Crowdfunding: Hardware Startups Beware

August 12th, 2013 · 7:00 am @   -  2 Comments

Hardware startups are one area I spend a fair amount of time with in my life as a VC, and while I love working with hardware companies, it should go without saying that hardware startups are incredibly difficult to do. They require knowhow across multiple disciplines — software, electrical engineering, industrial design, manufacturing, channel, etc. – and, as a result, have challenges and upfront capital needs that most software/web companies lack. This has led many angels and VCs to be wary of investments involving building hardware so its no small wonder, then, that many hardware entrepreneurs have turned to crowdfunding websites like Kickstarter and Indiegogo to try to raise funds for development.

While crowdfunding can be a great fit for certain projects, I think early stage hardware startups should beware. Yes, crowdfunding sites can generate upfront capital that can fund development, but unlike traditional equity/debt investments (like the kind an angel or VC or bank will give you), “crowdfunding capital” has a particularly onerous type of “string attached”: it’s a presale.

Obviously, the entrepreneurs trying to raise crowdfunding capital want to push their projects towards real sales – so why might a presale be a bad thing? For hardware companies:

  • Raw production costs are a major percentage of sales – so even if you raised $1 million, you probably are going to be able to keep max $500,000 after the cost of materials/manufacturing
  • These pre-sales are oftentimes discounted – so you are generating lower margins on each unit making these particularly painful sales to make
  • Except in a few instances, the number of presales tends to not be high enough to meaningfully change the cost of manufacturing (i.e. upfront tooling costs or supply procurement) – which further eats into the amount of capital you have left to deploy on development since you probably have to pay the low volume price
  • It means you need to keep to some level of deadline. There is a risk that you won’t make your own deadline and there’s also risk that the time pressure might lead to tradeoffs (leave out a certain feature or asset, run fewer tests, etc.) which could hurt your reputation since the public will be getting its first impressions of your company based on that initial launch.
  • It publicly commits you to a particular product even if you learn that your initial idea is wrong or needs tweaking.
  • It tips off the market and potential competition earlier since you likely are doing this at a point before your product is ready and need to provide a fair amount of detail to get supporters.

In the end this “capital” ends up being a very real “liability”, and is a big part of why serious hardware startups that do crowdfunding almost all go back to the traditional VC/Angel community – it is simply not practical to scale up a meaningful hardware business on crowdfunded capital alone.

That said, there are definitely cases where it makes sense for hardware companies to use crowdfunding – and they are cases where the above problems are irrelevant:

  • If your cost of production is tiny relative to the price (think pharmaceuticals, software, music, movie, etc. – trivial cost of production per unit sold)
  • If you’ve already completed the vast majority of development or managed to get capital from another source and are simply using crowdfunding to either gauge customer interest or raise publicity
  • If your intention is to raise money from a VC/angel using a crowdfunding success story (that you’re positive you will get) to show that a large market exists for your product
  • You couldn’t raise money from VCs period and have no other choice

In the first case, a very low cost of production means that more dollars raised can actually go into development, irrespective of volume of production and discounts. In the second case, the pre-sale becomes a good thing: a market signal or a heavily publicized pre-sale for a product which is/is almost done. The third is very risky – because I would maintain its nigh impossible to know if a crowdfunding attempt will “go viral” and even if it does, you are still left with the liability of these presales that you need to fulfill. The last is self-explanatory :-).

If you are an aspiring hardware entrepreneur, in almost all cases your best bet will be to go with traditional equity/debt financing first. Obviously, I am in part biased by my current choice of profession but while VCs and angels can be annoying to deal with and raise money from, the lack of the pre-sale liability and their potential for connecting you with potential hires and partners makes them a much better fit.

Got any questions? Disagree? I want to hear from you!

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  • Phillip Walker

    I find this post very interesting.

    Do you see hardware entering a new bubble in 5-10 years as the resources and capabilities of creating new hardware become cheaper and more accessible?

    Do you think that a new VC model could be created primarily in the angel/seed level to help mitigate the risk of pre-sales by boosting their capital upon closing of lets say a 200%+ cover of the goal? Maybe they just need that little extra capital at the right time to become very viable and juggernaut ahead (I am aware of the other qualifications in due dilligence … disregarding that for this conversation).

    Id love to talk more about this topic, if your willing…

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  • http://www.benjamintseng.com/ Ben

    Thanks for the comment

    Hardware startups are costly and difficult to do — so I hesitate to a predict a bubble — but without a doubt, smartphone ubiquity, the declining cost of silicon, and the ready availability of wireless communications technology like Bluetooth SMART and Zigbee are definitely making novel hardware devices easier for startups to tackle so I wouldn’t be surprised to see more hardware companies emerge.

    Your second question is an interesting one — is this an idea of yours in the making? :) — and actually one that probably is already being de facto implemented on some level: while I don’t know of any VC firm with an explicit target on crowdfunding amount, there are definitely VCs (myself included) which periodically look at the big crowdfunding sites to see if anything interesting has cropped up. Pebble and OUYA, for example, were definitely companies which struggled to raise money in a traditional way from VCs until after they blew away everyone’s expectations on Kickstarter.

    I think a “deeper” question anyone trying to take this approach needs to ask themselves is whether or not crowdfunding has any implicit biases in the types of projects/entrepreneurs — a cynic might say that those who turn to crowdfunding either don’t need the money (because they are using it as PR for a product that’s mostly fully funded) or couldn’t get the money through usual channels (and hence some other due diligence criteria is at play).