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.

“PCs are going to be like trucks”

Steve Jobs in 2010:

When we were an agrarian nation, all cars were trucks because that’s what you needed on the farms. Cars became more popular as cities rose, and things like power steering and automatic transmission became popular.

PCs are going to be like trucks. They are still going to be around…they are going to be one out of x people.

This transformation is going to make some people uneasy…because the PC has taken us a long ways. It’s brilliant. We like to talk about the post-PC era, but when it really starts to happen, it’s uncomfortable.

We are just scratching the surface on the kinds of apps for the iPad…I think there are lots of kinds of content that can be created on the iPad.

When I am going to write that 35-page analyst report, I am going to want my Bluetooth keyboard. That’s 1 percent of the time. The software will get more powerful. I think your vision would have to be pretty short to think these can’t grow into machines that can do more things, like editing video, graphic arts, productivity. You can imagine all of these content creation possibilities on these kind of things. Time takes care of lots of these things.

This year, about five times as many smartphones will be shipped versus PCs, and tablets will surpass PCs for the first time. According to Jobs, the right way to look at this isn’t that mobile devices are creating a new market. It’s that mobile devices are relegating PCs to special-purpose, mostly industrial devices.

The credentials trap

I talk a lot to people who are deciding between startups and established companies. They’re usually early in their careers and have been exclusively affiliated with well-known schools and companies. As a result, they’re accustomed to praise from family and friends. Going to a startup is scary, as Jessica Livingstone, cofounder of Y Combinator, describes:

Everyone you encounter will have doubts about what you’re doing—investors, potential employees, reporters, your family and friends. What you don’t realize until you start a startup is how much external validation you’ve gotten for the conservative choices you’ve made in the past. You go to college and everyone says, “Great!” Then you graduate get a job at Google and everyone says, “Great!”

But optimizing for external validation is a dangerous trap. You’re fighting over a fixed pie against well-credentialed peers. The most likely outcome is a middle management job where you’ll have little impact and never seriously attempt to realize your ambitions. Peter Thiel’s personal experience illustrates this well:

By graduation, students at Stanford Law and other elite law schools have been racking up credentials and awards for well over a dozen years. The pinnacle of post law school credentialism is landing a Supreme Court clerkship. After graduating from SLS in ’92 and clerking for a year on the 11th Circuit, Peter Thiel was one of the small handful of clerks who made it to the interview stage with two of the Justices. That capstone credential was within reach. Peter was so close to winning that last competition. There was a sense that, if only he’d get the nod, he’d be set for life. But he didn’t.

Years later, after Peter built and sold PayPal, he reconnected with an old friend from SLS. The first thing the friend said was, “So, aren’t you glad you didn’t get that Supreme Court clerkship?” It was a funny question. At the time, it seemed much better to be chosen than not chosen. But there are many reasons to doubt whether winning that last competition would have been so good after all. Probably it would have meant a future of more insane competition. And no PayPal. The pithy, wry version of this is the line about Rhodes Scholars: they all had a great future in their past.

Great institutions can prepare you for great things. Credentials can open doors. But don’t let them become an end in themselves.

Critics and practitioners

“When art critics get together they talk about Form and Structure and Meaning. When artists get together they talk about where you can buy cheap turpentine.” – Picasso (via Ribbonfarm)

When I was a kid, I tagged along with my grandfather who was an oboist in a big city symphony. I was struck by the dramatic discrepancy between the culture of the audience and the culture of the musicians. Before the show, the audience attended fancy events, and talked in abstract terms about classical music. After the show, the musicians played poker, told jokes, swigged bourbon, and traded tips about the best places to get parts for their instruments.

In the context of startups, it’s convenient to read the Picasso quote as a tidy summarization of the difference between critics (VCs and the tech press) and practitioners (entrepreneurs). There is some truth to this. When entrepreneurs get together, they tend to talk about tactical details. VCs and the press talk about trends, markets, and other abstractions.

But Picasso was just being modest. He thought about the meaning of his art far more deeply than his critics did. The same is true of great entrepreneurs. “Cheap turpentine” is important, but so is “Form and Structure and Meaning”. The best ideas emerge from the interplay between the two modes of thought.

Equity value

Warren Buffet once said:

Buy into a business that’s doing so well an idiot could run it, because sooner or later, one will.

This is a useful way to understand the meaning of “equity value”. You learn in finance that equity value is the overall value of a the stock (i.e. equity) of a business, which in turn is the present value of all future profits. Of course with startups the future is extremely uncertain, leading to a huge variance in valuations.

In perfectly competitive markets, all profit margins tend toward zero. So equity value is a function of the degree to which you can make your market inefficient by making your business hard to copy (so called “defensibility”). If your defensibility depends solely on having superior people, you have what VCs call a “service business.” In a competitve labor market, service businesses tend to have low margins and therefore low equity value. A popular saying about service businesses is “the equity value walks out of the building every night.”

Different types of tech businesses exhibit different relationships between capital, revenue, profits, and equity value. Enterprise software companies tend to require lots of capital to get to scale but command high equity values once they do, partly because enterprises are risk averse and like to adopt the most popular technology, leading to winner-take-all dynamics. Adtech companies tend to be quick to revenue but slower to equity value, and sometimes risk becoming service businesses. The equity value of consumer internet companies vary widely, depending on their defensibility (usually networks effects and brand) and business models (e.g. transactional vs ad supported). Biotech companies require boatloads of capital for R&D and regulatory approval but then can generate lots of equity value, with the defensibility coming primarily from patents. (Patents introduce market innefficiencies, but, proponents argue, are necessary to create sufficient incentives for entrepreneurs and investors). E-commerce companies generally require a lot of capital as well, since their defensibility comes mostly through brand and economies of scale.