Hard vs. Soft: software may eat the world, but hardware is better monetized
We work with many software companies, the world seems to like them. There are 1,000 VCs in the US and they all seem to like investing in software companies. The benefits are clear. They don’t need a lot of capital to generate income, with the big cash injections really only needed to fuel growth, making them a very capital efficient model.
guest author Jonathan Goldberg is the founder of D2D Advisory, a multifunctional consulting firm. Jonathan has developed growth strategies and alliances for companies in the mobile, networking, gaming and software industries.
On the other hand, it may cost a few hundred million just to get a chip for the first income. Enterprise SaaS doesn’t need inventory, or really working capital. But build a gadget or a chip, and you need a few thousand, hundreds of thousands, millions of units just to get your first orders. For many venture capitalists, seeing all their dollars spent before the product can even be tested makes hardware seem like a bad bet, especially in a world where a minimum viable product can be churned out in a weekend. by people without coding skills. Therefore, out of those 1,000 VCs, maybe 10 will even look at the hardware.
But all of this may be changing, for both structural and economic reasons.
First of all, even if the hardware is outdated, this model offers great advantages. Chief among them is monetization. Software can sell for $100/month, the lifetime value of many software products is a few thousand dollars (obviously this can be much more in enterprise SaaS). In contrast, hardware prices tend to be much higher – a high-end CPU or GPU can reach $10,000 per chip even in normal times. Of course, this is an apples and oranges comparison, and it’s not quite that simple.
But speaking of apples… Apple products are different and better because of their software. Apple – with full attention to
User Human Interfaces is very much a software company, but it monetizes that software with hardware. If Apple sold the iOS operating system, how much could it charge? Its main Android competitor is free (sort of), so probably not much. In contrast, the average iPhone price is around $600 or $700. If done right, hardware monetizes better than software.
Then, if we look at where we are in the investment cycle, there are several reasons why hardware is starting to look a lot more attractive.
First, software company valuations have skyrocketed, especially in the early rounds. These 1,000 software-only VCs have upped the ante considerably in the market. It also becomes much more expensive to invest in software. On the other hand, the initial capital requirements for a computer hardware business have decreased significantly. We know of chip companies that can go into production for $5 million, with teams of 20 people or less. And there is much less foam in valuations.
Granted, getting a chip into production can cost between $20 million and $50 million, all of which goes to foundries, IP licensees, EDA tools, and other outside parties. That being said, what is the difference with a SaaS company? They may have a good product that is successful, but growing the business from that point to an IPO will cost $50 million plus to build a business sales team. Scaling a hardware business and scaling a SaaS business require similar capital. Simply put, software can be as capital intensive as hardware.
The only big difference is that software vendors can win customers and demonstrate their appeal with a real product much sooner than hardware vendors. But even here the difference is not so great. For a software company, making the transition from small to large is extremely risky, fraught with execution risk on all fronts – and many don’t make the transition.
Slack came to the stock market, Yammer didn’t, and even Slack didn’t last that long as a public company. By contrast, well-executing chip companies can put a chip into production with a fairly high degree of confidence that the product will work, and design timelines are long enough to gauge real customer interest. So the difference here is one of client planning, timing and design methodology – ie management. And it’s a risk that venture capitalists are well able to assess and manage.
There is no doubt that hardware investment carries a very different risk profile than software investment. And of course, software startups still have immense value. But the balance is tilting. Much of the technology works on a pendulum, and it now steadily returns to a world with much more balanced returns for hardware.
Now let’s add some calculations…
There is no doubt that starting a software business from scratch is easier than starting a chip business. One person sitting in a basement, or two people in the proverbial garage, can put together a software product in a weekend, then bootstrap it for growth and customer attraction. But that’s only part of the story.
Taking this valuable product and turning it into a viable business entity capable of generating company-sized returns costs a lot more. Money for building an enterprise sales team, money for hacking mainstream user growth, and all other functions.
By contrast, taking a semiconductor from a good idea on a napkin to a fully engineered product requires a fairly large team. That being said, we know of companies that got there with a few million dollars in seed funding and a team of less than twenty people. That’s something that wasn’t possible even a decade ago, but there’s enough talent available that these kinds of development cycles are now possible.
At this point, semi-finals get expensive. It can cost between $50 million and $100 million more to get a chip from concept to mass production. However, the semis have an advantage here (or more of a bug that may be a feature in the right light). It can take about a year to design a chip, which allows plenty of time to solicit customer feedback. A well-run chip startup can delay production until it has a high enough degree of confidence in the form of solid orders from paying customers. This means they can build a sales pipeline with a much smaller sales force.
Ultimately, semi-finished and software companies need comparable amounts to achieve scale.
Let’s look at this from the perspective of a venture capitalist. A software company can start with $1 million and take it to minimum viable product. At this point, they can take a Series A of $10 million to develop the product. If that’s enough to demonstrate the product’s fit for the market, then they can raise $20 million to start a real business. But then it starts to get more expensive. Companies that raise a Series C to develop consumer growth or business sales raise $100-200 million rounds. The ease of starting a software business means there are plenty of them, so the competition can be fierce. How many CRM companies already exist? How about accounting software? How to stand out in these markets? It takes a lot of capital to stand out. Adding it all up, our hypothetical company needs $231 million.
The model for a seed business is different. This seed round is more like $5 million. This may be enough to prepare the design for the band and attract a first client. Going live will require an additional $30 million for IP licenses (like Death and Taxes, these are hard to avoid) and an additional $50 million for production. Then the company has to foot the bill for building inventory and delivering the chip to customers, say another $75 million, for a total of $161 million.
Both companies are now at the stage where they can see what their true business prospects are, and outside investors can start thinking about exits. Let’s say the software company is hugely successful and can go public at $10 billion, and the chip company at $2 billion. The software company seems like a better bet, $10 billion out of $231 million represents a 43x return, while the chip company is 12x. But there is a big difference, with each round of funding, the software company is able to rise to a higher valuation multiple, which means the venture capitalist ends up with a smaller stake. .
After all this dilution, the software venture capitalist will end up with almost a 10% stake in the company, while the semiconductor investor will likely have over 35%. This means that the cash returns of the software company investors get a 4x return, while the semi-finished investor gets a higher return of 5x.
Obviously, the numbers can vary across the map, but the underlying point remains, and we’ve seen plenty of examples that come pretty close to those numbers.
After a decade of “Software eats the world”, software company valuation expectations were greatly inflated, with the reverse being true in the semis. We would also say that semi-finished company returns are more heavily influenced by capital, with a small capital raise capable of generating larger returns. If an enterprise software company adds five salespeople to an already large team, their incremental value is quite minor. In contrast, adding five salespeople to a tractor-trailer business can double or triple the size of the team, with commensurate returns. We would also say that our calculations are too conservative on many fronts, such as ultimate output multiples.
Large-scale software companies can be just as capital intensive as semi-finished companies. If we then take into account the large valuation mismatch at each stage of the venture capital process, it is clear that there is a great opportunity in semi-venture investing.