We held a team offsite in New York last month. If you know any of us at Spark, you’d guess that we spent most of the time debating with each other, like a family where everyone argues passionately but loves each other at the end of the day. (I‘m guessing most of us at Spark grew up in a family like that. I certainly did.)
While we were all together, one topic we spent a lot of time discussing was how digital startups can build long-term competitive barriers. My partner Jeremy Philips led the conversation, and you can read more about his thoughts in a piece he published in the New York Times in August (here).
A couple of us also applied the thinking that came out of our offsite discussion to hardware. The main thing we all agree on: hardware startups can build true competitive barriers, but they have to be careful to avoid simply creating a “toaster.”
When we say a toaster, we mean a product that the market demands, but where margins get eaten away over time due to low barriers to entry and fierce competition. This analogy was popularized by Professor Bruce Greenwald at Columbia Business School (and mentioned by Jeremy in the New York Times article linked above).
It’s worth pausing for a minute on this. Some people think that highly-differentiated products will give a company a long-term competitive advantage. But without barriers, we’ve seen that all useful differentiation gets copied in the long-term. Today, intellectual property rarely creates a true barrier in hardware, where copycats emerge out of thin air after a funding announcement. Highly differentiated product ideas are what drive initial customer interest in hardware startups, but competitive barriers are necessary to build a valuable business in the long-run.
This subject is important to us at Spark, where we invest very actively in hardware startups. We led Series A rounds for Oculus, Cruise, Thalmic Labs, Superpedestrian, Freight Farms, and many more. We’re strong believers in the potential for hardware startups to create magical new product experiences, make a big impact on society, and generate venture scale returns for their investors in the process.
So: for a high-growth hardware startup, how do you create competitive barriers and not end up as a toaster company?
From our experience at Spark, the best hardware companies use superior hardware execution as a trojan horse for building a long-term relationship with their customers through software and data-driven experiences. Here are three successful strategies we’ve seen.
- Build a vibrant developer community/ecosystem. Oculus built a strong developer community early on in its journey to developing a commercial VR headset, giving the company a meaningful head start against competitors in terms of available content, games, and other applications. The company would never have gotten to where it did without thousands of developers building demos, experimenting, and proselytizing for the brand. The iPhone is a beautiful piece of hardware, but consumers are initially drawn to the platform and ultimately become locked-in because of iOS applications. Similarly, developers are drawn to the Apple customer-base and choose to create applications for iOS. As a consumer, switching from iOS to Android is more than buying a new phone — it’s also starting from scratch on your applications. As a developer, once you have a meaningful customer base on iOS, you will continue building for the platform for a long time.
- Create a data moat/network effect. Cruise Automation built an incredibly sophisticated brain for an autonomous vehicle, connecting external sensors (e.g. LIDAR, cameras) and a variety of other data sources to the mechanical automobile drive-train. More importantly, they built machine learning technology to recognize a wide variety of different objects and events. This dataset and the self-training model they developed to improve accuracy over time with use will be very difficult for competitors to replicate, especially since Cruise had a head start. 23andMe built the first direct-to-consumer brand in genetic testing. In my opinion, the real value doesn’t lie in their elegant spit cup design and the core IP around their genetic testing technology. The magic is in the dataset, which 23andMe can continuously mine and leverage on behalf of their growing user-base for medical and genealogical applications.
- Release sticky software tools to your hardware users. Freight Farms launched its flagship Leafy Green Machine product a few years ago, providing customers a hardware platform for hydroponic plant growing. As the company matures, they continue to release software products through their mobile app Farmhand to help farmers manage every facet of their business: from business planning and sales, to yield measurement and management, to purchasing consumables like seeds and nutrients, to sharing recipes with other growers on the platform. This keeps current customers highly engaged on their platform. Square started with a simple headphone-jack attachment to allow SMB merchants to accept credit card payments from a mobile device. Over time, Square launched a variety of other software products into that existing install-base, like merchant analytics, payroll, and streamlined lending, creating a much stickier business than a pure-play PoS and payment processing company.
Early-stage venture capital isn’t all about focusing on the creation of long-term competitive barriers. First and foremost, we invest in products we love and teams that inspire us. Sometimes it’s not clear how a market will develop or how a business will mature on the startup roller-coaster journey, and that’s just fine.
On the other hand, it’s important for us to invest in companies that have a clear vision for the future and the role they will play in it. So we get especially excited when we encounter a hardware team that’s not only maniacally focused on their product and customers, but also thinking proactively about how to protect their company from competitors in the long-run.
We love both investing in hardware startups and talking about them. Please let me know what you think about this piece, and give me a shout at [email protected].
Thanks to Ryan Shmeizer, Nabeel Hyatt, and Rachael Horwitz for their useful feedback.