Why Investors Should Prioritize Hardware Over Software Companies

Although venture capital has focused largely on software companies, it’s time to give hardware companies a closer look.

Written by Robert Cote
Published on May. 17, 2023
Why Investors Should Prioritize Hardware Over Software Companies
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In the world of venture capital, emerging software companies hold the limelight. Lower capital requirements, higher margins, and rapid growth potential have made them the sweetheart of the VC world. Digitizing the world through software, though, has proven to be a challenge for VCs when it’s time to deliver actual returns to investors from sales of the equity they hold in these companies. 

Software companies often have low barriers to entry for competitors, putting even the best investments at risk over time as the playing field becomes crowded. Either the investment doesn’t exit because the company has been replaced by one or more competitors and its business disrupted or the company doesn’t exit in a timely manner or at a price that matches a VC’s paper valuations along the way that set investor expectations.

Compounding the competition that software companies inevitably face is competition among VCs for the best software company deals. Too many VCs are chasing too few deals, which means the stock price gets bid up, resulting in irrational valuations that are hard to realize for investors. 

So, it’s high time we give hardware companies and other companies that make new physical products or infrastructure based on breakthrough innovations their due recognition. Why? 

3 Reasons VCs Should Invest in Hardware Companies

  • Hardware can create American jobs.
  • Meeting ambitious goals requires innovation.
  • High barriers to entry protect investors.

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Hardware Can Create American Jobs 

Our nation needs more of these hardware companies rooted here to create jobs. We read in the press every day that we must rebuild our manufacturing industries. We do this by investing in the emerging hardware companies that can make it possible. 

These hardware companies have developed advanced manufacturing practices that require our nation’s highly skilled workforce and support the resulting higher labor costs. They have figured out how to manufacture products in every industry in new, more efficient ways. And they have developed game-changing new categories and kinds of physical products.

One example is Ubiquitous Energy, which has developed solar cell coatings that are applied to the glass windows and facades of buildings to turn entire buildings into solar panels. Another is Nano-C, which has developed the manufacturing equipment and processes for making nanocarbon materials that are used to make these transparent solar cell coatings possible. 

If we wish to compete with China in the long term and reverse the exodus of our manufacturing industries and jobs to overseas markets, we need to focus on emerging hardware companies. Our national security and our economy depend on it. 

 

Meeting Ambitious Goals Requires Innovation

Hardware companies are at the forefront of breakthrough innovations based on deep science and engineering. Much of that innovation is focused on helping companies in nearly every industry meet sustainable development goals because they are under pressure from governments and the public to protect our planet for future generations.

Meeting these goals, however, requires new technologies — i.e., intellectual property — that make the manufacture and use of physical products much more efficient and thus much more profitable. These goals include using fewer resources, reusing waste streams, and using renewable sources of energy to decarbonize our world.

For example, major brands are committed to the circular production of their products, with H&M committed to reaching 30 percent recycled materials in all garments by 2025 and 100 percent by 2030. And PurFi, a Tulsa-based company, has developed equipment and processes that can take the clothing waste from cut-and-sew factory floors of major fashion brands and turn it into virgin quality fibers for use in making the same high-end garments.

Another example is a Denver-based Global Thermostat, which has developed equipment that can capture CO2 from the air to clean it and can make carbonated beverages and gasoline without petroleum products. 

These investments are like real property investments, with the IP assets holding considerable value to secure each investment from capital loss. They generate income for investors from use of the IP through sharing in revenues for returns, while still holding an equity or buyout percentage in an exit for the upside of a traditional venture capital equity investment.  

The potential for disruptive value propositions to businesses and people in the green transformation of the world is huge, and any venture capitalist should be enticed by these opportunities. Going green is no longer just good for the environment, it’s good for people and businesses as well.

 

High Barriers to Entry Protect Investors

Investing in hardware comes with its own set of challenges, but these are far outweighed by the benefits. This type of investing requires more capital, greater patience, and a deep understanding of manufacturing and supply chain complexities. But the payoff can be incredibly rewarding. 

Hardware companies pose high barriers to entry for competitors due to the substantial capital and long development timelines required in both research and development and in building proprietary manufacturing equipment and facilities. These companies also often have a substantial portfolio of intellectual property rights in the form of patents and trade secrets to protect their IP against competitor theft. 

These high barriers to entry come with the advantages of no or limited competition and durable revenues that enable cash flows to investors over the course of an investment rather than waiting years for an exit to see returns.

Yet hardware companies remain underrepresented in VC portfolios. As venture capitalists, we need to look beyond the initial hurdles that these companies may present and see the opportunity they represent for our nation, our investors, and the world’s people. Though there are risks associated with investing in hardware startups, those risks can be mitigated. Diligence is key: Investors must understand the market, the IP,  the team, the business model, and the customer pipeline to confirm that the value proposition is real and durable. 

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The Future Is Integrated

The future is not just about software or hardware; its about the integration of the two. The best example is the coming revolution in artificial intelligence, which will work with equipment and data to optimize uptime, quality, yield and predictive maintenance for improved efficiency and profitability. Companies that effectively combine hardware and software will lead the way. By overlooking hardware, VCs will miss out on the next big thing.

The age-old debate of hardware versus software is becoming increasingly irrelevant. The companies that dominate the future will be hardware companies that seamlessly integrate the two. Therefore, VCs should not shy away from hardware startups but should embrace them as part of a balanced and forward-looking investment strategy.

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