Why Venture Capital Fails For (Most) Hardware Companies.

In the last few weeks and months, we’ve seen the death of a lot of hardware startups. We’re seeing the struggles of a few successful ones (Fitbit and GoPro) and the ones that are building hard hardware (I’m looking at you Magic Leap) need to raise billions as a safety net even when they fall down what I’ll call the risk staircase. We’ve read about the woes of Jawbone, Lily Drone, Vinaya and Skully. All this makes the average founder wonder what is going on and whether they can get funding from VCs. In considering whether your hardware product should be funded by Venture Capitalists (VC), it makes sense to understand the risks, especially the risks as the VC sees them.

VC Risk Assessment

In the early days of an idea, when a founder goes out to seek funding, all the VC is basing the investment decision on is Entrepreneur/Founder risk. This is why referrals tend to be the preferred source of lead generation, there is some assignment of the ‘who’ based on the referrer's relationship with the VC. Some of the questions the investor is asking to determine whether it is an investment worth making are  

• ‘Is this founder crazy?’, 
• ‘Is this founder trustworthy or will I have legal issues here?’, 
• ‘Can I work with this person for a long time and does she take feedback?’, 
• ‘Do I believe this founder knows his/her stuff or has the expertise required here?’ 

and a whole lot of other questions baked in with known and unknown biases. The entrepreneur, on the other hand, needs to be truly authentic to him/herself so that neither party is surprised down the line when the founder does something that seems ‘out of character’.

Once the entrepreneur-risk questions are answered, this might be over time or even in the first meeting, and if the founder already has a product the next set of risks the investor is assessing are the product risks. The questions here tend to be 

• ‘is there something here or is it just smoke and mirrors?’ 
• ‘will this product solve the pain or improve the lives of the customers’,
• ’what are the technical requirements to get this product to market?’ 

and a slew of questions that provide the investor some comfort investing. 

When the product enters the ever changing technology market, the product-risk questions continue to exist. At this point though the next round of investment, which might include the original investors, start to make investment decisions looking through an execution-risk lens. Questions here are more nuanced depending on company stage. In the early days the execution risk questions are

• can this founder and her team get an MVP to market?
• How well does the team work together?
• How quickly does this team make iterations and deploy the product?

And once the company gets beyond product-market fit the questions switch to

• can this team scale this business?
• Can this founder run a business that is 10X what it was a few years ago?
• Is this market still big enough for this founder’s ambition?

And other questions that focus on the understanding that ‘what got this company here, will not get it there’. The above framework is a summary of the risk assessment and highlights a quirk with traditional VC; VC works when the company moves through the ladder stepwise till it scales. 

With the pace of technology change, hardware companies constantly moving back to the product/technology risk step of the ladder with every new version of the product. With every version and iteration of the product, back down the ladder. This hurts the VCs model of return expectation. Even if the tech works, the company might get starved of cash and die because the VC is, for all intents and purposes, investing in a new company every round of funding. If the tech doesn’t work at all, the company dies anyway.

That being said, there is nothing wrong with a one-time hardware hit. I’ve read of entrepreneurs who’ve had one product sell to hundreds of thousands of people and the entrepreneur rides off into the sunset. While that works for the entrepreneur and their family, it doesn’t work for VC. And that’s OK. 

This is partly why we’ve chosen to take a different approach with Varuna. This high possibility of failure but a need to reward the work is totally counter to the expectations of venture capital. This is not to rag on VC, it serves its purpose and expects its returns, it’s an acknowledgment on my part that

1. There is a lot of work to be done to get this product to market. Hardware is hard.
2. This will be more about building a brand. Brand is an intangible that the venture capital model isn’t structured to value that in this very early stage of the products life. It’s easier to value ‘brand’ when you are a large company like Warby Parker or Apple.
3. There is a lot more altruism here than wealth creation. The team all have income generating businesses but we’ve come together because this product needs to exist. No VC wants to hear that.

Despite how tough we know it will be, we believe strongly that no one should unknowingly drink or use water that is dangerous for them and that we now have smart technology that prevents that from happening. The first step to that optimal product is Varuna, a smart water quality meter. Donate here to help our work or sign up here to lend your expertise. Thanks!

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