process that the startup’s IP would be protected. From a founder’s point of view, that’s often easier said than done.
Margins are a Four-Letter Word
Multiple factors lead to gross margins getting crushed in hardware startups. Distributor’s cost, transportation costs, installation costs, maintenance costs—this is just the start of the list. And unlike software companies that can support subscription models, hardware startups can’t rely on consistent sales. They’re at the whim of a changing market, which makes competitive pricing a must. Competitively priced, the above costs add up, and gross margins suffer almost every time.
The Problem With Being One in a Million
Most prospective venture capitalists understand what it takes for a founder to succeed under the pressures of the industry.
Steve Jobs and Elon Musk are household names, but even for those history-making minds, it wasn’t a straight-line. Jobs was fired from his own company, and Musk is no stranger to bankruptcy.
Visionary founders win in the hardware space. As a prospective VC, it can be hard to assess who you’re dealing with, and even harder to assess that kind of risk.
Where I’ve Put My Trust and Where I’m Looking Next
Despite all the above challenges, a good fit is a good fit. Prominent founders will find their investors, but it will certainly take longer than it might in other sectors. Personally, I invested in several incredible hardware startups last year, companies that I believe are perfectly positioned for the new problems that will come with our new normal.
Galiano Tiramani, Angad Daryani, Johnathan Nydell, Dorrian Porter, and Ella Jade are the founders with whom I’ve placed my trust. I can’t wait to watch them on their journeys; I know there are big things to come.
I’m leaning fully into software toward 2021. The valuation arbitrage that comes with early stage investments in high-caliber software startups is hard to understate. Currently, public software multiples have skyrocketed—they sat around 25x annual recurring revenue in the last quarter of 2020.
Founders in the hardware space don’t need to be hopeless. They just need to understand the roadblocks that might stand in their way. My advice to founders in the hardware space would be to streamline your due diligence processes as much as humanly possible. Make it as easy as it can be for a VC to peek behind the curtain, and show that you understand the areas of risk that they’re looking for. Whatever you can do in the way of transparency, demonstration, and quantification is a huge help when it comes to furthering your leads.
Last, I always recommend that founders in any sector seek more capital than they initially think they might need. If a founder in the hardware space is having trouble attracting VC interest, they might be tempted to lower their ask. But it’s been my first-hand experience that we’re conservative by nature—the journey will always end up taking longer and being more expensive than you planned for. Having twelve or eighteen months of cash reserves in the bank can make all the difference.
Expect obstacles, maintain your ask, and try to keep team moral high as you encounter the inevitable challenges of seeking capital in the hardware space.