Why VCs should love hardware startups

Skip Fleshman is a partner at Asset Management Ventures.

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Venture capitalists hate investing in hardware startups for a myriad of reasons. Design and iteration are more difficult. Margins are low. Manufacturing issues are unpredictable. Inventory is expensive to hold and manage. Shipping is costly and cumbersome.

But this paradigm is shifting and venture should think twice before dismissing hardware companies out of hand. Here are some reasons why:

Hardware enables software: Not everything can be managed with a mobile phone app. Some software just works better with hardware. For example, when my 45 lb. border collie, Bailey, wants to get out of the yard, he gets out of the yard (six-foot fence be damned). My Tagg app helps me find him, but only because Tagg sells a collar with GPS tracker powered by a month-long battery that sends a signal to the software that uses 3rd party mapping sources that notifies me of his jailbreak and helps me find him. No collar, no Tagg, no Bailey.

Connected devices provide a better user experience: Often a connected device is more effective than a smartphone. For example, nearly every mobile phone has an accelerometer that can be used to count steps. But users are unlikely to carry their phones while working out or when running about on the weekend, when they most want to count steps. Connected wearable devices, such as Basis, FitBit, and Lark (an AMV portfolio company), are much more versatile solutions. Additionally, though the hardware is fixed, the startup can continue to update the software, so companies retain some flexibility to modify the product after it’s in user’s hands.

Rise of hardware ecosystem: Institutions catering to hardware startups are lowering both the costs and risks. For example, incubators and accelerators like Lemnos Labs, Bolt, HAXLR8R, PCH International and AlphaLab Gear allow startups to instantly plug into existing resources for design, prototyping, testing, regulatory approval, supply-chain management, manufacturing, packaging, and distribution so that they can get to market quicker and cheaper than ever. By working with PCH, Lark was able to bring their first product, a sleep tracker and band, to market for under $1M in less than eight months.

Additionally, the rise of crowd-funding allows hardware startups to validate their ideas, secure users, and raise the capital to start production all at once. Furthermore, when pre-orders exceed expectations, companies can take advantage of unexpected economies of scale. Pebble, the most highly-funded Kickstarter project to date, blew through their $100,000 initial goal in 2 hours, eventually raising $10 million for 85,000 smartwatches. Lockitron, which was rejected from the platform only to raise $1.5 million in just five days on their own site, demonstrates that there’s demand for Kickstarter-esque funding even outside the Kickstarter platform.

Monetization opportunities increase: Connected devices give companies multiple ways to generate revenue: basic hardware sales, peripheral equipment, premium services, advertising, app purchases and license fees for things such as corporate dashboards and user management. Consumers tend to be willing to pay more for something they can touch and feel than they will for basic application. So even though hardware margins may be lower than software margins, the hardware itself appears to add more perceived value.

These hardware trends have already anointed a pack of notable hardware successes. Nest, a personalized wi-fi controlled thermostat is now shipping 50,000 thermostats a month. Pebble, which originally turned to Kickstarter because venture firms weren’t interested, just raised $15M in venture funding and plans to make 15,000 watches a week. FitBit raised additional capital at a $300M-plus valuation. These are merely the first of many successes to come. Early-stage VCs would be remiss to let the next ones pass them by.

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Skip Fleshman was an early investor in HealthTap, Lark, Skybox Imaging, and Ooma. Follow Skip at @AssetMV and @SkipFleshman.

Jawbone Up and Pebble photos by Devindra Hardawar/VentureBeat