Hardware startups: B2B or B2C?

I was invited to speak at CoInvest 2015 Ventures Day, a startup conference held in a small town in Slovenia called Nova Gorica. This tiny town is actually right on the Italian border so I took the EasyJet flight from Paris to Venice and switched to shuttle bus to get here. The staffs at the hotels were Italian-Slovenian bilingual. Many signs were also bilingual. Even the food looked a bit like Italian – lots of risotto, rucola, pomodoro and formaggio. If not for the gloomy weather and rapid Slovenian conversations heard everywhere, I might have confused it with the country called Il Bel Paese that I held so dear to my heart.

After 24 hours filled with startup pitches and entrepreneur chats, I was surprised to find that there are actually a fair number of hardware startups here. However, perhaps I shouldn’t have been surprised. This is a country that has a long engineering history just like most East European countries. If you have enough talents in the pool, startups will emerge as always.

What’s also distinct about the hardware startups here is that they’re predominantly B2B hardware startups. And all of them asked me the same question: why do you guys do mostly B2C – or more correctly consumer electronics – than B2B startups?

As I said often, when it comes to early-stage venture investment, I don’t like either the top-down approach or the verticals. We’re searching for outliers and bottom-up is the only reasonable approach to find an outlier. Hence the argument is actually not B2C as opposed to B2B, but rather what kind of startups are VC-fundable?

 

VC fundability

While there might be hundreds of factors coming into play, VC-fundable startups boil down to two things: scalability and defensibility. And while both B2B and B2C hardware startups could potentially build defensibility — in fact, one could argue that a B2B hardware-as-a-service startup has higher client stickiness — the scalability is really where the difference is.

Whatever the offering is and however the clients are, B2B hardware businesses almost always have to rely on door-to-door sales process to push revenue growth. Marketing does not have that much effect. Yes, one can join all the conferences, setting up booths & LCD TVs showing beautiful videos and all that, but ultimately the deals are closed by the companies' salespersons. This is why B2B sales or pre-sales people in the technology companies (including startups) have the sweetest bonus incentive structure compared to other employees in the company, because without them, the deals just won’t close.

This also means that B2B business expansion is not only slow, but also potentially expensive. And it’s really the slow part that really kills the vibe. Early-stage VC funds have a very high required rate of return to meet for their LPs. If a hardware startup does not have the potential to grow exponentially in revenues, it’s basically VC un-fundable.

On the other hand, consumer electronics has always been a marketing game. With an exciting product, effective and flexible marketing strategies and solid operations, a startup today has the opportunity to grow exponentially, as evident in the revenues of Fitbit in the past couple of years before IPO.

Some people would argue that consumer electronics sales are also more volatile, more sensitive to economics cycles and consumer sentiments. This is all true, but it’s also this volatility that gives the potential for the revenues to grow really fast. The reason consumer consumption is volatile is because it only has a small part that depends on neccessity. Much of the consumption derives from perceived-value consumption. While in the bad time the consumption would fall back to more on neccessity, in the good time it will dwell heavily on perceived values. Therefore, if we’re gonna look for a hardware business that could potentially build that exponential curve, consumer electronics always has a better chance than B2B hardware businesses.

 

Value-chain analysis is critical in B2B

However, most of the time this is not even the reason why we decline B2B hardware startups to join the Hardware Club. More often it’s that B2B hardware startups did not figure out the most important thing in their business, which is their positioning in the value chain.

B2B is fundamentally a value sale – either you help the business clients increase the top line (revenue), or you help them reduce the cost line, or magically you kill both birds with one rock. However you cut it, the product’s value is capped by how much extra bottom line (profit) it could generate for the clients.

It’s almost 100% mathematical, leaving very little room for marketing to manoeuvre.

Let’s take a typical end consumer product, digicams, for example.

Assuming a B2B hardware startup has developed a filter that would improve the sharpness in the photos without reducing too much of the light hitting the sensor. And digicam is, despite the encroachment of smartphones, still a huge market, especially for this startup that has had zero revenues. The startup now starts to talk about the big picture (market), which is where I usually stop them.

"But where do you stand in the value chain?" I would ask.

Let’s say the ASP of a digicam today is $120. I will ask the startup to break down this number, showing how much goes into each value-added part of the supply chain to eventually renders a digicam in the hand of a consumer. And if they really do the homework, it might probably look like this:

  • 40% – channel (retail + distribution)
  • 15% – shared marketing cost
  • 30% – digicam BOM cost
  • 15% – expected net profit for the digicam maker (or brand)

Where does our example startup sit in this value chain? Squarely in the 30% BOM cost, which comprises: lenses, sensors, ASICs, housings, mechanical parts, etc.

After all of this estimation, the B2B hardware startup could finally see more clearly where they are. Then it’s time to assess the key questions:

  • How much of the value proposition of the said filter translates to final price bump?
  • Are people paying higher prices for sharper images or are they paying for the cute Japanese model holding the camera in the TV commercial shot in the beautiful Kyoto City?
  • Can that sharpness be communicated in an effective way so that consumers know they’re paying a premium price for that?
  • Do the makers (brands) even care to communicate that?

By all means I’m not shooting down the filter startup just yet. If they could provide a convincing picture after they do this analysis – hopefully before I even ask them to – the conversation could still carry on.

Otherwise such a B2B hardware startup is yet another that falls into the trap of “build it and they will come” – and I thought after 10 years worth of lean startups revolution we are already past that!

 

B2C is all about marketing

“Wait, wait wait! How does that make B2C startups any different? The digicam is still $120, right? Doing B2C doesn't make it rosier if your profit is eaten up by all the value-added part of the value chain, no?"

Well, yes and no. If you're a non-differentiating B2C product, like a random digicam, the answer is yes. You're probably worse off than your filter supplier.

However, if you're a brilliant modern startup that knows how to communicate your perceived values in the right way, you have the potential to price your product at a higher price that's not determined by functionality or specs.

Think GoPro, Apple or even Sphero BB8!

Consumers are not buying these products purely for functions. For each one of them there are emotional reasons for consumers to hand out their credit cards:

  • GoPro – buyers just want to be part of the cool GoPro community
  • Apple – ever heard about the term Apple fan?
  • Sphero BB-8 – do I even need to explain this one?

In other words, the best consumer electronics makers, including the startups, have the potential to sell perceived values to their customers which reflect in the prices. The consumers are paying what they "feel" that the products are worth. This is what gives the B2C hardware startups an extra leg in addition to its potential exponential growth and one of the reasons why we at the Hardware Club are mostly doing B2C investments.

Bottom line is, we do not shy away from B2B startups simply because they’re B2B. Absolutely not. In our portfolio we have Aryballe, the electronic nose, that sits 100% inside the B2B category. However, it's only after we understand its position in the value chain, the negotiation power, etc, that we believe it'd be a suitable investment not just for us but for other investors as well.

Therefore, I am totally open to hear out B2B hardware startups' pitches, as long as you understand well enough the value chain of your target market!

Hardware is hard – or is it?

Defensibility