Warsaw Equity Group

Hardware Investments: Understanding VC Reluctance and Advantages of Family Offices

Author: Jakub Głowaczewski

In the vibrant startup ecosystem, hardware-based ventures face distinct challenges in securing funding, particularly from Venture Capital funds (VCs). According to DealRoom, “Over the next five years, 60% of revenue in “Technology” will come from Hardware, with only 40% coming from software. And by contrast, just slightly over 20% of VC funding went to Hardware since 2016”. As you can see, this disparity is not just anecdotal. It reflects deep-rooted aspects of the VC funding model and the inherent characteristics of hardware businesses.

Let’s clarify why a lot of VC funds don’t invest in hardware and explore why family offices (such as Warsaw Equity Group) may sometimes be better equipped to face these challenges!

Why VCs Often Shun Hardware Investments?

Venture capital, known for fueling the rapid growth of tech startups, has a noticeable bias towards software over hardware, while there are some good reasons to believe that investing in hardware is much less competitive. Why is it this way? Well, the preference is rooted in several key factors:

1. Prolonged and Less Predictable Development and Market Entry times

Hardware development is typically a marathon, not a sprint. From the drawing board to the final product hitting the shelves, the journey is fraught with prolonged R&D, extensive prototyping, and exhaustive testing phases. This drawn-out process contrasts sharply with the rapid iteration and deployment cycles prevalent in software development. For VCs, whose success hinges on fast growth and quicker exits, the more prolonged and more unpredictable pace of hardware startups is often a deal-breaker. The longer it takes for a product to reach the market, the longer the delay in generating revenue and, consequently, returns on investment. This is a big issue when you have a limited investment horizon by fund tenure.

2. High and Less Predictable Capital Requirements

The initial phase of a hardware startup is capital-intensive. Costs include not just development but also setting up manufacturing processes, supply chain logistics, and distribution networks. When it comes to scaling, the stakes get even higher. Scaling in hardware startups requires substantial capital, mainly for expanding production facilities and machinery. This phase often coincides with the ‘valley of death,’ a critical period where startups have started production but aren’t profitable yet due to low scale. Overcoming this phase demands significant funding to expand operations to a profitable scale. However, securing this funding is challenging, as it is already too late for VC, and debt financing options are limited for businesses not yet showing profitability. This creates a crucial financial hurdle that hardware startups must overcome to succeed.

3. Specialization and Evaluation Complexities

Hardware is diverse and often highly specialized. Evaluating a hardware startup’s potential requires a deep understanding of the specific industry, manufacturing processes, material sciences, and the end-user market. Unlike software, where a SaaS model can be relatively more straightforward to assess and scale (easier, not easy!), hardware demands nuanced, industry-specific knowledge. For many VCs, especially those without a strong background in manufacturing or the specific industrial segment, this presents a significant challenge for risk-accurate assessment and executing a fast investment process, which is necessary given the target portfolio size (number of companies a fund is aiming to invest).

4. Cap Table Complications in Hardware Ventures:

Hardware ventures, given their inherent characteristics – longer development cycles, higher capital intensity, and slower paths to market, typically go through more financing rounds than software startups. Each round potentially introduces new investors, often with different investment terms. This frequency and variability can lead to a cap table that becomes fragmented and convoluted over time. This issue becomes particularly pronounced in hardware startups for several reasons:

• Dilution and Ownership Fragmentation: Repeated funding rounds often result in significant dilution of equity for existing shareholders. For early investors, including VCs, this dilution can substantially reduce their ownership percentage and, consequently, their influence and return on investment.

• Negotiation Complexities in Subsequent Rounds: A fragmented cap table makes negotiating future investment rounds more complex. New investors may be wary of entering a crowded and disorganized cap table, and may demand terms that further complicate the equity structure. For VCs, the prospect of navigating these increasingly intricate investment scenarios can be a deterrent, particularly when they prefer cleaner, more straightforward investment agreements.

• Implications for Future Strategic Moves: A complex cap table can pose significant challenges for strategic decisions, including exit strategies like acquisitions or IPOs. The risk of a ‘broken’ cap table can thus directly impact a hardware startup’s future exit opportunities, making them less attractive to VCs who are mindful of these exit dynamics.

5. Pivoting Is More Difficult – Market Risks and Product Adaptability:

The market for hardware products can be fickle, with trends and consumer preferences shifting rapidly. Once a hardware product is manufactured, making adjustments or iterations is not as straightforward as updating software code. This rigidity means that hardware startups often need to get it right the first time, as the cost of modifying a product post-production can be prohibitive. Furthermore, hardware products are usually subject to more stringent regulatory requirements, adding another layer of risk. These factors contribute to a perception among VCs that hardware is a riskier bet compared to software.

6. Supply Chain, Operational Challenges, and Many More…

Beyond development, hardware startups must navigate the complexities of supply chain management, production oversight, and quality control while scaling. These operational challenges can be daunting, requiring expertise and resources that are often beyond the scope of early-stage startups. The global nature of supply chains also introduces vulnerabilities, as seen in disruptions caused by geopolitical tensions or pandemics. For VCs, these are additional layers of risk that make hardware investments less attractive.

Why Family Offices May Be Better Equipped to Invest in Hardware?

Given these challenges, hardware start-ups are often forced to look for capital elsewhere than in the VC world. Family offices emerge as a potentially more suitable source of funding for hardware startups. These private wealth management entities have unique characteristics compared to traditional VCs, which can align better with the needs of hardware ventures:

1. More Flexible Investment Horizons

Family offices are typically characterized by their long-term investment outlook. This perspective is in stark contrast to the shorter-term, high-turnover approach of many VCs. The longer time horizon allows family offices to be more patient with their investments, aligning well with the extended product development cycles of hardware startups. This patience is not just beneficial in allowing time for product development but also in weathering market cycles and overcoming scaling challenges.

2. Capacity for Significant Follow-Ons

Many family offices have substantial assets under management and multi-stage investment policies, giving them the financial muscle to support the high capital requirements of hardware startups. This capability is particularly crucial during the scaling phase, where the need for investment in manufacturing and market expansion can be substantial. Unlike VCs, who often spread their investments across a diverse portfolio to mitigate risk, family offices can afford to make more significant individual investments and follow-ons, betting on the long-term success of a hardware venture.

3. Flexibility in Funding and Cap Table Structures

Family offices offer a significant advantage in their flexibility regarding both funding rounds and cap table structure. Unlike traditional VCs, they are not bound (not even mentally) by strict investment frameworks of “VC path” or preconceived notions of an “ideal” cap table. Family offices are less afraid to enter “broken captable” as their approach includes customizing not only the size and timing of funding rounds but also the ability to take larger stakes in the company (including majority ownership if beneficial). And engaging in secondary market transactions – providing liquidity options to less patient investors and allowing for a dynamic and responsive approach to cap table management.

4. Experienced Money

In a world where every investor boasts of having ‘smart money,’ there’s a unique breed of family offices that truly stand apart. These are the veterans, the ones who were investing in hardware when software was just a newcomer on the scene. Beyond just funding, family offices often bring a wealth of experience, industry connections, strategic insight, and a more hands-on approach due to a smaller number of portfolio companies. This comprehensive support can be invaluable to hardware startups that require guidance in navigating scaling complex manufacturing processes, establishing supply & logistic chains, and market entry strategies. The mentorship and network offered by family offices can be just as crucial as financial support in ensuring the long-term success of a hardware venture.

Conclusion: Investor Profile May Be a Helping Hand, But Not a Silver Bullet

There is no coincidence in the fact that many VCs avoid hardware investments, given their inherent challenges. While family offices don’t have a universal remedy for all these difficulties, they are often more suited to handle them. Equipped with a different arsenal than traditional VCs, family offices approach hardware ventures with a perspective that aligns with the long-term, capital-intensive nature of these businesses. Their capability to inject substantial capital and offer multifaceted support makes them potentially more effective partners for hardware startups. Although they may not have a panacea for every obstacle, the combination of a family office’s resources, expertise, and dedicated commitment can significantly impact the challenging journey of hardware innovation.