Hardware Seed Capital is Unbalanced

Hardware seed has changed.

Five years ago, we wanted investors to get excited about hardware. When we did, two things happened:

  1. They invested in 1–3M rounds prior to manufacturing, and then grew impatient when delays happened and product didn’t ship.
  2. They focused on the MRR numbers and discounted the hardware moat built to get there. They neglected the simple truth that value generation is not the same as revenue generation. For example, $2MM ARR for Enterprise SaaS < $2MM ARR for Hardware SaaS.

It seems like hardware seed is out of balance a bit.

Hardware MVPs can be capital efficient!

An L.A.-based Series A investor recently described an excellent funding framework to achieve Series A investment. The milestones included Seed, Beta Release, Wide Release, 50k DAUs, Initial Monetization, and finally Series A funding. A truth is that the process of achieving Series A round investment is tangibly different for hardware startups compared to software startups. Or to be more blunt: Series A VCs are looking at the wrong metrics for hardware.

ARR and MRR and WoW growth metrics do not capture the value created in derisking product/market fit, building a hardware brand, perfecting the user experience, and building a customer moat. In the pre-revenue world, your hardware startup may not be “investable” for a few years after an initial seed check. The path from formation to Series A can be as short as year in the case of Bird to as long as 7+ years in the case of DJI. We are now seeing founders raise 2.9 rounds before they secure their Series A.

Fortunately, hardware has its own language around three very critical milestones, and the majority of hardware startups can be put into these buckets. To simplify, let’s use the terms Pre-Seed, Seed, and Post Seed until we come up with a better term.

Caveat: The following is a theoretical framework meant more for investors than for founders. If founders try to apply this framework, they risk underfunding. All startups have different needs, different BOMs and NREs, different CACs, etc. and this framework is based on seeing several thousand companies struggle with how much they need and how to value their business. We have seen many companies raise less and hit revenue, and we encourage it. But it is not always possible.

Pre Seed Hardware: Designing Capital

Formation capital to get that prototype made and in front of a customer. Once a solid proof of concept has been fabricated, scrappy founders initiate customer discovery, and progress to developing an Engineering Prototype (EP).

Typical (3 Sigma) Deal Terms: Raise $500K-1M at a $1-5M pre-money valuation.

Typical Resources: incubators, makerspaces, evidence-based research methodologies, friends-and-family investors, and angel investors.

Seed Hardware: Engineering Capital

Product market fit has been derisked as much as possible pre-market and it’s time to derisk technology. Capital can be used to refine the Customer Proof of Concept and get to Design Validation Testing (DVT). This means that you have made your initial payment for tooling.

Typical (3 Sigma) Deal Terms: Raise $1-3M at a $4-8M pre-money valuation.

Typical Resources: contract manufacturers, design for manufacturing (DFM) engineering partners, seed hardware accelerators, and angel investors.

The MiLA POV on Seed

Post Seed Hardware: Execution Capital

If you have read our blog before, you have heard us preach about execution capital. The goal is to raise enough to get through Product Validation Test (PVT), begin marketing, and demonstrate impressive sell-through numbers. At this point, tooling and supply chain have been derisked. The danger in this phase is if you raised too much in prior rounds, you may be subject to a down round. Closing the Post Seed funding round after a scrappy Pre Seed and Seed allows startups to show a bank balance, which can and should be matched by a working capital line to fund first inventory.

Typical (3 Sigma) Deal Terms: Raise $2-4M at a $8-20M pre-money valuation, plus $2-4M line of credit to finance inventory.

Typical Resources: Traditional hardware funds, traditional accelerators, angel investors, distributors, customer and supplier credit lines, debt lenders, seed venture capital investors.

Series A Hardware: Mass Production

Once a hardware startup clears all three of these seed milestones, something magical happens:

Series A Hardware = Series A

Advice for Hardware Investors

So what does all this mean for hardware seed investors? It means we need to send startups “back to go” if the risks have not been removed satisfactorily and it means we need to fund startups appropriately when they have.

Hardware seed investors should monitor accomplishments of a hardware startup progression from prototyping, customer discovery, product-market fit, EVT, DVT, and PVT. Investors should be willing and able to increase investment to fuel growth in hardware startups that have successfully navigated the challenging product development cycle and validated market fit. This tiered/traunched investment approach can mutually serve hardware founders and investors to be capital efficient during hardware product development, and avoid unnecessary cash burn.

At MiLA Capital, the VCs behind the Make in LA hardware accelerator, we sustain funding through multiple seed rounds and bridges to help ensure that great hardware does not die because of overzealous investors. We are committed to educating the ecosystem and supporting hardware founders.