The Costs of Growth
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This essay is the first in a series documenting lessons learned from my time at Electric Objects. Follow me on Medium to find out when the next essay is published.
The challenging reality of building a hardware business is that growth is expensive. Each new customer acquired today costs money three months ago. Crazy, right? Turns out that’s how businesses have worked for hundreds of years, until software.
There are exactly three ways to finance the growth of a hardware business:
- Customers: You crowdfund or bootstrap your way to your first production batch, and money from that first batch funds the next larger batch.
- Debt: You sell debt in your business in exchange for money to buy new hardware. This can take the form of secured (from a bank) or unsecured (your factory lets you pay them later for goods you need today).
- Equity: You sell equity in your business in exchange for money to buy new hardware.
Most hardware startups need to employ all three to get off the ground. Each path is challenging, and each source of capital has its own set of incentives that are sometimes aligned and sometimes in conflict with the others.
Financing from your Customers
Getting financing from your customers is ideal when it works out, and awful when it doesn’t. I don’t need to recount here the long list of startups that have taken money from customers but failed to deliver on their promises.
At Electric Objects we ran a successful Kickstarter campaign, and were determined not to end up on that list of broken promises. I’m proud that we shipped a product to every single customer that ever gave us money.
The upside with customer financing is that you get to hold onto your equity, and you don’t have to hand your company over to a bank if your production run is a few months late. The downside is that you can lose the trust of your early customers, from which all future value derives.
Financing from Debt Investors
Debt is a powerful tool and can make your company work or help accelerate its demise. There are two kinds of debt investors that are typically available to an early stage startup: venture banks and venture debt funds.
Venture banks will likely only offer you a loan once your business has reached some level of predictability. Their capital will be relatively cheap (low interest rates) but capital availability will likely be tied to performance milestones.
Venture debt funds have a higher tolerance for risk and are less beholden to regulatory requirements than banks. You’ll pay for that risk tolerance in the form of a higher cost of capital (high interest rates and more warrants). Venture debt funds might participate as early as your seed round of financing, and will be placing a bet largely on the likelihood that you can raise additional equity financing in the future. Fewer strings attached, more capital available, but more expensive.
Larger, commercial banks should be avoided early on! Beware in particular the ones that decide to set up a “startup friendly” operation for a quarter or two. You want a partner that understands the fragility and tumult of the startup lifecycle. An executive at a large bank used to dealing with traditional companies will find your rollercoaster ride too hard to stomach.
We raised debt from WTI, a venture debt fund that our equity investors had worked with in the past. They were a great partner, and I can recommend them without reservation.
Just remember that when you raise debt without a cash flow model capable of repaying it, you’re essentially leveraging the probability that you can raise more equity capital. If an equity raise falls through, your financing problems tend to compound very quickly.
Financing from Equity Investors
Like it or not, if you’re raising venture capital for a hardware business you will be compared to an invisible made-up software business that costs a lot less, has a better chance of working out, and has a higher potential exit value. Let’s take a look at each one of these points.
First, and most importantly, in software, you only need to build one product for all of your future customers to share. When you’re in the hardware business, every customer gets their own product.
In addition to these working capital requirements, hardware startups have higher fixed costs to production, and tend to require more people in more roles earlier on: software, firmware, mechanical, electrical, industrial design, and supply chain operations, to name a few.
Second, it’s a truism in startup-land that your first product is probably the wrong product. If each hardware product cycle costs more and takes longer than a comparable software cycle, then the likelihood that you’ll have access to enough capital to find product/market fit is lower.
Third, hardware companies at maturity are often valued lower than their software counterparts (see the first and second reasons above, which don’t get less true over time), so your potential exit value at IPO or acquisition will be lower.
Behind the coffee meetings and custom hoodies, venture investors live or die on the ROI they can deliver to their investors. Ideally that’s a big return on a small investment. Unfortunately, hardware startups offer a generally smaller return on a generally larger investment.
We raised capital from some of the industry’s best investors — funds like First Round Capital and Bessemer Venture Partners — and I couldn’t have asked for better partners. But we were constantly battling against a core incompatibility: most VC firms are designed for the capital risk and return profile typically associated with software companies. There’s no way around this and so your job as a founder is to convince an investor (you only need one!) that those generalities need not apply to your business.
Building a physical product is as moving as it is challenging. There’s nothing quite like knowing that something you dreamed up lives in thousands of homes all over the world. I don’t mean to dissuade anyone from pursuing a hardware adventure, only to shed some light on the tricky realities of doing so. These challenges are not insurmountable, but they should be understood and faced squarely.
Facing it squarely means having a real understanding of the costs of growth, and making dead sure that you have enough capital to hire your team, develop your product, order your product, and market your product. You can finance the company with friendly manufacturing terms, profitable sales, affordable debt, or venture capital, but it needs enough funding to reach the next milestone of investor validation or profitability. More on these milestones, and the tradeoffs that come with them, in next week’s post.
