NRE for equity is a dead end for everyone

From time to time startups told me that their EMS companies wanted to invest in them. In most cases it's always an NRE-for-equity proposal, i.e. non-cash. In 99.9% of the cases this is a bad idea. It's bad for the startup, bad for the investors and bad for the EMS companies. Nobody wins in the long term in this case. In the short term many would suffer. The startups might even die early due to this.

Let me explain.

 

Startups need cash

This is probably the most important part of the discussion.

Startups need cash, especially in the early stage. I've seen several times a decent startup with a good product faced sudden death simply because they were having trouble raising money before they ran out of cash.

$1 investment in cash allows the entrepreneur to decides the best way to use it given the company's situation. It will also be used much more efficiently in the hands of good founders.

$1 investment in non-cash equivalents could not be used in places that should be of higher priorities. The entrepreneur cannot use the NRE "promised" by the EMS firms to pay its electricity bills.

If a hardware startup raised $500k in cash, the founders could find the best way and timing to deploy the capital.

If a hardware startup received $500k "investment" in NRE, it cannot do anything other than continue to use the EMS firm's engineering time. It could run out of money and go bankrupt despite still having $400k of unused NRE.

 

Long-term interests are not aligned

The only non-cash exchange for equities should be sweat equities for founders and employees. Their destiny is long-term aligned with the company.

On the contrary, EMS manufacturing projects are handled by sales people, who are responsible for P&L (Profit & Loss) every single quarter. A product has at best 1.5~2.5 years of life. Sales people also tend to get their bonus earlier, mostly in the year of the deal-signing. Sales people also tend to be the first one to ditch a failing client and move on to more promising clients.

In other words, on the other side of the manufacturing partnership it's usually this sales person that is traditionally motivated by short- to medium-term (self) interest. Having such people deciding to hold your equities is at best not helpful and at worst disastrous. They also rotate a lot inside the company so the next sales person might not want your account despite the company being effectively your shareholder.

 

EMS accounting nightmare and its more harmful derivatives

When an EMS firm uses NRE to get startup shares, the shares are acquired assets, which should be parked on the ASSETS side of the balance sheet of the EMS firm. The undelivered NRE might be booked as undelivered services on the LIABILITIES side of the balance sheet.

As the equities gain or lose values over each round of financing, the values have to be tracked and reflected on the ASSETS. As services are delivered every quarter, the LIABILITIES should go down. The net difference has to show up somewhere to keep the balance sheet balanced. It'll be a total nightmare if NREs are internally accounted at the department level while the startup equities are parked at the corporate level (as they should be).

Worse still, asset revaluation might be enforced by accounting regulations. If the EMS company is profitable then the paper gain due to startup raising a new round properly will generate extra profit for the firm and be subject to tax, which is not the case if such equities were held by VC funds.

Imagine that a profitable EMS company holds shares of Uber and is forced to keep revaluing it due to those mega rounds. Every revaluation generates extra paper profit without cash inflows, while the company has to pay tax based on its annual P&L without a doubt.

 

Cannot break up from a bad manufacturing partnership

While it's true that successful hardware startups tend to stick with their original EMS firms for the long run – and this is good for EMS firms – such as Fitbit with Flextronics and GoPro with Chicony, the reverse is not necessarily true. In other words, forcing a certain long-term partnership between an EMS firm and a startup without a good match might not be the best option for the startup.

For what it's worth, Chicony is actually the 2nd EMS firm for GoPro even though the switch happened in a very early stage. Imagine now if that first EMS firm and GoPro had done an NRE-for-equities deal, GoPro will probably have to stick with this EMS firm despite knowing that it didn't work. It would then never have had the success as it does today.

 

Pointless debate about NRE amount and valuation

While other problems won't surface until at least 1 year after the fact, this one is usually the most immediate: once NRE-for-equity investment is decided, the startup and the EMS firm will engage a pointless debate about the NRE amount and the valuation.

On the EMS side, they now have all the incentives to "pump up" the numbers of NREs. What might well have been a healthy $500k NRE might suddenly be listed as $1.5M, including many service items that were not necessary for a startup.

On the startup side, it will try to use a high valuation to bring down the dilution but the EMS might never agree with its valuation since most early-stage startups are pre-revenue. EMS's thinking is all about P&L numbers. Without revenue numbers, it could not even "pretend to" do a proper valuation.

This debate could drag on for months. The next thing you know, product shipments are delayed, cash burns out, other VC investors walk away and a promising startup dies for wasting too much time on this wrong debate for no good reason.

Of course the EMS firm gets burned as well by having wasted tons of time and resources on such a project.

Everybody loses.

 

Conflict of interest

Hardware startups are trying to disrupt the large electronics giants, who are the important clients for EMS firms. While on the sales side a strict confidentiality has been the norm among different sales teams, that might not be the case at the corporate strategy level, which is usually the one that makes the actual investment. 

In other words, the sales people are used to keeping shut when running into a client whose product might compete as their consumers. The strategic people, on the other hand, are supposed to survey new trends of the technology and enable sales people to propose new solutions to clients. However ethical they are, there's no way you could stop them from including into their proposals to larger clients some of the inspiration they gained from being your shareholder, and possibly on the board.

They might also be EMS firms for your competitor. Again at the sales level that's okay. As a shareholder level, however, it could be a major conflict of interest.

 

Many other problems

There are almost infinite amount of problems that could result from this structure. All of them stem from the fundamental differences in EMS firms (project-based, P&L driven) and the startup industry (going-concern-based, long-term-value driven). One could easily come up with many many disastrous scenarios: What if the guy who decided to invest leave the EMS firms? What if there's a new CEO of the EMS firm next year and he decides to sell all of non-core assets, which include shares in your startups? What if a new VC wants to invest in you, but in his LPs there's an EMS firm that's a a fierce competitor to your EMS firm shareholders? etc...

I once drew up such scenarios to a friend who's a key strategic person in a big EMS firm who was super keen on making startup investments himself. Before I even got to the 5th scenarios he asked me to stop and changed his mind completely.

 

Has it ever worked?

To my knowledge: NO.

And trust me, at the Hardware Club I have built 50 EMS partnerships including the top 9 EMS firms in the world (accounting for $280B+ revenues last year). Most of the NRE-for-equities stories I heard were horror stories, told by people who were burnt.

In fact, even cash investments by EMS firms directly in hardware startups rarely work if they're linked to manufacturing partnerships. AmTRAN's investment in VIZIO could count as a successful investment but they would tell you that they lost a lot more over the decade of manufacturing for VIZIO at cutthroat prices – another result of conflict of interest. 

Foxconn did make a decent amount of money from the investments in GoPro – but they've never been GoPro's EMS partner. Chicony was and still is.

 

Conclusion

In an ideal world of hardware startups, venture investments should be separated clearly from manufacturing partnerships. Trying to blur the line between the two introduces tons of misalignment/conflict of interest. And doing so without even putting in cash, which is the life line of startups, is even worse.

Believe it or not: 90% of the VC job is sell-side, not buy-side

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