The evolving financing needs of frontier technology companies
The emergence of hardware-as-a-service in the hardware industry
When Silicon Valley Bank first started in 1983, we focused almost exclusively on accounts receivable–backed lines of credit. As our clients’ needs became more sophisticated, we developed loan solutions like growth capital, mezzanine debt, syndicated transactions, acquisition financing and many others. Today, startups are breaking down the barriers of traditional industries and establishing novel applications never seen before. This has spurred new and more complicated financing demands across a wide variety of sectors. This has been particularly prevalent for Frontier Tech companies. A common thread ties many of these companies together: The adoption of a hardware-as-a-service business model, which in turn amplifies and extends a company’s capital requirements.
What is hardware-as-a-service (HaaS)?
Traditionally, a company selling hardware would make a onetime sale of its product and receive cash up-front. With the HaaS model, the company provides the product up-front and then is paid periodically (usually monthly) over the length of the contract, which normally is between one and three years. The major benefit of a HaaS model is that companies can achieve a more stable and predictable revenue base compared with the lumpy quarter-end models of the past. This yields greater predictability for planning and strategy purposes. Moreover, investors are more comfortable investing in companies that have a recurring revenue model. The greatest challenge of this model is the up-front capital investment required to build and sell the product, and financing the gap between initial sale and the end of the contract. The gross margins of a frontier tech company tend to be roughly half those of a typical software company, so the more successful a company is and the faster it grows, the need for additional capital increases exponentially.
The transition to HaaS
When I first started in banking 18 years ago, times were much simpler. A hardware company would design a product, manufacture it, sell it and then be paid the full sale price in 30 to 45 days. Banks could easily finance this cycle with a combination of an AR working capital line of credit and possibly some inventory financing. Today, the HaaS model has turned that system on its head; the cash needs are higher and the funding gap is longer, as highlighted in the following two charts, which show the difference in cumulative cash when selling a $750 product with a $500 cost to produce.
As shown by the example above, the time to receive the full purchase price under the HaaS business model is over six times longer than the traditional model. I speak several times a week with entrepreneurs who are facing the financing dilemmas inherent in the HaaS model. For instance, at the proof-of-concept stage, startups are often signing small contracts to deploy a very limited numbers of devices. This can typically be accommodated with traditional financial products like growth capital. As companies move beyond the proof-of-concept phase, however, they often compete for large-scale contracts that have a higher capital requirement to fulfill. Equity can play a role, but investors prefer that their equity dollars go toward accelerating growth rather than capital investments or inventory.
Some pertinent examples stand out for the companies innovating in the Aerospace, Transportation and Robotics industries:
Aerospace is an area we are very excited about. Our team is seeing startups building constellations of microsatellites for such uses as tracking weather patterns, earth imaging and asset tracking on land and sea. This typically requires large numbers of satellites in orbit to achieve a minimal viable product, so a company must spend many millions before generating its first dollar of revenue.
Transportation, particularly autonomous vehicles (AV), is another area seeing significant activity and new company formation. Like with many other frontier tech companies, however, there are significant upfront capital requirements before any revenue can be generated. Often, AV companies need to build out an entire fleet to test in a diverse range of driving environments to achieve proof of concept. This generates a tremendous financing need that is not easily met, given the amount required and the nascent stage of these companies and their market.
Robotics, combined with advances in artificial intelligence, will simultaneously transform a wide variety of industries, from retail, delivery and security to healthcare and construction. Robotics companies have a unique set of capital needs not faced by software-only companies. They need to fund not only research, software and business development, but also the build-out of potentially thousands of units. This capital need is exacerbated when these companies employ a hardware-as-a-service (HaaS) model instead of the traditional onetime sale.
Just the beginning
We are in the very early days of the HaaS business model; it will continue to evolve and grow in popularity as the benefits of sticky customer base and predictable revenue streams, far outweigh the funding challenges. That said, historical equipment and inventory financing options do not cut it because of the unknowns associated with the revenue-generating capacity of, say, a satellite or the resale value of an inventory-tracking robot. Before these unknowns are known, companies in the industry will face challenges in attaining the optimal mix of capital to meet their needs. At SVB we are working with our clients to find innovative ways to support the HaaS business models and working to create new products that are optimized for their needs. If you are facing a similar situation, please reach out and find out how we can help.
