Startups are often synonymous with risk. They’re started by founders with very unrealistic expectations of positive outcomes and who have little desire (or ability) to weigh actual 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 that is relevant to all businesses, however, is the issue of 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). Current conventional wisdom says that if the upside achievable in any given venture is the same, better to invest a smaller allocation of your investment pool and thereby minimize your exposure.
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 cost structure of portfolio companies isn’t a very serious consideration, but more the idea that “software” businesses are generally now considered quite cheap relative to their “hardware” counterparts. But capital-efficiency is an investor term, not a founder term. Chris Dixon most recently illustrated this dichotomy by contrasting the “finance lens” from the “product lens”. VCs must see through the finance lens, while entrepreneurs, though they can’t ignore the finance lens, need mostly be concerned with product.
So while the costs around building a hardware business are still considerable (but falling, see below), “makers" everywhere, are feeling 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. Paul Graham of Y Combinator has affectionately called it a renaissance. Albert Wenger of Union Square Ventures sees the writing on the wall, but admittedly isn’t sure how to participate as an investor. Amanda Peyton, a founder looking to capitalize on the space, has a nice steady outline of the opportunity on her blog as well. They’ve been articulately laid out in some of the aforementioned links, but factors giving rise to this shift include:
- Open-source hardware initiatives and communities like Arduino, Raspberry Pi, Sparkfun, Adafruit. Makershed, and SmartThings’ “Open Physical Graph”
- Ability for rapid prototyping with 3D printing
- Crowdfunding platforms (Kickstarter, IndieGoGo, etc) affording hardware tinkerers the ability to assess demand and raise proof-of-concept-money (that professional investors may still be reticent to deploy)
staying capital-efficient within hardware-
For the most part, this entire backdrop has been covered in recent months. What I’ve found most interesting among the debates though is that it has been a fairly binary discussion around whether we can expect true (venture-backed) growth in the category. You either accept hardware in all of its capital inefficiencies and believe that today’s climate is different (SoftTech / True Ventures’ FitBit, Venrock’s Nest, Lerer’s Romotive, etc.), OR you continue to believe that you’re better off focusing on software’s feasting of the world (as Kleiner partner Trae Vassallo put it, “Hardware is hard”). While I tend to 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, to a small extent, satisfies this definition, though it certainly has not made hardware its exclusive focus (in fact, it recently imposed changes that make it harder for product concepts to raise). Investors in Kickstarter will benefit 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 significant focus for investors in the new year.
At IDEO, hardware is perhaps more than any other category at the core of our DNA. While today over 50% of IDEO’s work is digital, it is a sensibility that has strengthened from the firm’s inception (designing the first laptop and the first Apple mouse). We’ve monitored this hardware resurgence in the maker and startup worlds over past months, and are energized by the conversations we’ve been having. While we’re comfortable exploring the traditional hardware categories, we’re also very excited to see what comes of this broader software ecosystem.
The products themselves are (rightfully) getting the most attention. The hardware devices and gadgets are clearly the most exciting fruits of the movement. Though equally as important will be the market that will be built around it. From an investor’s perspective, it may just be where the best risk-adjusted returns lie.
Some of the links that inspired this post (some above, others not):
Paul Graham - The Hardware Renaissance
Albert Wenger - The Return of the Capital Intensive Startup
Massimo Banzi, TED talk
Amanda Peyton - Hardware Disruption: Same Movie, Different Era
Steve Schlafman - The Era of Pervasive Computing
Chris Dixon - The Product Lens
Antonio Rodriguez - Changing the world is not always profitable
Joe Rizk - Kickstarter is Not a Store
“A Comprehensive Database of American Manufacturers Fast Company”, Fast Company
“Maker Movement" TIME
“The Next Industrial Revolution?" New Tech City
“Kitchen Table Industrialists" New York Times
“SmartThings Grows Community of Smart Object Developers”, TechCrunch
“The maker movement isn’t just for hackers anymore”, VentureBeat
“The Maker Movement”, Raising Geeks
“The Zombie Apocalypse of Smart Devices”, Wired UK