Software eats the world – but vertically integrated hardware delivers happy customers!


(circa 8 min read)

Marc was right – very, very right!

Marc Andreessen (of VC firm A16Z) wrote a famous article in the Wall Street Journal in August 2011 entitled “Why Software is Eating the world”.  

When re-reading this article today, it might feel as if Mr Andreessen was stating the obvious. But very few realised how right he was when it came to the meteoric growth of the big digital behemoths commonly known as the FAANG (an acronym for the market’s five most popular and best-performing tech stocks, namely Facebook, Apple, Amazon, Netflix and Alphabet’s Google).  Even after the recent market correction, the FAANGs currently have a combined market value of over $2.8 trillion! 

On top of FAANG, we now have a new slate of “asset-less” ride-sharing digital marketplaces like Uber and Lyft, who are still private but both announced plans to IPO this year with expected valuations of $90-120bn for Uber alone. The list goes on when it comes to less than decade-old companies that are changing the way that we live our everyday lives. We now expect everything from transport, entertainment and food to be available on-demand, on-line, real-time, all the time!  

Why VCs love software

The whole notion of Andreessen’s article was that everything is going digital, and no industry escapes this tsunami of disruption from innovative tech-startups that challenge “traditional” businesses with better, cheaper, simpler and more available alternatives.  

That’s clearly why VCs love to invest in software companies! The winners simply have the potential to return an obscene amount of return on invested capital. In the Uber example, FirstRound Capital seeded Uber with $1.6m between 2010-2011 which will be worth c.$5b at a $120b valuation according to this article in the Wall Street Journal! 

And especially favoured are the ventures that offer their Software-as-a-Service (SaaS) with recurring subscription fees and addictive user behaviours.  It’s nothing new to tie in customers to keep spending but it has become a lot easier and smarter. 

We now see the emergence of a “Subscription Economy” with everything on-demand from software, to hardware and media content.

With access to consumers digital profiles, subscription offers are often personalised and intelligent algorithms ensure that customers are continuously engaged. It’s often really hard to get an overview of all the subscriptions you have signed up for, let alone cancel or renegotiate them. This model has generated innovative startups such as Minna Technologies that help customers manage an avalanche of subscriptions and vertically integrate with existing bank apps.

“Speed of feature & function iteration” has also become a key success factor for progressive software companies. It’s a race to stay ahead and charm customers. There is little or no customer loyalty to software based services that are easily swapped for something better and cheaper.

So is disruption and success really all about the software eating the whole cake?

Why customers love vertical integration

If we take a closer look at the ventures that have grown and stayed in the stratosphere, they tend to have more than clever software and lots of deep user-data in common. They also have found a way to vertically integrate services and hardware into the valuation-chain. Growing and sustainable tech-companies tend to control and deliver the “whole experience”.  

A classic example of this vertical integration is of course Apple. It wasn’t just the iPod that transformed Apple from a crisis company to a success in the early 00’s. When the iPod was launched in 2001 it was a cool MP3 player, but it was two years later that the combination with the iTunes Store took the experience to a whole new level. The combo of elegant hardware with the easy downloads of songs, was the start of the Apple turn-around from the doldrums of the late nineties. 

The same synergy was repeated when the iPhone was released in 2007 with the innovative App Store (arriving a year later).

Some of today’s meteoric disruptors are using the same vertical integration playbook from start. For example, Scooter-sharing startups such as Bird and Lime are disrupting urban mobility with a piece of smart hardware (connected scooter with digital locks) and an easy to use app to find and pay for the ride. The result: billion dollar valuations.  

Uber in their quest to not lose out on the new mega-trend of electric urban mobility, took a step out of the asset-less model to buy Jump in April of 2018. This e-bike sharing company will extend Uber’s now classic taxi-hailing services, but with their own hardware but the same app. It is a very smart move as cities suffer increased congestion and we will see more and more of car free city centres.

Today´s King of Vertical Integration – Guess who? 

Of course Amazon is the prime example (excuse the pun!) of vertical supply chain integration. Amazon has gone from being a marketplace for books to becoming a fully integrated software, hardware and services company. Amazon’s vast data and algorithms probably provide them with better knowledge about its consumers’ behaviour than their customers themselves! 

Amazon now owns trucks, planes and warehouses. Not to mention the server racks that make up the world’s largest cloud services platform – AWS.  And now more than 50m Alexa smart speakers and tens of million Echo enabled devices have been shipped, with 100m jokes delivered according to CNET! The result is the most valuable company on the planet as of January 2019 (c.$800b).      

One challenge still for Amazon is the “last-mile-delivery” in congested urban environments. This part also requires physical transport assets and 3rd parties to complete the perfect service. I’m sure that Jeff Bezos’ obsession to deliver an outstanding customer end-to-end experience makes this challenge high on the agenda to solve.  Not just with drones that are limited to small packages and causes all sorts of issues with safety. 

My bet is that Amazon will turn to high capacity containerised eCargoBikes like the ones build by Velove Bikes, that are vertically integrated with last-mile delivery and route optimisation software.  Not just to deliver what you bought, but to offer complementary products and pick up returns.  A mobile shop, enabled by vertical integration of hardware, software and services.  

The recent physical Amazon Go stores is also an example of not just a futuristic high street shop, but a piece of the Amazon vertically integrated supply chain that can never be solved by software alone.

Why VCs don’t like Hardware…and maybe miss the benefit of vertical integration ventures

So with all these great examples of successful companies, why aren’t most investors keen on startups that include integrated hardware, if it’s a key component to deliver the ultimate customer experience?

In my daily work as adviser to growth ventures I converse with many VCs as to what they are looking for these days. Many of them have decided to focus on B2B SaaS companies with proven sales traction, typically defined as Annually Recurring Revenues (ARR) of minimum $2-3m with monthly growth of at least 5-10%. 

These ventures are especially attractive if they also focus within certain industry verticals. The trick is to capture a market´s sweet-spot by having deep domain know-how and thereby shutting out competition.  

Other investors favour B2C marketplaces with a clear target group and proven Cost of Customer acquisition (CAC) and Lifetime Value (LTV) that won’t be eaten alive by Amazon or Alibaba. 

The more technically advanced VCs want to see “deep tech” in areas of crypto/blockchain, AI or similar. If it also solves an immediate industry vertical “big hairy problem” the better. 

But very few VCs will jump for joy when they see an entrepreneur demonstrating a piece of hardware, even if it comes with an integrated digital component for connectivity or subscription model for recurring revenues.  Typically, antibodies are activated in the investor’s brain when they hear the word “hardware”. They think capital intensity, long product lead-times, Chinese copy-cats and poor margins in a race towards commodity margins. 

The paradox is that the same things can be said for software companies today, with China forging ahead with not just copying but also innovating faster than Silicon Valley.  

This article in Forbes makes a good point about this trend.  

Another example is eCommerce marketplaces. Most of the ones started off in the US have been cloned by Rocket Internet in Europe, Asia and beyond. So speed of execution and “happy customers” are still the entrepreneur’s North Star. What’s out there, software or hardware, will surely be copied sooner or later.

But to try and copy a vertically integrated company is not as easy. To build one is of course also not trivial.

The reason for the specific concerns with hardware-based companies is of course valid and to some degree based on experience of how hard it is to scale.

In spite of this, many of the category leaders in hardware-defined markets have gone on to deliver handsome returns for the investors, even if some have had some hard landings and have had to pivot just like software makers. I’m thinking of drones, action-cameras, 3-D printers, wearables fitness wristbands and now of course e-scooters/vehicles and autonomous cars.

What’s interesting though is to see the boost in market value that is created when hardware innovation combines with societal mega trends. We are seeing some early trends like this when fitness trackers with pulse-meters are sold as part of health-insurances, or when an e-bikes receive government concessions to accelerate clean city initiatives. This is another example of vertical integration of hardware/software with services where additional synergies are released.

Maybe investors need to pay a bit more attention to these hidden opportunities, where smart industrial hardware design, combined with great software (typically AI enabled) meet larger societal changes driven by health, food, environmental, energy or other factors.

Will China win the full stack vertical integration in tech? 

Will Chinese companies take over the industrial design innovation baton from the West, and not just contract manufacture hardware “designed in Silicon Valley”? We are seeing signs of this innovation shift from the SF Bay Area to Schenzen. The amazing thing is the speed of making and launching products in Schenzen. It goes for the full stack including software, hardware, services. 

Chinese consumers can today use a single app like WeChat by Tencent to perform a multitude of integrated services like messaging, payment, games, conference calls and social media.  Consumers clearly love this vertical software integration as there is no need to keep swapping apps like we do in the West with a multitude of different incompatible apps. It would be no surprise if the Silicon Valley companies would take a page out of these Chinese companies’ book. Now we have cloning going from East to West.

So the question in my mind: With a beeline of investors in the West chasing the best B2B SaaS ventures, who will invest in the stuff that actually executes the software services, delivers the food and moves us around in the future of smart and clean cities? 

Why Consumers love great hardware design…connected!

It seems to me that some of the world’s most valuable, loved and admired companies are based on beautifully crafted hardware with a loyal fan-base that almost acts as a tribe. 

People love to buy products that reflects a certain lifestyle. Some customers even pay premium prices up-front to buy their products before they are even launched (e.g. new products from Tesla and Apple).

Some people say that Harley Davidson Motorcycles are offering an overpriced old technology, but some of their customers go as far as to tattoo their bodies with their logo. I wonder if their new LiveWire e-Motorbike showcased at CES 2019 will still entice such deep  sentiment with their products?  I haven’t met anyone yet with a Facebook or Google tattoo but maybe the Tesla logo might be on offer next to Harley Davidson’s in the parlour in the future:)? 

So why aren’t most investors keen on industrial design and hardware anymore? Have they gone off it since GoPro ran out of steam as a one-product camera company without any ARR (even if they tried to create a shared action video space), and clones are now appearing at less than half the price and maybe even as a better product? 

Or again, is it simply because of the threat from Chinese copy-cats that now have become innovators themselves, delivering better and better quality than their Western competitors. 

Maybe this trend will be bucked by the current tariff war between US and China?  And it’s not just the US who are pressing China on fair trading conditions. Just last month we saw that the EU slapped tariffs on eBikes made in China, after it was revealed that China had given subsidies to their domestic manufacturers to compete unfairly with their European competitors.

New manufacturing trends to reignite investments in hardware – maybe? 

We are now seeing “Industry 4.0” and “Additive Manufacturing” advancements in how product cycles can be reduced substantially by automation.  Many large manufacturers are now moving away from Asia to be closer to target geographical markets in Europe and the US. Both to avoid the geopolitical uncertainties, use the latest in manufacturing automation and benefit from direct e-commerce biz models.  Adidas is a great example of this trend.

Germany has never really given up on making quality goods “at home” and as a probable result is the strongest economy in the EU!  It will be interesting to see in the next few years if German vehicle and home appliances manufacturers can innovate faster than Silicon Valley on both electrifying and integrated software and services. 

On a more personal level, it seems to me that people still love gadgets and stuff, especially if it boost their lifestyle.  It’s like we are still kids at heart and can’t wait to get our hands on the latest smartphone, eBike or intelligent speaker! This year’s CES award winning new innovations is proof of this.

With these advances in manufacturing maybe the best investment opportunities are ahead of us. Driven by both vertically integrated innovations and the sharing economy.  IoT (Internet of Things) has just begun and it seems that the 10 predictions by Gartner for 2019 will affect us all in both human experiences and related social issues.  Dumb hardware is fast being replaced by smart stuff!

The cherry on top of the cake is the unique data, that only these connected hardware devices will generate and hopefully improve peoples health and happiness. 

My hope is that the entrepreneurs behind the new connected devices  will also value personal integrity and security whilst delivering exceptional user experience. Then they might well find their logos tattooed on their future customers’ skin.

I would love your comments and thoughts.

Greetings!

Thorgeir

Disclaimer: Elevera Advisers is an investor in Velove Bikes AB and adviser to Minna Technologies AB


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