Software may be eating the world, but hardware monetizes better.
We work with a lot of software companies, the world seems to love them. There are 1,000 VCs in the US and they all seem enamored of investing in software companies. The benefits are clear. They do not need a lot of capital to get to revenue, with big cash infusions really only needed to fuel growth, making this a highly capital efficient model. By contrast, it can cost a few hundred million just to get a chip to first revenue. Enterprise SaaS does not need inventory, or really much in the way of working capital. But build a gadget or a chip, and you need a few thousand, hundred thousand, million units just to get your first orders. For many venture investors, seeing all their dollars spent before the product can even be tested makes hardware seem like a bad bet, especially in a world where minimum viable product can be whipped together over a weekend by people with no coding skills. Hence, of those 1,000 VCs, maybe 10 will even look at hardware.
But all this may be changing, for both structural and cyclical reasons.
First, as much as hardware has fallen out of fashion, this model offers some big advantages. Chief among them monetization. Software can sell for $100/month, Life Time Value of many software products is a few thousand dollars (obviously it can be much more in enterprise SaaS). By contrast, prices for hardware tend to be much higher – a high end CPU or GPU can reach $10,000 a chip even in normal times. Of course, this is an apples to oranges comparison, and it is not entirely that simple. But since we are talking about apples…. Apple products are different and better because of their software. Apple – with all its focus on
User Human Interfaces is really a software company, but it monetizes that software with hardware. If Apple sold its iOS operating system, how much could it charge? It’s chief competitor Android is free (sortof), so probably not a lot. By contrast, the average iPhone price is something like $600 or $700. If done right, hardware monetizes better than software.
Then, if we look at where we stand in the investment cycle, there are several reasons why hardware is starting to look a lot more attractive.
First, venture valuations for software companies are through the roof, especially the early rounds. Those 1,000 software-only VCs have bid up the market considerably. It is also getting much more expensive to invest in software. By contrast, the upfront capital requirements for a hardware company have fallen significantly. We know chip companies that can get to production for $5 million, with teams of 20 or less. And there is much less froth in valuations.
Admittedly, getting a chip into production can cost $20 million to $50 million, all of which goes to the foundries, IP licensees, EDA tools and other outside parties. That being said, how different is that from an enterprise SaaS company? They may have a good product which shows traction, but to grow the company from that point to an IPO will cost $50 million and up to build an enterprise sales team. Scaling a hardware company and scaling a SaaS company require similar amounts of capital. Put simply, software can be just as capital intensive as hardware.
The only big difference is the fact that software companies can win customers and demonstrate traction with a real product much earlier than hardware companies. But even here, the difference is not that great. For a software company to make the transition from small to big is immensely risky, filled with execution risk on every front – and many do not make the transition. Slack made it to IPO, Yammer did not, and even Slack did not last that long as a public company. By contrast, chip companies that execute well can bring a chip to production with a fairly high degree of confidence that the product will work, and the design timelines are long enough to gauge real interest from customers. So the difference here is one of customer planning, timing and design methodology – aka management. And this is a risk that venture investors are highly capable of assessing and managing.
There is no question that hardware investing carries a very different risk profile than software investing. And of course there is still immense value in software start-ups. But the scales are tipping. So much of technology operates on a pendulum, and that is now tilting steadily back towards a world with much more balanced returns for hardware.