Hard vs. Soft – With Math

Last week we touched on the subject of how venture investments in hardware are starting to look more attractive in comparison to every Venture investor’s favorite sector – software. A common refrain we hear is that software businesses are much less capital intensive than hardware. We think that has changed and this time we are bringing some numbers to make the point.

There is no question that starting a software company from scratch is easier than starting a chip company. One person sitting in a basement, or two people in the proverbial garage, can put together a software product in a weekend and then bootstrap it to growth and customer traction. But that is only part of the story. Taking that interesting product and building it into a viable commercial entity capable of generating venture-sized returns costs a lot more money. Money for building an enterprise sales team, money for growth hacking consumer users and all the other functions.

By contrast, getting a semiconductor from a good idea on a napkin to a fully designed product requires a fairly substantial team. That being said, we know companies that have gotten to that point with a few million dollars of seed funding, and a team of less than twenty. This is something that was not possible even ten years ago, but there is sufficient talent available that these kinds of development cycles are now possible. At this point, semis do get expensive. It can cost $50 million to $100 million more to get a chip from design to tape out to volume production. However, semis have an advantage here (or more of a bug that can be a feature in the right light). Designing a chip can take a year or so, and that allows enough time to solicit input from customers. A tightly run chip start-up can hold off on production until they have a fairly high degree of confidence, in the form of solid orders, from paying customers. This means they can build a sales pipeline with a much smaller sales force.

In the end, both semis and software companies need comparable amounts to reach scale.

Let’s look at this from the perspective of a venture investor. A software company can get started with a $1 million, and take that to minimum viable product. At that point, they can take a Series A of $10 million to build out the product. If that is sufficient to demonstrate product-market fit, they can then raise $20 million to build out a real company. But here it starts to get more expensive. Companies raising a Series C to build out consumer growth or enterprise sales are raising $100 million to $200 million rounds. The ease of starting a software company means that there are a lot of them out there, so competition can be fierce. How many CRM companies are out there already? How about accounting software? How to differentiate in these markets? It takes a lot of capital to stand out. Adding that all up our hypothetical company needs $231 million.

The pattern for a semis company is different. That seed round looks more like $5 million. That can be enough to get the design ready for tape out and land an initial customer. Going into production will take another $30 million for IP licenses (like Death and Taxes these are hard to avoid) and another $50 million for production. Then the company needs to foot the bill for building inventory and getting the chip to customers, say another $75 million, for a total of $161 million.

Both companies are now at the stage that they can see what their true commercial prospects are, and outside investors can start to think about exits. Let’s say the software company is a huge hit and can go public at $10 billion, and the chip company at $2 billion. The software company looks like a better bet, $10 billion on $231 million a 43x return, while the chip company is 12x. But there is a big difference, at every funding round the software company is able to raise at a higher valuation multiple, which means the venture investor ends up with a smaller stake.

After all that dilution the venture investor in software is going to end up with close to a 10% stake in the company, while the semis investor is likely to hold closer to 35%. That means the cash returns to investors in the software company are getting a 4x return, while the semis investor is getting a superior 5x.

Obviously, the numbers on this can vary all over the map, but the underlying point remains, and we have seen many examples that hue fairly close to these figures. After a decade of “Software Eating the World“, valuation expectations for software companies have gotten heavily inflated, with the opposite true in semis. We would also argue that the returns at the semis companies are more heavily levered to capital, with a small increase in capital capable of delivering greater returns. If an enterprise software company adds five sales people to an already large team their incremental value is fairly minor. By contrast, adding five sales people to a semis company can double or triple the size of the team, with commensurate returns. We would also argue that our math is overly conservative on many fronts such as the ultimate exit multiples.

Software companies at scale can be just as capital intensive as semis companies. If we then factor in the big mismatch in valuation at every stage of the venture process, it is clear that there is a big opportunity in semis venture investing.

Photo by Riccardo Annandale on Unsplash

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