The Case for Hardware + Software + Internet Startups

Those who know me know that I have been tooting the HW+SW+Internet horn since early 2010. I hinted at it in my post Internet Startup Bubble and The Supposed Super Seed Crash back in July of 2010. But now, more than ever, the evidence is here that hardware is ready to make a comeback in startups. In fact, it already is.

But it's been hard talking about this for the last 2 years. I've met nothing but resistance from the investor community. Practically every VC I've talked to has told me that hardware is awful and that software and internet is much better as an investment. And for a long time, it's been true.

If you think about it, the last VC who was OK with investing in hardware startups entered into the VC business in 1994. After that, the internet came into being and from that point forward, every VC who didn't jump on the internet bandwagon missed one of the biggest opportunities to make a ton of money. (Of course, those that didn't jump off the bandwagon at the right time lost their shirts and more). Still, memories about the downsides of bubbles are short; those same VCs were heroes for the money they made and they continued to invest in the internet, and training hordes of emerging VCs along the way. This has continued for 17 years now. Think about it; 17 years of VCs whose thinking has been molded by the success of internet startups and investing in them. And also the advantages of not having to build physical product to get there.

I think the world has changed to the point where the previous advantages of internet/software startups has been declining, and the advantages of hardware startups are ascending.

For a long time, internet/software startups had a distinct advantage over hardware startups. You didn't have to use up money in paying for inventory of product. Digital products cost so much less and upon copying the bits digitally, the cost of the product declined over time as you sold more. Plus, the internet created distribution mechanisms that were hard to compete with; customers could be reached with extremely low cost and sold to with great ease. But that has changed:

1. Competition in internet/software startups is way too fierce. You start something and competitors pop-up all over the place. With all the easy ways to create software, it is extremely easy to build something that somebody else has built and do it fast.

2. Given the rise of competition and the fact that consumers, along with B2B customers, are deluged by these startups screaming for your attention and your money, the money that you would need to pay for hardware inventory is now money required by internet/software startups to buy traffic. This was not true not too many years ago; now the competitive world has changed - the battle for consumer mindshare AND the IT manager's mindshare in B2B customers has risen exponentially.

3. Some argue that distribution channels for hardware are limited. However, social, word of mouth, and viral mechanisms for internet/software startups do not work any more and you have to market traditionally to build awareness and brand. This more than equalizes the distribution channels for hardware. At least hardware is unique and not just another website product or service which gives hardware a leg up in customers' eyes simply because of uniqueness. Do we need another photosharing app?

4. Because it takes longer to gain mindshare in today's world, you must raise for longer runway - 18 months-24 months at least, which means more money is required in any case.

On the hardware side, advantages are emerging or here already:

1. Hardware technology is commoditized and cheap - what was previously rocket science is now readily available in chipsets to everyone. There is not much out there now that requires serious hardware design resources and custom chip fabrication resources. Advanced technologies of the past are now commonplace.

2. Contract manufacturing can make anything on contract - you don't need your own factories now. When I worked at Apple back in 1990-93, we had our own manufacturing both here in California and in Asia. I designed plastic parts and oversaw the construction of metal tooling to shoot the plastic. We had to build prototypes, test them and their manufacturability, and arrange our own staff to build everything. Now you can hand off all the manufacturing to contract manufacturers, whether here in the US or in Asia.

Because you do not have to setup factories and manufacturing yourself, you don't have to raise money to do so like in the past. You can raise the same amount of money as your typical internet/software startup and get product in boxes and on shelves.

3. In huge contrast to internet/software startups, there is *virtually no competition*. It is exceedingly rare that when I meet a hardware startup, that I can find another let alone two competitors! This gives hardware startups an unprecedented period of time where they can advance in the face of no competition and grow and learn.

Universities are graduating enormous numbers of software engineers and everyone is racing to internet/software. Hardware engineers, by comparison, don't exist in nearly as much quantity. In fact, opportunities for hardware engineers are so limited by a wide margin as these skills have moved offshore to Asia. Thus, nowhere near as many hardware startups appear versus the hordes of internet/software startups.

The barrier to entry is experience and knowledge of hardware. Most people fear it because they have never done it; it is natural to avoid that which is unknown.

4. We are now at the edge of what software can do by itself with respect to the physical world. Having humans type in information or self reporting data is just not practical and filled with potential errors. To do better, you need hardware to do the actual touching and sensing of the physical world and connecting that via software to the internet. An example is Quantified Self - self reporting of physical condition has reached its limits; we need 24/7 monitoring of physical condition to get to next level of knowledge, usage, and innovation.

5. Hardware has become small enough, low power enough to do amazing things for long periods of time. Huge possibilities open up due to low power, small size, and accessibility of the technology. Instead of wearing a huge box that is heavy and uncomfortable and needs to be recharged every few hours, we can wear small, unobtrusive sensors all day long, broadcasting vital information to the internet all day and night.

6. By selling hardware, you make money off every sale. By selling software services on top, you further monetize users far beyond the money made from the sale of the hardware. Due to the intense competition, internet/software startups often need to give away services for free which means survival until customers get to a point where they will pay for something you offer, whereas selling hardware means you make money each time you sell it. But then you offer a recurring, monetizable service on top of that to get more revenue.

This is why hardware+software+internet is the key, not just hardware alone.

7. Accelerator programs are now emerging to bring like-minded and experienced people together to enable better hardware product development. Thes are people like PCH International's accelerator program help new startups get off the ground and provide competitive advantage because the accelerator startups get access to PCH International's manufacturing capabilities. Other great accelerator programs are HAXLR8R, a combination China and Silicon Valley hardware accelerator, whose purpose is to spend some time in China to learn how to access and manage Asian manufacturing resources.

Other great hardware accelerators are Lemnos Labs, based in San Francisco, and the newly formed Bolt, to be based in Massachusetts.

The declining advantages of internet/software startups and the increasing advantages of hardware+software+internet startups make hardware the next big emerging opportunity.

The evidence is clear. Over the last two years, here is a list of fantastic startups, using hardware+software+internet:

Evoz - advanced baby monitors, analyzing baby cries with recorded data, and giving advice to new parents. [Disclosure: I'm an investor].

Fitbit - activity monitor and scale for better health and fitness.

Lark - silent alarm clock and personal sleep coach.

Zeo - your sleep manager.

Withings - WIFI enabled scale, blood pressure, baby monitoring.

Lumoback - back health and posture tracking.

Green Goose - making everyday things more playful with tiny wireless sensors that automatically measure what you do.

Leapset - a hardware POS play transforming the cash register for local merchants. [Disclosure: I'm an investor].

Metawatch - a platform for wrist based technology development.

Nest - the learning thermostat.

Elacarte - tablet based menu system for enhancing and optimizing ordering for restaurants. [Disclosure: I'm an investor].

And the list goes on. Still, I meet resistance on this issue.

17 years of entrenched thinking, and exploding economies to power profits and return on capital via internet/software startups make the opinion hard to change. And certainly what I argue doesn't apply to all hardware startups; for example, to build a new car business like Tesla would still require a ton of capital. However, for small, high technology, connected devices this is exceedingly true.

But that doesn't mean the VC community has to believe what I believe. If there is anything I've learned about investing, it's that the best returns are derived from not following the herd. This is definitely anti-herd, and I'll either be totally right or I'll be amazingly wrong - but if I'm right, I hope to be one of the first to ride the wave of this emerging class of startups to success.

4 Comments

  • Mark Sigal wrote: 02/22/2012 2:18 PM

    Great post. I think that it's inferred from your examples, but one variable that has yet to be meaningfully realized is hardware peripheral extensions to iPhones and iPads.

    Since iOS 3.0, Apple has provided APIs for both bluetooth-based device peripherals and direct access peripherals via the 30-pin connector.

    It seems that this is an area where there is a large installed base, a clear software host (and great SDK) for building rich software-hardware applications, and a natural model for creating three tier types of apps, where there is a 'partitioning' of functionality between the peripheral, the iPad/iPhone and the cloud.

    I will say that one core challenge in realizing the thesis that you put forth is that hardware is far harder to get right than anyone gives credit for, and there is an inherent blind spot by engineers in that hardware guys always trying to obviate and abstract software, and software guys are always trying to obviate and abstract hardware.

    You see this in the Android realm, where the Samsungs, HTCs and Motorolas of the world enthusiastically outsourced differentiated software as a core competency to Google, which has really spelled doom in the un-subsidized tablet segment.

    By contrast, Amazon, which has married the two domains, is achieving success with Kindle Fire as a result of the integrated approach.

    Reply
    • David Shen wrote: 04/27/2012 12:31 PM

      I agree with your points - one additional point is that this is a very much an investment thesis. The case for HW+SW+internet is very much bound in the opportunity it presents from an investor point of view in finding the next big company. Thus when you say HW is far harder to get right, you are absolutely right and that is precisely why this is a great investment opportunity thesis - if things were too easy, then everyone could do it and you'd get a proliferation of startups, in which we investors can't figure out who is better and who is not. This is precisely what is happening with internet only startups now.

      Reply
  • ericwpageamplify wrote: 02/26/2012 8:38 PM

    I would argue that you could also replace "hardware" with "service", meaning a service that requires personal interaction. I see healthcare IT companies struggling to create a business model while service businesses that leverage software+internet are scaling up quickly. I'm a firm believer in getting out of the bloody mess that is straight software and delivering a solution that people are willing to pay for, whether that is hardware or a service.

    Reply

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