What Is Your Hardware Business Gross Margin?

I’m seeing an endless stream of hardware-related companies these days. In our world, we are focused on software wrapped in plastic, a line I think I first used some time in 2012. If you understand our themes, it fits squarely within human computer interaction for us.

There was a point in time – probably less than six years ago – where very few VC firms would even consider an investment in a hardware related company that was aimed at consumers. Every financing for every company we’ve invested in this area has been extremely difficult. We were not the first, nor are we the only, but in 2010 it was a very large, very dusty, and very dry desert landscape.

Suddenly, hardware related startups are all the rage.

While there has been more clarity on the core long-term economics of a hardware business, I continue to be baffled about the lack of understanding – by both VCs and entrepreneurs – of the core economics of a business like this at scale. A few folks, like our friends over at Bolt, have written great blog posts on this, but I fear that they are being overlooked, unlike the 3,671 blog posts on SaaS software, especially around SaaS metrics.

I was listening to a panel recently where several hardware entrepreneurs were discussing their businesses. I asked a simple question: “How do you think about your gross margin?”

The answer was all over the place. There was a lot of focus on current gross margin %, vagueness about how to compute gross margin, and discussion on subsets of cost inputs. There was no consistency in definition or view, especially at different scale points of the business. I could tell the panelists were uncomfortable with the discussion and the audience seemed to want to just move on and talk about something else.

I expect over the next year there will be 174 VC-based content marketing posts about how to build a successful hardware business. If they emulate the 3,671 posts about SaaS-based businesses, there will be plenty that discuss gross margin and how to think about it. Hopefully they’ll include a bunch of derivative metrics around pricing, BOM, shipping, and channel mix. Maybe they’ll even include information at different scale points of the business and tie the metrics to marketing and sales expense.

For now, if you are a founder building a hardware-based business, I encourage you to get to know other founders who have built successful hardware-based businesses at scale and go deep on the financials of their journey. You might be surprised how little equity is actually required to build a marketing-leading, cash flow positive, high growth, hardware related company.

  • Campbell Macdonald

    I’m new to the hardware world and this is right on. When we look at drivers for GM, scale plays a big role. But the other one is business model and customers willingness to pay, which I think has more latitude (at least in the early days) in B2B products vs B2C.

    I see so many consumer hardware products that are stressing about BOM costs just to make their models work. Whereas with most B2B ones, the hardware costs are not a material part of their cost structures. Here, much more like B2B software, the costs are in two main categories: 1) product development (salaries for designers and developers) and 2) customer acquisition. And like software, the key numbers to align are a large LTV relative to CAC and a payback period you can live with.

  • Or not.

    I went down this path a couple of years ago. I even talked to Bolt at one point. The economics are clear (and beyond Bolts control btw). Its not possible to make any kind of profit at all unless you do most of your work offshore. Offshore work is only possible if you’re willing to do things at scale, otherwise the offshore manufacturers are not interested. I don’t like Trump, but he’s right in that foreign govts. (China mostly) have artificially lowered their costs to us with subsidies and currency manipulation.

    Interesting, I wonder if this new “rage” is because you VCs are anticipating Trump doing some things that might change this dynamic. There’s nowhere to go but up in that business I would guess so it might actually be a good time to put some money in it….

    • Wow – cynical. I don’t think has anything to do with Trump.

    • Matt Kruza

      Or also the fact that average wage rate in china is (was a decade ago.. changing some now) $1-3 fully loaded vs $20-50 fully loaded here. So in labor intensive business very easy to see how it works even before currency and regullatory manipulation. Now for heavy industries like steel production currency manipulation is definitely a big issues.. not enough nuance is typically articulated in these speeches.

    • uhh…im a bolt company. and we do our manufacturing in the usa. Maybe your idea just wasn’t right?

      • Actually, I was mistaken, it was another startup. My apologies.

  • Everything goes in cycles. Having built two SaaS companies I just can’t believe the amount of press that they now get, but what do that say innovators, then imitators, then idiots.

    Years ago I said that I wanted to use software to improve a traditional business not just sell to business. That has now happened in spades. I think it will now happen in hardware.

    It amazes me when people don’t understand gross margin. To me it is the most critical part of a business. The only thing that covers costs is gross margin.

    Not that it has to be as high as possible but to just understand what it is. For instance I would argue that Amazon’s moat is its very low gross margin. The same for Walmart.

    • Matt Kruza

      100% agree. Was able to quicklly find another good article on that. It is completely how I think about my business now and how i have in the past in both consulting and equity research. Gross margin is “where the business begins and determines the decision set” i believe. http://tomtunguz.com/gross-margin-trends-saas/

  • StevenHB

    You were/are involved with Fitbit, Sphero, and Harmonix (off the top of my head). How did these companies deal with this issue?

    • And a bunch of others. Makerbot, Glowforge, Occipital, Revolar, TrackR, … The short version is that they / we understand the underlying metrics extremely well at all stages. My partners and I have made a study of it, we’ve now had experience with companies that have scaled from revenues of $0 to $multiple billions, we’ve had some failures that helped us understand what not to do, and we keep thinking about it.

      • The Bolt Blog is full of great content to start to understand the business.

      • Since you mention you keep thinking about it, why do you not invest (of the companies listed and including Fitbit, Sphero) in anything important and serious? They all seem somewhat lightweight gadgetry trendy things with a consumer tilt that inevitably will just end up in cramped competitive spaces? They seem to be things that anyone can do soon enough and many are doing. They may reach a temporary high volume point, but will they ever become a critical need? Is it a focus on quick scaling and fast returns? Or is it just a refection of the world view of the people / investors?

        • What you think is important and serious may not be equivalent to what I think is important and serious.

          • Clearly. So I will take that as it’s world view of the people / investors. Perhaps it’s not an aspect your willing to “keep thinking about”.

  • Doug Gibbs

    When I used to work in hardware businesses in Boulder, we aimed for 60% margin over the landed BOM cost. The margin covered office space, engineers and overhead usually.
    The key is to figure landed BOM cost, not just parts. What does it cost in a box, ready to ship with everyone paid?
    Also, a rule of thumb, “if you can’t build your product and break even locally, you won’t magically become profitable in China.” It gets harder and harder to find local manufactures, but I think that still applies. Trying to work out the manufacturing kinks on another continent has never worked in my experience.
    Most of my experience is with low to medium volume products, not direct to consumer electronics. We expected a high margin to stay in a nice office off 55th and Arapahoe.

  • curious if you think licensing is a good strategy for hardware if it’s something that goes inside something

    • Nilesh Trivedi

      Licensing IP or licensing compostible parts of the software stack ? Or are you probably talking about ‘components’ that go inside the actual HW product ? Licensing the IP and letting an OEM or skilled manufacturer take over the building side of your IP is only attractive if you never intend to grow big. Depending on the margins, the buyer you are licensing to, will find ways around you unless you are an incredible part of the system and they can never build the product without. And for obvious reasons, wwith licensing, you don’t get to attain the bigger pie since you were only a small part of the pie no matter how large it gets.

      But if you are talking about the former i.e Hardware as a Service kind of business model, then there are some really good companies that have grown high margin business based on the software in it. Meraki is a good example for something like that, and we see these companies in the old/enterprise/B2B sectors a lot more than consumers.

      • In some cases I see a way to grow faster and generate revenue. Toys for example. I can understand and appreciate Brad’s point of view though. I recall his post around a year ago on trying to turn a mega corporation into a customer. Not worth it.

    • Nope. I hate licensing. Own it.

  • I’m new to the hardware world and this is right on. When we look at drivers for GM, scale plays a big role. But the other one is business model and customers willingness to pay, which I think has more latitude (at least in the early days) in B2B products vs B2C.

    I see so many consumer hardware products that are stressing about BOM costs just to make their models work. Whereas with most B2B ones, the hardware costs are not a material part of their cost structures. Here, much more like B2B software, the costs are in two main categories: 1) product development (salaries for designers and developers) and 2) customer acquisition. And like software, the key numbers to align are a large LTV relative to CAC and a payback period you can live with.

    • That’s exactly what we see in our financials, the LTV is huge, but into big industry such as Energy, Aviation, Civil Infrastructure etc.. the CAC is also large, mostly just to due-process. The journey through papers, workshops, pilots.. means a minimum of 4 years before returns, but these returns are long term with minimum 5-10 year full service deals and extra high value. There really is no short cuts, just the right connections to make sure there are no missteps. Products in these regards (new, not previously existing) if in the right place and time can step in and simultaneously set up their own barriers to entry with sanctioned IP/Methodology against would be followers.

    • David Merrill

      Payback period is something I’ve been talking to other HW entrepreneurs about lately.

      The dilemma that plays out with a HW+service model business is: how to price the hardware? Say you’re selling a device that *only* works with an associated (not free) software service, and the service pays back the cost of the hardware over 10 months. Do you give the hardware away for free to remove a barrier to entry and stimulate quicker scaling of the customer base, knowing that the software service pays it back 10 months in? This ties up capital. Or do you price the hardware at cost or with some margin, to reduce the payback period?

      In a recent example of this dilemma I’ve talked with both the entrepreneur and investor: the entrepreneur wants to invest more upfront capital to give the hardware away for free, to scale the customer base more quickly and let the service revenue create good unit economics over a longer period of time, while the investor wants them to charge $$ for the hardware, to reduce the payback period in order to be able to reinvest revenues into building more hardware sooner with less capital.

      In some way, this seems like an inversion of typical roles. The entrepreneur wants to plow more money into the business upfront to make it grow faster while the investor is arguing for a more organic approach to scaling. Anyone know of a good post about this topic?

  • I’ve been calling out for a this change in mindset (from hype to pragmatism) ever since getting back into tech ~ year ago, and it seems it’s now happening. We have the best hardware startup there is possible. Unique advantage, new hybrid technology area opening up a global untapped market, high-tech not easily reproduced, strong senior exec team well placed, top engineering, led by an experienced native entrepreneur. But early in the process, after long bootstrap discovery process to figure out the manufacturing chain and bring the team together. Our margins are literally whatever we want them to be, our products make that much of a difference, are worth that much to the richest asset markets on the planet. We save clients hundreds of thousands per month, to hundreds of millions per installation. No joke. Looking for first angels, and here is the dichotomy; we are building on real value, going it a logical step at a time as such we are far below the radar/scale of VC’s who actually should be / would be most interested, if they gave it an ear. We are also too advanced of accelerators and incubators, we are more like a team of mentors ourselves, respectfully. What works is good old fashion voice communications to start imo. But this doesn’t seem to be the mode of operation of these VC’s unfortunately who have a more treadmill approach to cycling through same ole startups. No exceptions?

  • DaveJ

    I’m old enough to remember the day when you realized what gross margin really meant, in terms of being able to make payroll.

    • Yup – it was helpful to learn that lesson early.

  • The initial investor is the hardest to find especially in the Consumer/Hardware market. I couldn’t agree more with Brad, mentioning the word hardware or manufacturing is met with mixed signals. That being said there are investors that see the big picture. Those investors and entrepreneur that are willing to wait for the business to percolate up that will see the fruits of their labor. It sometimes takes iron will but for those that stick it out you will see light at the end of the tunnel.

    Its funny but at one of my pitches everyone was numb until I showed the software (IoT) side of the product (smart phone app). The lights turned on and away we go. What I was thinking why this was happening when the app will be free but I understand mobility is what makes the world go round. My thoughts are there still may be investors with a foul taste from the dot.com but worse the 2008 recession. Software may have an earlier return and higher margins but at a higher risk (but then again my opinion may be skewed). The <60% margin is a great reply I read on this thread (and my target margin) vs a software margin that may project <85% margins or better.

    Other words of wisdom, KEEP EVERYTHING that is IP! I believe early on what helped us immensely was to contract (in the US) manufacturing. This is keeping our engineering and manufacturing expenses low. We will be better than 60% but keep everything. Our business will bring in manufacturing when it makes sense (sustained cashflow, healthy reserves and happy investors is key.

    I recall one of the corporations I worked for (before taking my leap into entrepreneurship) our CEO (Great visionary and leader IMHO), communicated to the entire company (4k employees at that time) the following;
    Only 96% of businesses sustain $1 Million or less in profits. The remaining companies, only 0.4% of those businesses sustain greater than $10 Million in profits. The percentage of business become even smaller when you are looking at $Billions. He challenged the company and we responded 3 years later. I was part of the company when we sustained $Billion over2 yrs. Now that company remains a multi $Billion dollar company with sustained growth.
    So, patience is my take away and choosing the VC that understands this will not be only an investor but truly an ally, mentor and partner!

  • Some years back I was reading Marc Barros (Founder of Contour and later Moment also I think one of your portfolio companies) post on product pricing http://marcbarros.com/how-to-price-your-hardware-product/. It was eye opening. We learnt

  • Some years back I was reading Marc Barros (Founder of Contour and later Moment also I think one of your portfolio companies) post on product pricing http://marcbarros.com/how-to-price-your-hardware-product/. It was eye opening to get the whole picture laid out by someone who had done it before.

    We learnt the hard way at Phonejoy that we had fundamentally missed pricing our product right to allow for retail later. At the same time due to the product price retail was mission impossible because nobody would have bought the product at the increased price. Now afterwards with a cost down version it was possible to achieve that lower price point at retail again. Then again looking back at our failure there going retail early on was the wrong focus anyways. Creating sufficient demand is much more important.

    Having said that I also believe it depends on your product. If you achieve certain value points at higher scale I can also see benefits of foregoing gross margins simply to capture additional values elsewhere through data or software models. Now few hardware companies have achieved that yet. Other than Dropcam I’ve still to see a decent service model. Most successful is still the high margin hardware plus integrated software model as championed by Apple and Fitbit.

    Will see. Pricing is tricky. We’ll try to run tests for our new company (ShapeScale) but it’s definitely going to be a tough call. One thing I learnt though is that changing pricing for hardware is much harder than for software.

    Hope you’re right and we see those blog posts popping up at some point throughout the next years.

  • I think “software wrapped in plastic” is an apt way to describe why some hw startup entrepreneurs consider traction as many SaaS companies do, i.e. traction = number of users, conversion rates, etc. An encouraging sign is the number of Supply Chain related roles at hw startups I’m seeing here in the East Coast. Effectively managing gross margins means, IMO, effective BOM management -overlooked at times. Especially in the frenzy to scale beyond prototypes and trying to build a product across distributed environments.

  • One of the challenges I’ve seen some new hardware startups face, when it comes to pricing, is assuming that manufacturers will just “figure out” how to get their BoM under control. When you start from that point, that pricing is external, it cascades into other thinking about your overall GM, that “you’ll figure it out as you go.” That’s not a great place to be for any startup, but it’s particularly problematic for hardware startups as no one wants to fund selling a product at a loss that can’t suddenly become GM positive by downsizing the team.