Source: https://unsplash.com/photos/nyAzMQ6Ejgs
When I think of technology, the first thing that comes to mind is a computer. However, a Google image search for “technology” will show many results of digital and holographic apps. Clearly, software has dominated the “tech” space in the last couple of decades, in both consumer’s minds and for VCs. Software investments typically outnumber hardware by a factor of 10, though of course it is much easier to envision a software idea than a hardware one. Comparing Pitchbook VC data for 2021, a search for “hardware” and “equipment” yielded far fewer deals and capital invested than a search for “platform” or “app”:
However, despite the obvious benefits in investing in software, the truth is that truly transformative technologies rely on both hardware and software – they are two complements of a wider solution. We can’t solve climate change or treat illnesses with just a software update. A recent example is how a Covid-19 vaccine was developed within one year due to advances in mRNA technology. Therefore, VCs should also invest in and support hardware startups innovating in areas such as medical devices, battery technologies, robotics, advanced manufacturing and quantum computing.
This bias towards software ventures was noted in a Pitchbook article in 2014 (https://pitchbook.com/news/articles/why-arent-vcs-funding-the-future), with the closing statement “venture capital has ignored the future, and what price the industry—and the general public—will pay down the road, nobody knows.”
Too Hard?
Why are VCs so hardware adverse? The main reasons all have to do with the fact that hardware faces many challenges that software ventures typically don’t:
High capex and upfront costs, including equipment, laboratory access, highly skilled researchers and workers.
Longer commercialisation timeline and innovation lifecycle. Rarely will there be consistent exponential growth in hardware customers, but success can be sudden and less predictable.
Complexity of integration both within development process and into customer systems.
Complexity of supply chain and distribution channel. Hardware requires physical logistics and complicated procurement processes, and are prone to delays of raw materials or equipment.
No quick fix if things go wrong (e.g. equipment breakdown).
Hardware innovation often also requires some software innovation (e.g. control systems), but new software can usually work on existing hardware.
Hardware can be expensive to test and show progress. There are often no standardised trial or beta testing frameworks (except for certain biotech fields).
For biotech, there are additional regulation, legal or ethical hurdles to overcome.
Ultimately, most VCs see too many risks associated with hardware. However, there are also compelling reasons why investing in hardware can be so worthwhile:
We may have already picked the low-hanging fruits in software innovation. The next big returns might come from higher risk ventures in hardware.
Hardware can bring huge, transformative, fundamental change - think batteries, computers, semiconductors, robotics, pharmaceutical discoveries.
It is easier to dominate a hardware market than a software market due to much higher barriers to entry. This can bring investors huge multiples if successful.
Hardware innovation can lead to further software innovation. A full stack or “software-enabled hardware” startup (e.g. robotics using computer vision) may initially innovate in hardware, but can lead to innovations in control software, user interface, computing algorithms or security protocols.
New business models such as hardware-as-a-service (HaaS) can utilise offer the benefits of transformative potential from the hardware through recurring revenues.
Exits in hardware startups, and hence investor returns, do not necessarily take longer, and can still be within VC fund lifetimes. For instance, the first two quantum hardware IPOs on the NYSE occurred within 10 years of their founding.
Encouraging more Hardware Investment
While there are some specialist VCs that are very pro-hardware tech (e.g. Bolt, Root Ventures), most would prefer investing in a new payments platform rather than a cutting-edge robot.
What needs to change for more hardware investment from VCs? I believe it takes more than just a simple cost-benefit-risk calculation. There needs to be a shift in the whole VC industry:
More VCs with Technical Backgrounds
The old saying “never invest in something you don’t understand” also applies to technology investments. Gone are the days where investment banking is an ideal path into VC. A recent survey from Hello Tomorrow and BCG indicated that 81% of deep tech entrepreneurs found that investors lacked the scientific or technical ability to properly access deep tech potential. Given VC is such a people-orientated industry, a high degree of trust and respect will go a long way towards facilitating a healthy, long-term relationship between founders and investors. VCs coming from STEM are also more likely to invest in others with a similar background or interest.
More VCs with Operational Experience
VCs with operational experience would be able to add much more value and support to a hardware startup than just capital. For instance, one overlooked aspect is in supply chain and procurement. A software company would rarely need to consider delays in the supply chain (downloading and paying for a software library is practically instant!), but these issues are a common and constant headache for hardware companies. Investors that understand how best to mitigate or avoid these issues are key to a well-rounded assessment of hardware startups.
More Engagement with Universities and their Spin-outs
Deep tech innovation often spin-out of university research, so a serious deep tech VC should have strong relationships with academic researchers, or set up university “in-house” funds dedicated to these spin-outs. VCs can also support universities through sponsoring competitions. Parkwalk Advisors, Albion VC and Octopus Ventures are examples of VCs in London who maintain strong relationships with leading universities, ensuring they have access to the most cutting-edge innovations.
More Tech Founders with Commercial Awareness
Effectively communicating a vision to investors and recognising the key messages (often non-technical) during a pitch is a skill many scientists have not had enough opportunities to develop. Universities should encourage researchers to take business training programs so they are prepared for non-technical challenges.
New Financing Instruments or Structures
Perhaps the most fundamental solution would be to design new financial incentives for VCs to invest in hardware opportunities while reducing risk, or changing the conditions of a fund that reduces the emphasis on short-term gains. A future blog post will dive into this in more detail, looking at the different ways deep tech can be funded and how this should shift in the future.
Hardware ventures are difficult, but should not be overlooked by investors, especially those with a long-term vision to contribute to real transformative progress. For instance, the world doesn’t need another app to track our carbon footprint, but rather new hardware to further improve efficiency in renewables or energy storage.
Software may be cool and is the tech you date, but hardware is the tech you should marry.