Why Investors Don’t Love Your Hardware Startup and What You Can do About It

Hardware-focused entrepreneurs know that starting and scaling a hardware startup is a monumental task. Between product creation, manufacturing, supply chain, sales and branding, it takes focus and stamina. Not surprisingly, nearly 90% of new startups are software focused.

Hardware startup founder

According to PWC and the National Venture Capital Association (NVCA), of the companies receiving venture funding for the first time in Q4 2015, software companies received the largest share, accounting for 37% of the dollars and 39% of the deals. Investment in hardware was less than a quarter of the amount invested in software. So why are VC’s hesitant to invest in hardware companies and how can you finance yourself without their funding?

Venture investment in hardware startups

Source: Wall Street Journal

There are three key reasons why hardware startups have a more difficult time fundraising.

1. Large upfront investment needed

There is an enormous difference in the amount of money needed to launch a hardware product compared to a software product. The market cost of launching a software product can be as low as $10,000 to $50,000 while for a hardware product it could be several millions of dollars. This difference can be attributed to the high cost of fabricating a prototype and setting up the manufacturing of a product at scale.

Regardless of how much money a hardware startup raises, it’s easy to get trapped with rising upfront costs, unfavorable manufacturing contracts and shipping complications, which can all lead to major cash flow and timeline issues. And, while the cost of production of software has decreased rapidly in the past decade due to open source, horizontal and cloud computing technology, hardware costs have not come down at the same rate. Despite the advent of Alibaba and other online intermediaries, manufacturing a custom tech hardware product is still a very hands-on and relationship-driven process.

Hardware startup ecosystem overview

Hardware Startup Ecosystem – source: Hardware Startup Report 2015

2. The perilous prototype to production path

This is another challenge for fundraising and a process that investors watch closely. Once a successful prototype is built, the process of identifying manufacturing partners to create the product at scale begins. Sourcing and logistics increase in complexity during this process, which can lead to difficulty tracking costs of materials and sources of components. As a result, investors often set funding milestones that focus on “de-risking” this process. For example, you get a third of the funding with a strong prototype, a third of the funding after the first order has been made, etc. However, this leaves a significant part of your business success out of your own hands and with third party manufacturers and vendors.

Because of how many parts of the process are out of your control, projecting cash runway for hardware companies is more difficult than for software companies. To be as involved as you can, visit the manufacturer. For instance, if you’re manufacturing in China, go to China, check out the factory, understand their process and meet the managers. Getting a product to market is not easy. It’s important to understand how difficult your product is to make because, otherwise, your expectations are based entirely on what your suppliers’ salespeople are promising. Salespeople will always tell you that everything is great, but they’re not invested in the end product. Unlike you, their brand is not on the line, so from their perspective, they need your product to be just successful enough to earn their commission.

As Mark Cuban accurately noted: “Never take advice from someone who doesn’t have to live with the consequences.”

3. Changing hardware is a difficult process

The final reason hardware startups have a tougher time raising money is that changing hardware is a much more difficult process compared to software. Changes to hardware are more easily made during the prototyping phase. However, once you’ve moved to the manufacturing stage, it becomes much more difficult and expensive. There is usually upfront investment in tooling, engineering services and equipment before manufacturing starts. If any of that needs to be changed, you’re looking at trips to visit the manufacturer, expensive new equipment and a delayed timeline. The last part can be extremely detrimental to your business if existing investors have set up funding milestones.

So where should hardware companies go for financing?

1. Crowdfunding presales. Kickstarter, Indiegogo and other crowdfunding platforms are a great way to prefund consumer products before launch. Create a cool video, write a “salesy” description, set up pricing tiers and get the news out to the world. If you can generate the necessary buzz, you can also presell on your own website and avoid the fees that the platforms charge.

The creation and marketing of crowdfunding campaigns has become its own cottage industry. Videographers, marketing specialists and graphic designers are all vying for the money spent to create and promote crowdfunding campaigns.

As mentioned, Kickstarter and Indiegogo are the two big players in the space, but key differences exist between the platforms, which are explained in more depth here.

2. Friends and family. Leveraging your personal network for the first ~$100k of startup capital is a tried and true method of getting started. Prior to asking, you should have already done market research / customer validation to measure the demand for your product. Use this “proof-of-concept” capital to prove out your product by designing a strong prototype.

3. Purchase order financing. Also called PO financing, this solution allows funding of orders before they are delivered to the customer. This allows companies to take on orders that would normally be too large given their financial position. However, purchase order financing requires a significant amount of diligence as inventory and orders need to be verified, even overseas. This type of financing can also be quite expensive due to the risk the lender takes on.

4. Invoice factoring. If you’ve delivered the customer’s order and are now waiting on payment, invoice factoring is a helpful form of financing. Selling your accounts receivable to a factor and receiving immediate payment can free up your supply chain cash flow. Oftentimes, if suppliers are demanding net 30 and you’re able to deliver the order to your buyer within two weeks, a factoring company can pay off your suppliers within their desired payment term.

Note, both factoring and PO financing can only be used if you’re already generating sales.

5. Suppliers. How can suppliers help you fund your hardware startup? By giving you better payment terms, of course. Allowing you to pay them at a later date, gives your business the breathing room to deliver on large orders, receive payment from your customers and pay off other vendors. This is tough to do at the early stage because suppliers want to see traction before agreeing to longer payment terms. They’ve been burned in the past.

However, if you have a good relationship with your supplier, they can also help spread out the upfront set up cost of manufacturing. Before a single unit leaves their factory, tooling can cost up to $200K, engineering services could cost $50K and test fixtures may add another $50K. If the supplier agrees to include some of these expenses in your per unit cost instead, it could save you a significant amount of initial set up investment.

6. Equity crowdfunding. Not to be confused with crowdfunding sites like Kickstarter and Indiegogo, which take no equity ownership, equity crowdfunding sites bring together investors to buy shares in your business. These platforms can be a viable alternative to traditional venture capital if you must sell equity in order to get to launch. Several notable equity crowdfunding sites include CircleUp (which focuses on consumer products), SeedInvest and Angellist. Be aware that raising on these platforms can take months and require a similar or higher level of marketing effort as raising on Kickstarter or Indiegogo.

7. Bank debt. This is a viable option only if you’re already profitable and have been in business a couple years. Banks will usually give you about 80 cents on every dollar in accounts receivable and 50 cents on every dollar in inventory in the form of a credit line. This is a great and cheap form of financing, but unfortunately inaccessible to most early stage startups. If you think you can qualify, look into banks that offer SBA loans. SBA loans are backed by the government, so banks are willing to offer lower rates to small businesses than they typically would because the government will cover up to 85% of loan losses.

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