How To Fund A Hardware Startup
Hardware is a cash flow business. It takes money to get to market, and even more money to scale your company. This means that your funding strategy is second in priority only to creating an amazing product.
I got the funding strategy wrong at Contour.
Despite being a $30 million business with award-winning growth (#7 on the Inc500, we couldn’t properly fund the business. Being number two in a fast-growing category wasn’t enough as every investor wanted to lead the market, not follow it. In the end Contour ran out of money, which is still mind blowing when you consider that the company had hundreds of thousands of customers.
Contour losing the category wasn’t a result of the decisions made at the end. In reality Contour lost almost two years before when our competitor raised $80M to our $5M. It was at that point that we should have stepped back and re-thought our strategy, but instead we plowed forward and assumed number two could get just as much funding. We couldn’t.
A lack of proper funding prevented us from fulfilling customer demand, growing brand awareness, and staying in front of the innovation curve. Our lead in product quickly deteriorated as a lack of cash prevented us from moving the business forward.
In the end I learned a very painful lesson: Your funding strategy is critical to your survival. Get it wrong and you go out of business. Get it right and you can become super successful.
If you are building a hardware startup, here is a guide to help you think about how to fund your company.
Getting to Market
I’m a big believer that a successful minimal viable product (MVP) in hardware is all about the fastest path to cash. It’s definitely not about over promising features and under delivering on quality. Instead it’s about picking a single feature and not only delivering it amazingly well, but quickly.
A solid hardware MVP should cost $500K or less to get to market. That includes any tooling, engineering, design, brand, and people costs. If you are spending more than that, limit the features. This is true especially if you are a first-time hardware entrepreneur because you want to keep your MVP simple to limit your cash exposure.
If, during the process, you create enough momentum to raise more than $500K, then great. But most likely you will be scratching and clawing your way to complete this first round.
You can raise this initial capital in a combination of ways.
- Friends and Family: Finding $50-100K from close relationships is a great place to start. With this amount of capital your goal is to validate your idea by creating a solid prototype.
Supplier: The costs of getting a supplier off the ground is your most expensive hurdle. Depending on the complexity of your product, tooling will run you $50-200K, engineering services could be up to $50K, and test fixtures another $25-50K. To help minimize your cash requirements you will want to negotiate with your supplier to roll these fees into your per unit cost. Without a track record, this isn’t easy, but if successful it can dramatically change the amount of capital you need to raise.
Consulting Firms: You will need design and engineering services to produce a great product, which means if you don’t have those skills on the team you can outsource this to a consulting firm. Often this can be cost prohibitive, but it’s worth finding a firm that will be creative in cash requirements to help you get to market. With Contour we found a design firm that charged us $50K for the work and then a $3 per unit royalty until the bill was paid. It was a risky proposition for them, but it worked out as we paid them the full $350K over two years.
Pre-Sales: Whether you use Kickstarter, Indiegogo, Dragon, or your own website, pre-selling your product can drive significant cash flow. Even after your campaign ends you can continue taking pre-orders on your own website to increase the amount of cash you raise. Only pre-sell your product once you have a supplier on board and a firm understanding of the schedule.
Angel Investors: Are not easy to convince before you have pre-selling momentum. A lot of hardware entrepreneurs assume that angel investors will give them capital as they reach development milestones. The reality is most won’t, especially when most hardware prototypes look like crap. Unless you have pre-existing relationships, the best time to approach angels is after you have a prototype and momentum from your pre-sales.
Crowd Funding Equity: Now that you can publicly raise capital, both Angel List and your own customers become potential sources of equity capital. This form of capital raising is still in its infancy, but the startups finding success appear to have solid momentum both in media attention and customer interest.
Venture Capital: There are a handful of funds participating in seed rounds, based on the quality of your prototype and the momentum of your pre-sales. You often don’t get a second chance at the same funds so unless you have a previous relationship or incredible momentum, I would save these discussions for your next round of funding.
If you end up raising equity dollars I recommend using a convertible note that converts into your Series A round, using standard series seed docs. Be sure to give yourself enough time to complete the series A round (up to 24 months) with an automatic conversion for investors, as you can’t afford a massive cash outlay down the road.
To reward your earliest investors you can change the discount they receive off the Series A depending on when they invest. For example you can raise the first $100K with discount X to complete your prototype and the remaining $400K with discount Y, after you pre-sell your product. Whatever you do, keep it simple!
A few things to keep in mind:
- Terms with your supplier will be an ongoing discussion. If you can get momentum with investors they may be willing to give you better payment terms.
- Don’t over promise to increase your pre-sales results. It may help to increase the amount of cash you collect up front from customers, but if the product is poor quality or significantly late, you could have an even larger problem down the road.
- Build your financials projections and product pricing based on today’s costs. Don’t make decisions based on what your product will cost at volume, or you risk running out of cash as soon as you ship your pre-sales.
Reaching Market Fit
Now that your product is shipping you begin to control your own destiny. Although your actions are still dictated by how much cash is in the bank, you can begin to think about how much capital is required to reach product market fit, an important milestone in validating that you have a profitable, repeatable business model.
At Contour it took us two years, and two iterations on the hardware, to reach market fit. Not until our product was under $300 and High Definition (HD) did customer demand go through the roof. Overnight the company went from $2M and unprofitable to $7M and very profitable. Despite making dozens of mistakes, we reached market fit with less than $1.5M in capital raised.
The right amount of capital to raise depends on the complexity of your product and the cost to acquire new customers. As a general rule of thumb it can take from $0 to $10M in capital to reach product market fit.
You should consider the following to calculate the right amount of capital.
- Product: After shipping an MVP you need to follow up quickly with version 2 to fix all the bugs and poor customer interactions. You’ll want to calculate what it costs in people and production to make your existing product F*#$ing great.
Customer Love: A key part to reaching market fit is having customers that can’t stop using your product. Understand what it takes to fully engage your existing customers, including offering amazing customer support.
Cost to Acquire Customers: One of the hardest parts of making a successful hardware business is profitably reaching new customers. You need enough capital to try a variety of tactics with financial systems to measure which are and aren’t working.
Limited Distribution: Reaching market fit has nothing to do with building successful retail channels. To be great in-store it requires experienced people and a heavy investment in training. On top of that, it will strain your cash with delayed payment terms and lower margins. Save retail for after you reach market fit.
Working Capital: Your most important cash consideration is your working capital (the time between collecting cash and paying your supplier). Managing your cash flow is critically important as you try to grow from an interesting product to a profitable business.
When you are ready to look for capital you can consider:
- Cash Flows: You don’t have to raise money. If your business is driving great cash flows you can use that cash to fund the business.
Debt: Banks will give you about 80 cents for every dollar in receivables and 50 cents for every dollar in inventory. The key is that you have to be profitable. If not, it will be hard to get bank debt.
Factoring Receivables: If you have strong receivables, but are not yet profitable you can factor your AR. It’s insanely expensive, up to 20% interest, but it can work to move cash flow if you get stuck. This is a last resort option.
Your Supplier: Continuing to work with your supplier to improve your payment terms is critical to minimizing your cash requirements. You can offer to pay more per unit in exchange for better terms.
Angels: If you are raising a smaller amount, say $1.5M, then you can approach angels, but asking for more will be an uphill climb.
Venture Capital: Find a partner with experience investing in hardware and a belief that founders can become great CEO’s. You want the right partner so don’t make this choice lightly. Once you raise institutional capital, the requirements change dramatically.
Scaling Your Company
If you survived this far, congratulations. Hopefully your cap table is still intact and you have some understanding of what is driving your business.
Your vision for the future, from this point forward, will dramatically change the amount of capital you need to grow your business. If you want to win a category, you need a minimum of $50-100M dollars. If you don’t, you need a highly profitable, cash flowing business so you can invest in product at the same rate as the category leader, without bankrupting your company. Otherwise you will suffer from the Law of Increasing Returns, a fateful result Contour experienced.
To provide some perspective on category leaders:
After Contour reached market fit I never stepped back and painted the picture of what kind of company we wanted to become. Did we want to be the largest camera company in the world? Did we want to be the category leader for action video? Or did we want to make a small, kick-ass company that was highly profitable?
Because I wasn’t clear about the future, I didn’t raise the right amount of capital. Instead I raised $5M from two small funds, which essentially meant I wanted to win the category, except I didn’t raise enough money from deep enough pockets to do so. Instead I created a situation with mixed expectations and in the end a dynamic that made it very hard to raise future capital.
To calculate the amount of capital required you first have to decide IF there is a category to be won and IF SO, do you want to win it?
If the answer is yes, you need a serious amount of capital to become the brand of choice, and from investors that believe in your same vision. A venture return is not possible if you don’t win the category. Boxee is a great example, they raised almost $30M and in the end couldn’t win the category, so they had to sell for about the same amount that was invested.
If the answer is no, prioritize your business model to be highly profitable, raising as little capital as possible. Selling a $20M business with very little capital raised can be a larger return than falling short on a quest to be the category leader.
The places to look for capital include:
- Cash Flows: If you aren’t trying to win the category, continue to optimize your cash flows to keep the business moving forward. You have to keep innovating on the product and creating a sticky brand experience.
Supplier Investment: Either through your existing supplier or through a new supplier, you can explore them investing in your business. Vizio did this early on and it fueled their growth.
Venture Capital: Assuming you have a product, technology, and category advantage this can be the right group. You have to present a path to winning the category.
Private Equity: If you have at least $10M on the top line and 20% on the bottom line, private equity can be an option. Just recognize that they are looking to resell your business in 3-5 years so you have to demonstrate category leadership with minimal technology risk. They want a business that is cash-flowing so they can multiply what is already working.
Strategic Investors: Of all the types of strategic relationships, distribution seems to be the partnership of choice. Either from a brand that can take you into mass distribution (i.e., Monster investing in Beats Headphones) or from a brand that opens up new geographic markets (i.e. Softbank with FitBit).
Success isn’t binary with hardware, which means you don’t have to create a billion dollar company to be successful. Because hardware drives cash, you can create a fantastic company that is small, profitable, and produces amazing products.
All that really matters with funding your hardware startup is that you have a clear picture of the future. And from that picture, find the right capital to fulfill your dreams.
Image Credit: Aresaburn via Creative Commons