The most critical competitive advantage of a VC is the private VC network, comprised of an inner circle of frequent co-investors and an outer circle of VC friends who are happy to do a catch-up coffee anytime when in the same city.
We frequently check with our private VC network on the investment trends. Call it a herd instinct but the reality is one cannot be too contrarian to the point where your portfolio companies don't get any follow-on funding from other tier-1 VCs.
As 2017 kicked off for the Hardware Club as usual with a grand firework at CES in Las Vegas and a following week in Bay Area, we've done some heat check with our private network. Here are some thoughts for the investment trends in hardwares for 2017.
Deep Technology is Back
We've always been a deep tech proponent as we're based in Europe with a lot of research institutes and less caught up in the frenzy of lean startup trends such as SaaS or sharing economy. However, during the 2nd half of 2016 we started to see our friends in Silicon Valley talked about deep tech more and more.
Even Y Combinator, synonymous to lean startups, started talking more and more about deep tech since last year. Now terminology such as "anti-lean startup" are starting to hit the VC and startup blogs. It's almost without a doubt that this year if a startup comes to a tier-1 VC with a super lean biz model without deep tech, they better have very good user or sales tractions already. Otherwise the discussion could be quite awkward.
For hardware startups, there has always been a perspective on deep tech. We see 2017 as the year where hardware investors lean toward heavy but scalable technology, more B2B and protected partly by patents.
Consumer electronics startups that are not based on deep tech will have to show very strong capabilities in branding and marketing and probably do much better in pre-order sales to get early-stage funding.
Caveat: always beware of capital efficiency, as always. Deep techs by themselves don't necessarily generate great investment returns, as evident in the semiconductor industries.
Artificial Intelligence / Machine Learning
Not a buzzword play but it's getting more and more common that the hardware startups, whose products collect a lot of real-world data rather than internet data collected by the software startups, are employing machine learning in the cloud to help them make sense and monetize on the data or provide better user experiences.
Hardware startups who could apparently benefit from AI/ML but do not incorporate it will have to explain to VCs their rationale for not to do so.
On the other hand, hardware startups with at least one AI/ML expert in the team would be favorable to get tier-1 VC funding.
Financing Working Capital with Alternative Options
The trigger-happy days of completely using VC money to fund working capital of hardware products are probably over. While realistically VCs won't expect hardware startups to fund working capital completely with loans or revolving facilities provided the likes of Silicon Valley Bank, the startups have to at least come to pitch the VCs with some options addressing this.
We're also seeing more and more financing providers showing interest in financing working capital of hardware startups, as inventories are tangible and working capital cycles are more predictable. This would be an interesting development to watch in the whole capital structure of hardware startups.
While outsourcing remains a powerful option for hardware entrepreneurs, the hands-down dominance of DJI in the drone market and the failures of several high-profile hardware startups in Silicon Valley that focused mostly on softwares and outsourced most of their hardware designs have sent a very clear signal to the VCs that in certain categories the hardware startups cannot be just purely software people.
In other words, instead of claiming "outsourcing everything" as an advantage, hardware startups have to reflect carefully the option of vertical integration in-house, when applicable, or at least have a clear roadmap for such an option.
Just like in the software startups, M&A exits will continue to grow and dominate the exit scene for hardware startups. While it's usually not the job of entrepreneurs to think about exit channels too early, it's good to keep in mind about potential acquires 4~6 years down the road.
The key point of hardware M&A exits is that, unlike software startups who usually get acquired by large players in the same field, hardware startups will see a lot of cross-industry M&A exits.
For example, I won't be surprised if some activity sensor startups get picked up by large insurance companies in 2017. Likewise, hardware products that actually collect valuable consumer purchasing behaviors, such as our portfolio company Shortcut Labs with their best-selling product Flic buttons, could be targets for Chinese consumer internet giants such as Tencent and JD.com, as they eagerly tape into the lucrative consumer markets in Europe and USA on top of their dominance on the domestic market.
Hardware startups therefore could benefit from a little bit a brainstorming within the team about their products, which might bring different values to the product users now and the potential acquirers in the future. Both would be good justification to implement certain product features & functions, provided they won't hurt user experiences or add significantly lots of cost.
Europe, including UK for now
It's becoming obvious to even tier-1 Silicon Valley VCs that Europe is very good in hardware startups. We're seeing our Silicon Valley friends visiting us more and more often.
France and UK remain the most compelling countries in hardware startups, both in quantity and quality. We're still waiting for Germany to pick up in quantity, which has been an odd case since one would have thought that Germany should lead the pack given its roots in industrial and automobile technologies. I guess the most likely reason is that most hardware guys continue to work for large successful German corporates such as BMW. To encourage them to leave and create their own startups would take something more.
Nordic countries continue to be the most interesting. Much like their software startups, their hardware startups are fewer but all of very high quality. We continue to be excited by the startups coming out of Sweden and Denmark. Finland is picking up as well. Furthermore, as citizens from these countries have always known that their markets are too small for them, they always start with European or USA markets, or even global market, which is important to us.