Hardware startups

For a long time, entrepreneurs and investors shied away from hardware. This seems to be changing. As Paul Graham says, there are many reasons for this:

Hardware does well on crowdfunding sites. The spread of tablets makes it possible to build new things controlled by and even incorporating them. Electric motors have improved. Wireless connectivity of various types can now be taken for granted. It’s getting more straightforward to get things manufactured. Arduinos, 3D printing, laser cutters, and more accessible CNC milling are making hardware easier to prototype. Retailers are less of a bottleneck as customers increasingly buy online.

Another important factor is what Chris Anderson calls “the peace dividend of the smartphone war”:

All the components in a smartphone — the sensors, the GPS, the camera, the ARM core processors, the wireless, the memory, the battery — all that stuff, which is being driven by the incredible economies of scale and innovation machines at Apple, Google, and others, is available for a few dollars. They were essentially “unobtainium” 10 years ago. This is stuff that used to be military industrial technology; you can buy it at RadioShack now.

It also doesn’t hurt that the most valuable company in the world (Apple) and some of the most exciting startups (e.g., Nest, Jawbone, Leap Motion) make hardware.

If you are thinking of doing a hardware startup, here are a few things to keep in mind:

Manufacturing. Many hardware startups stumble when they try to go from prototype to large-scale manufacturing. There is no AWS-equivalent for hardware. To get manufacturing right, entrepreneurs often end up living in China for months and even years. The difficulty of manufacturing is one reason that hardware entrepreneurs tend to have more work experience than software entrepreneurs.

Defensibility. Hardware companies generally have economies of scale but hardware products generally don’t have network effects. This means that as soon as you prove the market, you’ll face competition from lower cost manufacturers. The best startups complement hardware with software and services that have network or platform effects. Think of hardware as bringing the revenue and software/services as bringing the margin.

Planning. The build-test-iterate model that is popular in software startups doesn’t translate well to hardware startups. Proper planning is essential because mistakes can be unrecoverable. For example, you might create a design that fails environmental tests but only discover this years later when you are about to go to market. (See all those symbols on the back of your phone? Those are regulatory certifications).

B2C vs B2B. Consumer hardware tends to get more attention, but B2B hardware has a number of advantages. You’ll have fewer startup competitors, because entrepreneurs who have both hardware and business domain expertise are rare. You’ll also have fewer incumbent competitors, because B2B hardware usually requires local sales and service teams, making it harder for foreign competitors to copy you. Finally, manufacturing can be done locally because higher price points mean you can be less sensitive to labor costs.

Samsung’s predicament

In the past year, Samsung went from being a moderately successful electronics manufacturer to the leading non-iOS mobile device maker. Together, Apple and Samsung earn 98% of the profits in the smartphone market. MG Siegler echoed a common sentiment when he wrote that Samsung is now the “fifth horseman” of tech, alongside Apple, Google, Amazon, and Facebook.

The mobile device industry is still in its infancy. Samsung’s fate depends largely on how the industry evolves. If the computer-in-your-pocket (smartphone/tablet) business ends up being like the computer-on-your-desk (personal computer) business, Samsung is on track to be the modern Dell. Dell had a good run as the low-cost provider in a highly commoditized business, but the vast majority of the industry profits went to Microsoft.

So the big questions for Samsung are:

1. Will the smartphone/tablet industry stratify the way the PC business did? 

The dominant view is that technology markets inevitably stratify. Clay Christensen is the most sophisticated proponent of this view. In his theory (more here and here), every tech market eventually “overshoots” the needs of its customers, at which point the benefits of horizontal specialization outweigh the benefits of vertical integration.

A minority view, held mostly by Apple faithful, is that Christensen et al are guilty of over-theorizing. Apple lost the PC business simply because, when Steve Jobs was fired, they stopped innovating. When Jobs returned, Apple started gaining PC market share again. In this view, the future mobile industry structure mostly depends on whether Apple management is innovative enough to keep making superior vertically-integrated products.

2. If the industry stratifies, will the lion’s share of the profits go to the OS and application layers as it did for PCs?

Generally, technology businesses that are defensible have network effects, and network effects usually arise from products with significant software components. Samsung’s competitors like HTC are just one hit product line away from stealing Samsung’s position. Eventually, handset designs will converge and, as happened in the PC market, consumers will stop paying premiums for performance improvements (arguably, this has already started happening). The OS and apps layer, on the other hand, are very hard to replicate. If you invest enough money you can usually build or acquire decent software, but it takes more than just capital to build a vibrant developer ecosystem (just look at Microsoft).

Samsung’s predicament is: their current strategy succeeds only in the scenario where both (a) the industry stratifies, and (b) significant profits flow to hardware. Samsung seems to understand the improbability of (b), which is why they’ve been hinting at throwing serious support behind a new OS. Getting traction with a new OS will be difficult, to put it mildly. Google and Apple have vastly more experience making software and a huge head start with developers. Moreover, Google’s strategic position is even stronger today than Microsoft’s was in their heyday. Google makes so much money from web services (mostly search, for now) that they can afford to lose money on handsets and OSs indefinitely – a very scary fact for Samsung and everyone else in the mobile hardware business.