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Different Paths to Success for Tech vs Hardtech Startups

Having been lucky enough to invest in both tech (cloud, mobile, software) and “hardtech” (materials, cleantech, energy, life science) startups (and having also ran product at a mobile app startup), it has been striking to see how fundamentally different the paradigms that drive success in each are.

Whether knowingly or not, most successful tech startups over the last decade have followed a basic playbook:

  1. Take advantage of rising smartphone penetration and improvements in cloud technology to build digital products that solve challenges in big markets pertaining to access (e.g., to suppliers, to customers, to friends, to content, to information, etc.)
  2. Build a solid team of engineers, designers, growth, sales, marketing, and product people to execute on lean software development and growth methodologies
  3. Hire the right executives to carry out the right mix of tried-and-true as well as “out of the box” channel and business development strategies to scale bigger and faster

This playbook appears deceptively simple but is very difficult to execute well. It works because for markets where “software is eating the world”:

  • There is relatively little technology risk: With the exception of some of the most challenging AI, infrastructure, and security challenges, most tech startups are primarily dealing with engineering and product execution challenges — what is the right thing to build and how do I build it on time, under budget? — rather than fundamental technology discovery and feasibility challenges
  • Skills & knowledge are broadly transferable: Modern software development and growth methodologies work across a wide range of tech products and markets. This means that effective engineers, salespeople, marketers, product people, designers, etc. at one company will generally be effective at another. As a result, its a lot easier for investors/executives to both gauge the caliber of a team (by looking at their experience) and augment a team when problems arise (by recruiting the right people with the right backgrounds).
  • Distribution is cheap and fast: Cloud/mobile technology means that a new product/update is a server upgrade/browser refresh/app store download away. This has three important effects:
    1. The first is that startups can launch with incomplete or buggy solutions because they can readily provide hotfixes and upgrades.
    2. The second is that startups can quickly release new product features and designs to respond to new information and changing market conditions.
    3. The third is that adoption is relatively straightforward. While there may be some integration and qualification challenges, in general, the product is accessible via a quick download/browser refresh, and the core challenge is in getting enough people to use a product in the right way.

In contrast, if you look at hardtech companies, a very different set of rules apply:

  • Technology risk/uncertainty is inherent: One of the defining hallmarks of a hardtech company is dealing with uncertainty from constraints imposed by reality (i.e. the laws of physics, the underlying biology, the limits of current technology, etc.). As a result, hardtech startups regularly face feasibility challenges — what is even possible to build? — and uncertainty around the R&D cycles to get to a good outcome — how long will it take / how much will it cost to figure this all out?
  • Skills & knowledge are not easily transferable: Because the technical and business talent needed in hardtech is usually specific to the field, talent and skills are not necessarily transferable from sector to sector or even company to company. The result is that it is much harder for investors/executives to evaluate team caliber (whether on technical merits or judging past experience) or to simply put the right people into place if there are problems that come up.
  • Product iteration is slow and costly: The tech startup ethos of “move fast and break things” is just harder to do with hardtech.
    1. At the most basic level, it just costs a lot more and takes a lot more time to iterate on a physical product than a software one. It’s not just that physical products require physical materials and processing, but the availability of low cost technology platforms like Amazon Web Services and open source software dramatically lower the amount of time / cash needed to make something testable in tech than in hardtech.
    2. Furthermore, because hardtech innovations tend to have real-world physical impacts (to health, to safety, to a supply chain/manufacturing line, etc.), hardtech companies generally face far more regulatory and commercial scrutiny. These groups are generally less forgiving of incomplete/buggy offerings and their assessments can lengthen development cycles. Hardtech companies generally can’t take the “ask for forgiveness later” approaches that some tech companies (i.e. Uber and AirBnb) have been able to get away with (exhibit 1: Theranos).

As a result, while there is no single playbook that works across all hardtech categories, the most successful hardtech startups tend to embody a few basic principles:

  1. Go after markets where there is a very clear, unmet need: The best hardtech entrepreneurs tend to take very few chances with market risk and only pursue challenges where a very well-defined unmet need (i.e., there are no treatments for Alzheimer’s, this industry needs a battery that can last at least 1000 cycles, etc) blocks a significant market opportunity. This reduces the risk that a (likely long and costly) development effort achieves technical/scientific success without also achieving business success. This is in contrast with tech where creating or iterating on poorly defined markets (i.e., Uber and Airbnb) is oftentimes at the heart of what makes a company successful.
  2. Focus on “one miracle” problems: Its tempting to fantasize about what could happen if you could completely re-write every aspect of an industry or problem but the best hardtech startups focus on innovating where they won’t need the rest of the world to change dramatically in order to have an impact (e.g., compatible with existing channels, business models, standard interfaces, manufacturing equipment, etc). Its challenging enough to advance the state of the art of technology — why make it even harder?
  3. Pursue technologies that can significantly over-deliver on what the market needs: Because of the risks involved with developing advanced technologies, the best hardtech entrepreneurs work in technologies where even a partial success can clear the bar for what is needed to go to market. At the minimum, this reduces the risk of failure. But, hopefully, it gives the company the chance to fundamentally transform the market it plays in by being 10x better than the alternatives. This is in contrast to many tech markets where market success often comes less from technical performance and more from identifying the right growth channels and product features to serve market needs (i.e., Facebook, Twitter, and Snapchat vs. MySpace, Orkut, and Friendster; Amazon vs. brick & mortar bookstores and electronics stores)

All of this isn’t to say that there aren’t similarities between successful startups in both categories — strong vision, thoughtful leadership, and success-oriented cultures are just some examples of common traits in both. Nor is it to denigrate one versus the other. But, practically speaking, investing or operating successfully in both requires very different guiding principles and speaks to the heart of why its relatively rare to see individuals and organizations who can cross over to do both.

Special thanks to Sophia Wang, Ryan Gilliam, and Kevin Lin Lee for reading an earlier draft and making this better!

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What Happens After the Tech Bubble Pops

In recent years, it’s been the opposite of controversial to say that the tech industry is in a bubble. The terrible recent stock market performance of once high-flying startups across virtually every industry (see table below) and the turmoil in the stock market stemming from low oil prices and concerns about the economies of countries like China and Brazil have raised fears that the bubble is beginning to pop.

Company Ticker Industry Stock Price Change Since IPO (Feb 5)
GoPro NASDAQ:GPRO Consumer Hardware -72%
FitBit NYSE:FIT Wearable -47%
Hortonworks NASDAQ:HDP Big Data -68%
Teladoc NYSE:TDOC Telemedicine -50%
Evolent Health NYSE:EVH Healthcare -46%
Square NYSE:SQ Payment & POS -34%
Box NYSE:BOX Cloud Storage -42%
Etsy NASDAQ:ETSY eCommerce -77%
Lending Club NYSE:LC Lending Platform -72%

While history will judge when this bubble “officially” bursts, the purpose of this post is to try to make some predictions about what will happen during/after this “correction” and pull together some advice for people in / wanting to get into the tech industry. Starting with the immediate consequences, one can reasonably expect that:

  • Exit pipeline will dry up: When startup valuations are higher than what the company could reasonably get in the stock market, management teams (who need to keep their investors and employees happy) become less willing to go public. And, if public markets are less excited about startups, the price acquirers need to pay to convince a management team to sell goes down. The result is fewer exits and less cash back to investors and employees for the exits that do happen.
  • VCs become less willing to invest: VCs invest in startups on the promise that future IPOs and acquisitions will make them even more money. When the exit pipeline dries up, VCs get cold feet because the ability to get a nice exit seems to fade away. The result is that VCs become a lot more price-sensitive when it comes to investing in later stage companies (where the dried up exit pipeline hurts the most).
  • Later stage companies start cutting costs: Companies in an environment where they can’t sell themselves or easily raise money have no choice but to cut costs. Since the vast majority of later-stage startups run at a loss to increase growth, they will find themselves in the uncomfortable position of slowing down hiring and potentially laying employees off, cutting back on perks, and focusing a lot more on getting their financials in order.

The result of all of this will be interesting for folks used to a tech industry (and a Bay Area) flush with cash and boundlessly optimistic:

  1. Job hopping should slow: “Easy money” to help companies figure out what works or to get an “acquihire” as a soft landing will be harder to get in a challenged financing and exit environment. The result is that the rapid job hopping endemic in the tech industry should slow as potential founders find it harder to raise money for their ideas and as it becomes harder for new startups to get the capital they need to pay top dollar.
  2. Strong companies are here to stay: While there is broad agreement that there are too many startups with higher valuations than reasonable, what’s also become clear is there are a number of mature tech companies that are doing exceptionally well (i.e. Facebook, Amazon, Netflix, and Google) and a number of “hotshots” which have demonstrated enough growth and strong enough unit economics and market position to survive a challenged environment (i.e. Uber, Airbnb). This will let them continue to hire and invest in ways that weaker peers will be unable to match.
  3. Tech “luxury money” will slow but not disappear: Anyone who lives in the Bay Area has a story of the ridiculousness of “tech money” (sky-high rents, gourmet toast, “its like Uber but for X”, etc). This has been fueled by cash from the startup world as well as free flowing VC money subsidizing many of these new services . However, in a world where companies need to cut costs, where exits are harder to come by, and where VCs are less willing to subsidize random on-demand services, a lot of this will diminish. That some of these services are fundamentally better than what came before (i.e. Uber) and that stronger companies will continue to pay top dollar for top talent will prevent all of this from collapsing (and lets not forget San Francisco’s irrational housing supply policies). As a result, people expecting a reversal of gentrification and the excesses of tech wealth will likely be disappointed, but its reasonable to expect a dramatic rationalization of the price and quantity of many “luxuries” that Bay Area inhabitants have become accustomed to soon.

So, what to do if you’re in / trying to get in to / wanting to invest in the tech industry?

  • Understand the business before you get in: Its a shame that market sentiment drives fundraising and exits, because good financial performance is generally a pretty good indicator of the long-term prospects of a business. In an environment where its harder to exit and raise cash, its absolutely critical to make sure there is a solid business footing so the company can keep going or raise money / exit on good terms.
  • Be concerned about companies which have a lot of startup exposure: Even if a company has solid financial performance, if much of that comes from selling to startups (especially services around accounting, recruiting, or sales), then they’re dependent on VCs opening up their own wallets to make money.
  • Have a much higher bar for large, later-stage companies: The companies that will feel the most “pain” the earliest will be those with with high valuations and high costs. Raising money at unicorn valuations can make a sexy press release but it doesn’t amount to anything if you can’t exit or raise money at an even higher valuation.
  • Rationalize exposure to “luxury”: Don’t expect that “Uber but for X” service that you love to stick around (at least not at current prices)…
  • Early stage companies can still be attractive: Companies that are several years from an exit & raising large amounts of cash will be insulated in the near-term from the pain in the later stage, especially if they are committed to staying frugal and building a disruptive business. Since they are already relatively low in valuation and since investors know they are discounting off a valuation in the future (potentially after any current market softness), the downward pressures on valuation are potentially lighter as well.
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