August 11, 2022 by Adam Hoeksema
According to CB Insights, almost 30% of all startups fail because they simply run out of cash. That number is even higher for hardware companies, which typically require a lot more money to get to market. So aside from developing a great product, there is nothing more vital to the success of a hardware startup than its funding strategy.
Without adequate funding, your company won’t have the resources to maintain growth. A deficient product development budget will set you back on the innovation curve, prevent you from fulfilling customer demand, and hinder your brand awareness efforts. In other words, hardware companies simply cannot afford to “wing it” when it comes to valuation and financing.
If your company is ready to develop a winning funding strategy, you’ve landed on the right page. This guide details everything you need to know about hardware startup valuation and funding, starting with an overview of its life cycle.
Life Cycle of a Hardware Startup
Hardware companies generally begin with one of two possible scenarios. Either the founders identify a problem and develop the tech to solve it, or they discover an innovation and look for a problem it solves. In both cases, the life cycle of their companies looks very different from that of software startups.
Your choice of valuation methods and funding sources will depend on how far along you are in the life cycle. So before evaluating the individual options, it’s important to examine the five stages in the context of funding strategy.
Stage 1: Sketching
The Sketching phase includes everything that must be done before developing a prototype. As the name suggests, this step consists of sketching and outlining ideas. If the founders started out with a technical breakthrough, they come up with options for how the innovation can be integrated into a marketable product. And if they’ve identified a problem, they “sketch” hardware that solves it most efficiently.
Many hardware companies try to secure their seed round financing before completing the Sketching phase. That said, most of them live to regret it. Investors are weary of early-stage startups, so founders rarely get fair offers at this stage. Those that do find reasonable investors tend to raise less cash than they seek, which means they’ll struggle to meet milestones until their Series A funding comes in.
Stage 2: Prototyping
Once you’ve chosen your market and zeroed in on the best product sketch, the prototyping stage can begin. The main goals of prototype development are to validate your sketched ideas and make sure the product solves the problem you identified in Stage 1.
Unlike the Sketching stage, which may not require substantial investment, Prototyping comes with sizable funding expectations. A startup absolutely must secure seed funding before starting to work on a prototype.
Stage 3: Production
While the Prototyping stage tests your product idea, the Production phase tests your entire business plan. This stage is all about setting up the logistics of manufacturing. You’ll need to complete all the necessary certifications, find suppliers, write user manuals, design packaging, and so on. Although your startup will still be 6-12 months away from shipping the finished product, Production is among the most work-intensive stages of the life cycle.
This is also your first chance to really show investors what you can do. If they see you’re serious and resourceful enough to handle the pressures of the Production phase, they will jump on the opportunity. In fact, this is often their favorite entry point - it is still an early-stage investment, but it comes with a bit less risk than a company in the Prototyping stage.
Stage 4: Manufacturing
The Manufacturing stage comes with a lot of trial and error. You are producing and shipping your hardware, all while trying to smooth out the numerous issues that arise during the process.
First and foremost, you should pay attention to customer feedback. In theory, your prototype may seem like it accounts for everything. But it’s not very likely to be 100% perfect in practice. It’s recommended to boost your customer service efforts during the Manufacturing stage.
Hardware companies are also highly reliant on suppliers. The problem is, suppliers prioritize larger volumes, and a startup in the Manufacturing phase will not be placing the biggest orders. As a result, founders often struggle with delays, defects and/or missed shipments during this stage.
All that being said, there’s no reason to panic if you run into some of the issues described above. Investors are well aware of how rocky the road gets during Manufacturing. In fact, if the company reacts to similar issues quickly and resourcefully, it can signal certain investors to jump onboard.
Stage 5: Scaling
Scaling comes as a natural next step of any startup that made it through the Manufacturing stage. That means they’ve established supply lines, created a loyal customer base, and still remained ahead of the innovation curve. At this stage, a startup officially evolves into a company.
Founders start working on larger batches of products and hiring additional staff, but they usually still need a financial boost in the form of Series C funding. If you got this far, you can dictate your own terms and choose from a multitude of investment sources.
Hardware Company Valuation Strategies
If you do everything by the book, your hardware company valuation will grow exponentially with each new milestone you reach. Depending on what stage you are on, some valuation methods may be better suited than others.
If you’re performing the valuation with a pre-seed or seed round in mind, the traditional valuation methods may be completely useless. Here are a few reasons why you can’t apply the most common methodologies:
- Hardware companies in the Sketching and Prototyping stages may not have any applicable financial data available. If your company has zero or negative net profits & EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization), these metrics can’t be used for valuation. In some cases, revenue may be the only available metric.
- Hardware startups are notorious for explosive growth, so current data may not yield an accurate value, even in the short term. Some are so high-growth that their revenue can easily go from $500,000 in one year, to $3 million in the next. This may seem like an advantage for the founders, but in reality, it makes investors think twice before jumping on board.
- Even the most successful early-stage hardware startups are rarely profitable at first. Contrary to common belief, net profit is one of the least useful valuation metrics. Hardware companies are notorious for failing to make a profit in the first 12 months, regardless of how great the company is doing otherwise. This excludes numerous legacy valuation methods from being applicable to startups.
The good news is that, despite not being able to utilize traditional methods, you can still complete an effective valuation of your startup. Here is an overview of the methodologies most often used for hardware firms:
- Risk Factor Summation
This technique works by assigning a value based on the probability of your company’s future success. Risk Factor Summation allows you to account for 12 different variables. Each variable is given a ranked value, and their sum provides a value of the startup as a whole. The deciding factors are:
- Current life cycle stage of the company;
- Management quality;
- Political risk;
- Reputational risk;
- Manufacturing & supply chain integrity;
- Marketing & Sales;
- Ability to raise capital;
- Competition-related risk;
- Technological risk;
- International viability;
- Valid exit strategy.
- Cost to Duplicate Approach
The Cost to Duplicate method is particularly effective in the hardware sector because it hinges on the value of tangible assets more than anything else. The basic idea is to calculate how much it would cost to build an identical business. Assets that must be accounted for include the cost of product development & innovation, prototyping, research and patents, among many others.
Of course, the Cost to Duplicate approach cannot account for intangible things like team cohesiveness and management quality. These factors are estimated by using industry averages in a particular geographic area or market segment.
- Berkus Method
Created by acclaimed angel investor Dave Berkus, the Berkus Method is basically a more focused version of Risk Factor Summation. You start by identifying the most valuable strengths of a startup. The company is then ranked on each of these factors using a monetary scale. If a startup is doing everything perfectly in any single category, $500,000 is added to its value. Since there are five elements the maximum total value is $2.5 million. As such, this method is only applicable to hardware firms in their earliest stages.
Here are the five elements of success according to the Barkus method:
- Marketable Idea
- Sound Prototype
- High-Quality Management Team
- Strategic Relationships (suppliers, brand ambassadors)
- Product Shipping Schedule (or sales)
- Multiples Technique
Although this method does require a net positive EBITDA, the metric does not have to be as high as with other methods. First, a “multiple” value is assigned depending on which stage your business is on. Then, you simply do the math, multiplying the EBITDA by the assigned “multiple”.
Hardware Startup Funding Strategies
You can spend hours going over different funding sources and industry trends without ever finding a straightforward answer to the above question. Considering the sheer number of options, you’ll have better luck finding the hay in a needle stack.
Lucky for you, we’ve rounded up all the worthwhile alternatives. From the textbook methods, to innovative shortcuts, here are the best ways to get funding for your hardware startup.
These are the traditional types of pitches that apply to hardware businesses. They may not be the most innovative, but they have withstood the test of time.
- Team Focus
A large chunk of tech investors live by the motto “invest in people, not companies.” So, if you’ve got talent that’s worth bragging about, it may be best to lead with who you are, rather than what you do.
Did any of your team members work at a conglomerate like Facebook or Google? Are you a veteran of your niche? Do you have an ivy league education? This is your chance to showcase all of your team’s credentials.
- Real Traction Metrics
The best proof that your business is profitable will always be measurable and tangible. So if you’re far enough along the startup life cycle, your best pitch may be a summary of your accomplishments so far. Ask yourself, have you exceeded any of the technical milestones you set out to reach? Do you have a working prototype or demo? Have you filled any pre-orders? How is the customer feedback so far?
Tech & Timing ComboEven with an amazing product, timing can make or break a hardware startup. If you rush to launch, you might end up with a low-quality product or underdeveloped distribution and market coverage. On the other hand, waiting too long can make customers lose all interest or move on to a competitor. So if you have a strong case for why now is the best time to launch your product, it may be your strongest talking point. Did the market shift in a way that makes your product in high demand? Is the hardware ready for manufacturing?
Shortcuts to Funding
We would love to tell you the startup economy is an equal-opportunity lender. Unfortunately, that’s far from the truth. As in any private sector, there are certain factors that can give you a leg up whether your product deserves it or not.
- Industry Fame
Sometimes, an endorsement is worth more than a multi-million dollar investment. With the right recommendations and PR, Venture Capital firms will approach you all on their own. The biggest advantage here is having considerable leverage during negotiations simply because they are the ones who came to you.
- Insider Connections
VCs are constantly receiving referrals from industry leaders. So, if you have any friends in high places, try asking for a recommendation. Otherwise, the VCs are choosing between recommended companies and you.
- Leveraging Revenue Models & Templates
No two startups are exactly alike, but that doesn’t mean most of the leg-work you set out to do has never been done before. Instead of spending countless hours putting together the right financial projections, you can rely on the tried-and-true templates offered right here at ProjectionHub. And if your company is in the SaaS space, make sure you take advantage of our Hardware as a Service Revenue Model Builder.
- Staying Local
A decade ago, it might have made sense to look for funding in Silicon Valley or Austin, where there are so much more investment dollars at play. However, that is increasingly becoming a bad idea. You will be in a place where no one knows you, you have no track record, and your knowledge of local regulations will be limited.
Instead, start with your local VC firms. The competition will be limited and you won’t be wasting much-needed money and time on a long-shot. They may not have the deep pockets of Silicon Valley, but at least you’ll be competing on your home turf.
- Media Coverage
A single celebrity endorsement can go a long way to solidifying your company’s image as a low-risk investment. If your category doesn’t produce any exciting “hardware porn” elements like humanoid robots or large displays, interview a celebrity customer for a human interest story that will make your product go viral.
- The Crypto Angle
Even if the problem your product solves has nothing to do with Web 3.0, you may be able to find a way to integrate blockchain technology into it. The particular features may not be essential, but they will open your company up for cryptocurrency investments. Investors poured a whooping $30 billion in blockchain startups just last year.
What Do Investors Look For In a Hardware Startup?
Chances are, you’re already familiar with the phrase “hardware is hard”. Well, even if you’re not, you can bet that investors are. Hardware startups present an inherently higher level of risk. With software, an error can be mitigated with an emergency update. But if there’s a problem with hardware product rollout, there is rarely a quick fix available.
Adjusting supply lines takes time and changing the product during the manufacturing process is often impossible. That’s why any recall issued before the Scaling stage will make most investors run for the hills.
If you want your company to stay funded throughout its life cycle, you’ll need to know what investors are looking for at each stage. Here are the questions that influence their decision most.
- Are you capital efficient enough?
Investors know how cash-hungry hardware startups are, so one of the first things they look at is how well you can manage your cash flow. If this isn’t your first round of funding, they will calculate the capital efficiency multiple. It’s calculated as your latest valuation divided by previously raised capital. If the multiple is high enough, it will attract VCs all on its own.
- How eager is your customer base?
In other words, do your customers express they need your product? Nothing is better than high pre-order numbers, but even social engagements can serve as a benchmark. VCs and angel investors are constantly looking for the next viral hardware product.
- Is the team solid?
Many founders have tried doing everything themselves, and many have failed. That’s why investors are interested in well balanced, specialized teams. When it comes to hardware firms, that means having a solid engineer, software specialist, designer, etc.
- Is the business model sustainable?
First off, are you selling a B2C product? If so, you better have some amazing, disruptive, innovative ideas, because that sector has become way too oversaturated. B2B is bound to be easier to navigate and make the hardware company valuation an easier task.
- Do you have an exit strategy?
No one starts out with the goal of selling out, but it is often the right move. Investors want to see that you’re business-savvy enough to prepare for this contingency from the start.
Valuing and funding a hardware startup comes with a long list of unique challenges. But with the right know-how and some elbow grease, you can still effectively finance your business. It is absolutely vital to consider your valuation from the investors’ point of view by concentration on what they look for. In other words, always put your strong foot forward. And remember, a good valuation will always account for both the short-term and long-term prospects of your company.