What sort of Hardware Startup are You?
- in Business Models
Everybody seems to agree that it’s never been easier to start a hardware company than it is today. After years of being eclipsed by software and services, hardware is sexy again. However, that doesn’t mean it’s any easier to be successful. Over the past few years I’ve mentored a number of startups and realised that their expectations often don’t match the reality of what they are. That doesn’t mean they can’t succeed, but it does mean that they’re probably wasting effort trying to be the wrong sort of company. There are lots of different models which can be successful, but a company is most likely to work if it knows where it is going and what it wants to be.
Hence this article. If you’re contemplating a hardware startup, or have already taken the first steps, you need to think seriously about what you want to be doing in five or ten years’ time and how you’re going to get there. It’s every bit as important as getting your product out. Recognising that gives you the best chance of achieving your goal and minimises the risk to your investors and employees – considerations which should be at the top of your priority list. It still won’t be easy, but if you can reduce some unnecessary pain by getting the right model, it will certainly be a lot less stressful.
Before describing the different types of startup business, there are two basics which every startup needs to understand. These are as important as your product, arguably more so, but far too often they’re give little more than lip service.
Let’s start with investment. There’s a very basic fact that a lot of startups don’t seem to understand, which is that when someone puts money into your business they expect to get something back. You need to respect that fact. It may be products they’ve trusted you to deliver if they’ve paid upfront, which you need to deliver. But normally, if they’ve put in cash, they’ll want it back within four to five years, hopefully with interest. Even if they’ve just put in time, it’s normally with some expectation of return. So whenever you’re soliciting money or resources to fund your startup, whether it’s from friends, parents, credit cards, customers, bank loans, crowdfunding, angels or VCs, your business plan needs to show how and when you will repay it. You have to factor that in, because ultimately what kills most startups is cash flow. Either because funds run out before your product generates enough revenue to keep things going, or because investors pull the plug because they see no prospect of getting any return on their investment. If you can’t see a solid way to pay them back, you don’t have a viable business plan. Go back and try again.
Burn rate is how much it costs to keep you company alive. In other words, how much money you will spend every month. Most companies start with a fixed amount of cash and the challenge is to make and start selling a product for a profit before that investment runs out. Actually it’s not just making a profit; it’s selling enough products with a sufficient profit margin to cover your ongoing running costs. Once you run out of cash, the company dies.
As we’ll see, some startup models look for massive funding to expand rapidly. That often needs to be topped up in successive funding rounds, leading to companies accumulating tens of millions of dollars of investment before they start shipping. That’s not the norm. But for every startup, understanding the costs and how they grow is vital to keeping afloat. Taking on too many staff too quickly or slipping development timescales (they will slip – the question is by how long) are both pitfalls that kill many companies. However good your product is, cash is what will determine your company’s survival. Fire-sale exits are not a good outcome.
So if your business plan doesn’t show how to maintain cash until your worst estimate of shipping and product ramp-up, preferably with some extra safety margin, go back and start again. Don’t fall into the trap of assuming you can constantly go out to find more funding. That may be possible, but it’s incredibly distracting.
With those provisos, let’s look at the different types of hardware startup. All of what follows is based on tech hardware, generally with a high electronics content. They cover both consumer and B2B models.
What sort of company are you?
There are plenty of different definitions of company types, but I’ve tried to group them into the sort of hardware startups I’ve come across. In doing that I’ve invented some new category names. The biggest differentiator between them is probably their expectation of where they think they will be in five years’ time and how many employees they’ll have after the first eighteen months.
These are the hardware equivalent of the little Mom and Pop companies, although being hardware, they’re more likely to be Johns and Jims. They typically consist of somewhere between 2 and 20 people after the first few years, making things which are specialised, but not at the bleeding edge of technology. Many start from a passion in a particular area, a desire to commercialise a good idea or taking an opportunity to support a company or industry they’ve been working for with a niche product.
Because they start small, they may be funded personally, by a loan, a Government grant, an angel, or by pre-orders for their product. They’re close to their customer and know what that customer wants.
Small manufacturers generally want to stay that way. They’re organic companies and their ambition for five years is to make enough for the founders to pay their mortgages. It’s also their ambition for ten years and twenty years. Their biggest long term challenge will be adapting their niche as technology and their customers evolve. They face the same cash flow issues as all companies, but being lean may have more room for manoeuvre. They also benefit from having one of the lowest burn rates of any hardware startup.
Makers at Scale
The revolution in crowdfunding, which has made hardware startups appear so much easier to form, has resulted in a class of startup with a rather different agenda to the small manufacturers. They generally believe they have a product which will change the world and bring them riches. The problem is that whereas small manufacturers often have a fair degree of experience about low volume production, a lot of Makers at Scale don’t. They may have made a few prototypes, but have a very rose tinted view of how that will scale to several thousand, let along the business processes which are needed to support a real, long term company.
The crowdfunding principle, where you ask people to pay upfront for a product before it’s been made, or in some cases even designed, is not new. One of the greatest exponents of that model was Clive Sinclair, back in the 1970s, selling calculators and computers in kit form before moving on to make personal computing affordable in the UK with his ZX80. Kickstarter and Indiegogo have reinvented and popularised the model, and in the process helped launch hundreds of new hardware companies.
What many of these companies fail to realise is that it costs a lot more to bring products to market in the thousands than they will raise from pre-orders. A good rule of thumb is that you need between $3 and $5 million, which is considerably more than most startups are likely to raise from a crowdfunding campaign. Because of their burn rate, unless the crowdfunding is part of a larger investment, many of these will fail, or else soldier on to try and fulfil their orders before fading away.
Because you can make one or two does not mean you can make thousands. Despite that, once they have money, Makers at Scale tend to grow headcount much faster than small manufacturers, often because once they become aware that they can’t meet their stated delivery dates they resort to throwing resources at the problem. That’s a dangerous approach, as it increases the burn rate and results in a very unbalanced company as they get to shipment, which either needs drastic pruning or will drain future resources. This means that the founders need to grow up very quickly and take hard decisions, or risk being replaced by investors. However, getting rid of half your staff just at the point you’ve started shipping can be disastrous for morale, with the remaining key staff jumping ship before they’re next in line for the chop.
Makers at Scale like to push boundaries. Many of their products try to do new and novel things because their founders are passionate about the vision. It’s a common fault to try to incorporate too many features, promising a far more complex offering than is needed simply because they can. Usually, all that does is cause delays and increase costs. A few have used crowdfunding campaigns to good effect to ascertain exactly what prospective customers do want. It’s often a less technically complex product than the founders had envisaged, with simple things like colour being more desirable than additional technical features.
In most cases, Makers at Scale assume that in five years they will have developed a cool brand and probably been acquired. Their ten year ambition will be to be out looking for an acquirer for their second startup. There’s nothing wrong with that, but they have to realise that success will depend on finding an experienced team who know the things they don’t, as opposed to collecting a group of similarly passionate colleagues. Knowing what you don’t know is a highly important skill for the founders of any start-up.
Whereas small manufacturers mostly know their customers well, Makers at Scale often fall into the trap of only thinking they know their customers well. The canny ones use crowdfunding as a way of validating their business plan, adjusting what they do based on how the campaign was received. It’s still early in the cycle to see how the crowdfunding process plays out. A few have had notable exits, but a larger number have failed and others are struggling. Managing customer expectations while things slip can be difficult and time consuming, as is the effort to get investment when the original crowdfunding money starts to run out. But crowdfunding is a powerful new route to funding which has transformed the startup market.
I’ll mention these in passing, as they’re beloved by Government funding bodies, but often don’t help the hardware economy. Zombie companies are generally formed by a small number of consultants, engineers or academics who think up a plan to get a small company Government development grant. Whilst they may have a good idea, the limited investment means that this often gets done on the side of their day job. Small investors are then asked to come in to get it into production.
Some will ship products, but many spend as much time looking out for the next Government grant as they do on product development. As a result they’ve earned the name within the industry of “Grant Tarts”. Their ambition is generally no more than to still be in existence in five years’ time.
The problem with Zombie companies is that if the grants dry up, or interest rates go up they’re dead. They don’t live on sales, they live on handouts. The sad thing is that they often suck in one or two good engineers who could do really well in helping another company that was going somewhere.
It would be interesting to see some figures for the value returned from funding this sort of company. Whilst grants certainly help some small manufacturers get off the ground, a lot of the time they seem to be a high tech unemployment scheme to keep engineers and civil servants off the streets.
Brand Nouns are fairly rare beasts. They believe they have a product offering which will change a consumer sector. Whilst that may not be different from many other startups, the Brand Nouns want to be remembered – they want to create a lasting brand which transcends a product, but enters the language as a noun. Think Hoover, Dyson, Biro and Jacuzzi. Although technology plays a strong part in their vision, manufacturing efficiency is often more important. They aim to become global players and are not afraid to challenge existing market leaders at their own game.
To succeed they need significant levels of investment over many years. If you ask their founders what they want to be doing in five years, the answer will be starting to make a global mark, planning their IPO and working on what the company will be in ten, fifteen or twenty years. They’re often run by people who are more interested in making a change than making themselves rich, although the successful ones will certainly do that. They’re often run by people who have considerable experience in manufacturing, or who have attracted that talent around them. By the time they’re through their first five years most people won’t think of them as a startup anymore – they’ll become part of the establishment. Intriguingly, many are named after their founders, but that’s probably because they don’t see the point in wasting time and marketing money on thinking up a snazzy name. To them getting on with the job is more important. And yes, there really was a Laszlo Biro and a Candido Jacuzzi.
Technology Disrupters are very similar to Brand Nouns, but rather than concentrating on end products they focus on a B2B model. They’re companies, often at the bleeding edge of technology which believe they can change the way that products work. That may be by developing new platforms, chips, components, or new ways of doing something which will challenge the current market leaders. They’re a lot less visible than Brand Nouns, working on hardware that will be used by others, rather than aiming themselves as the ultimate product manufacturers.
But they share many characteristics. One is experience, often being founded by industry veterans. Another is the expectation that an IPO is as likely an exit route for investors as an acquisition. Both types of company have a long term view. If they are acquired it will probably be after a period of having established themselves as a profitable and stable industry leader.
Investors are fascinated by what they call Unicorns – startups which are miraculously acquired for a billion dollars or more within a few years of being in business. Far too many hardware startups appear to believe that there is a chance that they will become a Unicorn. If you’re founding a hardware startup, don’t even think about it. Even a minute’s thought is a minute wasted which could be better employed in making your startup work. The fundamental fact is that even Unicorns don’t know they are Unicorns until it happens. Startups which think they are Unicorns are not – they’re just pretentious horses that have wasted their time trying to glue pointy sticks onto their foreheads.
Growing a hardware company, particularly at the point when you start manufacturing, needs specialists. It needs people at an early stage who know how to design for manufacturer and test and how to perform production test. It needs people who understand the regulatory requirements to place a product onto the market. Most importantly it needs someone who understands and can manage cash flow, because getting that wrong will kill the company.
Try not do to everything in a vacuum, but get external advice from people who have been through it before and can challenge what you’re doing. You can take or ignore their advice, but you’ll be better for having had your views challenged.
As you start to grow, try and make sure you have two to three years of funding in place. Funding should not be an annual activity, as it will take most of the senior management team out for six months during each round, which is incredibly disruptive. There is a breed of CEO which seems to believe that their primary job is organising constant investment rounds, rather than managing and inspiring their company. Avoid that approach at all costs. You’ll end up with a business plan which is more about raising money than designing and shipping product, so aim to ask for enough at the start. Most hardware products will need between $3 and $5 million to get to market. Mom and Pop firms can survive on less – some do remarkably well on Government grants; but for anything else be realistic with your costs and timescales. I’m sure some exist, but I don’t think I’ve ever come across a hardware startup which shipped early or below their projected cost. I have come across quite a few which went bust before they shipped anything.
Startups do transition from one type to another. Being small and flexible, they’re well placed to seize the opportunity, although whether they do depends on how risk averse their founders are. And founders of hardware startups can be surprisingly risk averse as far as their business model is concerned. Most of today’s largest companies started small, established themselves and then grew. Sometimes because the founders discovered a bigger opportunity (Microsoft), others because an outsider with a wider vision discovered them and took over (Macdonalds – a great example, even though they aren’t hardware). The important point is that they started knowing what they could achieve and took care of looking after the cash flow to ensure they were stable and successful, ready for the point when opportunity eventually arrived and changed their future. Like Malvolio, they weren’t born great – they had greatness thrust upon them.
The point of which is that you should plan to be solvent rather than plan to be sold. That at least gives you time to find a buyer if you need an exit to repay investors, which is a much better state to be in than desperately looking for an acquirer before the cash runs out.
In some parts of the world, notably San Francisco, other rules may apply. If you’re based anywhere else, don’t think those will work for you – they won’t. Instead dedicate your time to working out what sort of startup you are and apply yourself to making it work. Most importantly make sure that you and your team have fun.
Patents are an interesting subject, and probably worthy of an article in their own right. My view is that they have a use for startups, but mainly as wallpaper. You want to get a couple granted and display them prominently in your office, as that will save you hours of investors asking about them.
The reality is that they’re of limited use to a startup. You won’t be able to afford to take competitors to court if they infringe them, nor will they help a lot in protecting you against any action from other patent holders. But investors do like to see them – they’re a tick box when you come to an exit. So go for a couple of simple ones which are likely to get granted quickly (the UK patent office is quick and cheap at the moment). Limit yourself to a European country and the US to save cost, and once they’re granted, stop.
There is another reason for filing, which is to see what other patents may be out there. You can pay patent attorneys to do a freedom to operate search, but that will cost you in excess of $25k. A cheap option is to file a patent with claims that are relevant to what you’re doing and see what comes back from the patent office search. The search is only a few hundred dollars. Again, the UK patent office is cheap and quick. If you only want to find out what else is out there, you can draft the patent yourself and then abandon it after the search. If you want to take it through to grant, find a decent patent attorney, which will cost around $5k per patent.
If you do have a really good idea, go for a patent. But you might find it better to sell it once its granted.
Brilliant article – perceptive and illuminating. Required reading for any start up.
Would be interested to hear your views on worth of ‘patents’ for start ups !