"Hardware is hard.”
-Ancient VC Proverb
“We choose to go to the Moon in this decade and do the other things, not because they are easy, but because they are hard”
-John F Kennedy

Hardware is hard, but doing hard things well is the only way to build a long term competitive advantage and generate excess returns. Software is a tremendous opportunity, but the IMF suggests that digital activity represents less than 10% of most economies. The cost structure for hardware startups has changed: automation has reduced operating leverage, barriers to entry are lower than ever, and new hardware businesses can scale with much less equity capital. Finally, software runs on hardware. These hardware platforms convey access, data, and distribution.

The markets for physical goods remain massive. When paired with the right business model, even non-technical products can be interesting investment opportunities. Scale dynamics are key — these businesses must be able to grow quickly without consuming vast sums of equity capital. Though this has been a disqualifying factor in the past, times have changed.

Historically, many hardware companies required large and increasing investments in capital equipment and inventory, and were bottlenecked by unwieldy supply chains. Today, supply chains are increasingly automated. These new supply chains are more agile than their predecessors. Hardware innovations drive down the marginal cost of additional SKUs, open up new opportunities for international manufacturing at small scales, and enable novel forms of distribution. Entire supply chains are now rentable.

These changes upended traditional notions of manufacturing, heralding the emergence of logistics and transportation companies like Flexport, Convoy, and Flexe. Shopify seamlessly links online distribution to modern supply chains. Today’s hardware companies, freed from the constraints of legacy distribution channels, are nimble and efficient. This shift presents an exciting opportunity for new entrants to build scalable hardware businesses. By doing the hard work of hardware, they can gain unique competitive advantages.

Even in our increasingly connected world, many locations and scenarios remain offline and inaccessible: incumbents may raise barriers to entry, existing hardware might be insufficient, or the requisite partners may move at a glacial pace. Hardware platforms can create enormous software opportunities in these circumstances.

New hardware solutions can generate novel and proprietary datasets, not only by gaining access to new scenarios, but also by deploying new sensors or technologies. They can also provide new data outputs to the user, and these bi-directional data streams can unlock massive value.

Hardware provides distribution for software and services. When distribution is exclusive within a customer segment, companies can capture the lion’s share of the value they create. Hardware sales and physical presence represent incremental barriers to entry, allowing hardware companies to build deep moats.

For these reasons, platform technologies are the most compelling category of hardware investments. They are also few and far between. For these businesses, hardware primarily enables them to sell software and services in a way that is otherwise impossible. Platform companies can realize the best of both worlds: high-margin recurring revenues from their software products and the enduring competitive advantages that arise from doing the hard work of hardware.

Subscription products also present exciting investment opportunities if they target sufficiently large markets. Their recurring revenue structure allows them to scale efficiently. The business model also lends itself to prepayment, which can allow for negative cash conversion cycles in some circumstances. Direct to consumer offerings (which represent a large chunk of subscriptions today) are able to take full advantage of modern supply chains to achieve massive scale quickly.

The razor/razor blade model is also common. The “razor” product is generally used to create switching costs for consumers and is often sold as a loss-leader. Though these businesses cannot achieve software economics, when done well they can generate recurring revenues with high margins.

Discrete transactions encompass a vast swath of product categories and distribution channels. Consumables and durable goods, retail and direct-to-consumer models — they all lack dependable recurring revenue. Consequently, every dollar of revenue growth requires a proportional investment of capital. To the extent that these companies are investable, it is because they are able to build strong brand loyalty and increase LTV, making them ultimately look more like subscription businesses.

There are a number of lines of inquiry that are unique to hardware businesses. All of these drive towards the question of scalability. How quickly can the business scale, and how much capital will it require? Outlined below are some of the most significant and illuminating questions to ask investment candidates, along with commentary on the motivations for each.

Creating venture-scale hardware companies is indisputably difficult, but the potential rewards are well worth the effort. Hardware can unlock vast new markets and create durable competitive advantages. From Apple to Square to Bird, there are numerous examples of tech companies which have seized these advantages and made them the cornerstones of massive, transformative businesses. World-class entrepreneurs are building exciting new hardware companies every day. Investors should be eager to work with them.

Key Questions:

Questions about capital requirements:
Are you manufacturing in-house or outsourcing? If in-house, there had better be a very good reason and a plan to keep the required equity investments in line with business milestones/de-risking. Alternative forms of financing, including venture debt, may be appropriate to fund CapEx.
If outsourcing, then we need to understand both minimum order quantities (MOQ) and manufacturer’s margin. MOQ is much more important in the short term; margin is more important long-term.
Assuming you outsource manufacturing, can your provider drop-ship for you? If yes, what will they charge you for the convenience? Drop-shipping can be a useful tool, but it’s not free and it reduces companies’ ability to control the customer experience.
Will they be producing just-in-time or in batches? The vast majority of outsourced production will be batched. This means longer lead times and higher inventory balances
What is the lead time on inventory from suppliers? The most expensive line items are the most significant here.
How can you manage demand to keep it in line with your ability to fulfill orders? Runaway demand can result in massive stock-outs and tarnish the brand. It’s critical to have a marketing policy that is tightly coupled to the inventory policy, especially with long-lead products.
Are your customers willing to pre-order or tolerate long wait times before receiving the product? For some products this makes sense and can be a tool for keeping inventory balances low.
What payment terms will you receive from suppliers? How will this change over time? Payment terms can make or break a fast growing business. It can make sense to grow more slowly for long enough to build a credit history with suppliers and get more favorable payment terms. This can drastically reduce working capital requirements.

Questions about margins:
What gross margin can you expect on day one? How will this change once you are at scale? No rocket science here: bigger is better.
Are there other significant variable costs associated with selling your product that are not part of COGS (ie. commissions, etc)? It’s important (and not just for hardware) that companies understand the difference between gross margin as an accounting concept and variable cost as an economic one.
Can you expect significant volume discounts? We generally expect some price breaks, but the magnitude can vary wildly. Generally, commodity components will see smaller price breaks (but lower base pricing) while more specialized items will see the inverse.

Questions about supply chains:
Walk me through your supply chain on the whiteboard and map each step back to the corresponding COGS item. It’s critical that founders thoroughly understand all elements of the supply chain and their economic impacts on the business.
How will you handle distribution/fulfillment? What costs does this impose? How does this scale? There are lots of right answers but we need to see a plan. Bringing it in house gives companies more control over the customer experience, but increases time to market and increases operating leverage.
Which piece of your supply chain is the bottleneck for lead times? Volumes? This will probably be the first thing to cause problems as the business scales.
When do you expect to exceed the capacity of your bottleneck? How will you increase your capacity when the time comes? We are trying to gauge whether the CEO has planned for the inevitable problems that will arise as things start breaking with scale.
How much overhead is required to manage your supply chain? Does your team have the experience to handle it? Not all supply chains are created equal. Large numbers of vendors, international suppliers, and multi-tiered supply chains all impose a significant management tax. Outsourced supply chains still must be managed.
Is your supply chain international? If so, how much will customs and/or tariffs impact your business? Economic tariffs are important, but delays and logistical hang ups are more common and often more problematic.
How “deep” is your supply chain? Which vendors will need to talk to each other? How will you/they manage this? Multi-tiered supply chains are especially susceptible to the bullwhip effect. This can be somewhat mitigated by detailed communication of customer demand between and across the links in the supply chain.
Written on May 20, 2019