Atoms Are the New Bits

by Ryan McIntyre

During our careers, we’ve invested in a number of companies that sell consumer-electronics devices. In the past several years, we’ve invested in companies like Sling Media, Pogoplug, Smith & Tinker, Pie Digital, Sifteo, and most recently, FitBit and Orbotix.

In recent years it has become dramatically less expensive to design, build, and bring a consumer electronics device to market. The emergence of low-cost and low-power processors, DSPs and SOCs (systems-on-a-chip), the declining cost of all forms of memory, and Asian-based outsourced manufacturing (primarily in Taiwan, China and increasingly, Indonesia) has made investments in companies offering a consumer-electronics device a much more compelling opportunity from a VC perspective.

These cost-savings have enabled the companies we’ve invested in to maintain 40% – 60% gross margins on their products (while selling at sub $300 price points) sold into the retail channel, even at wholesale pricing levels. When these companies sell direct-to-consumer via their websites, the margins can be even higher. Contrast this with earlier venture-backed consumer-electronics companies like TiVo (whose DVR we essentially a PC in different packaging), which initially had to sell its product at negative margins and hope to make up the difference with service/subscription revenues.

Most venture capitalists would not agree with our view that gadget companies can present compelling investment opportunities, and there are certainly challenges associated with a business model that involves building widgets overseas and shipping them around the world to third-party logistics companies, distributors, and retailers. To name but a few: there is more operational complexity around manufacturing, distribution and sales, there are increased working capital requirements, the margins are lower relative to software or SaaS models, the cost of product defects is much higher, and there can be less real-time visibility into sales and the customer base, given that a retailer sits between the company and its users, at least up until the point of purchase.

There are some special things that we look for in a consumer electronics investment. First and foremost, we focus on the software element of the consumer electronics product. When we were on the road raising our fund, we’d often be asked by potential investors what it was the made the Slingbox special, and why we had decided to invest in a device play. We’d reply that the magic behind the Slingbox was the software and that Sling Media was a software company that just happened to package its software in a cheap plastic box.

Second, for any consumer electronics device to be successful, it must be dead simple to use and to set up. The out-of-the-box experience has to be seamless and just work, hiding all configuration complexity from the user. Not to pick on TiVo again, but rumors are that in the early days of TiVo, the return rate was well over 50%, primarily because of the great complexity of setup. Customers gave up in frustration before they were able to experience the magic of TiVo. Even today, upwards of a third of wireless routers are returned to the store because of difficult setup procedures.

We think the Slingbox set a new standard of usability and ease-of-installation in its day, while the setup process of the Pogoplug currently sets the gold standard for an install – it can be done in under two minutes, requires zero knowledge of network configurations or firewalls, and is literally as easy as typing in a URL and signing up for an account. Naturally, most any modern device should be network-aware and work closely with web-based services to provide an integrated experience. A software-powered consumer electronics device should also evolve – regular software updates mean that a good gadget gets better over time.

Finally, we also believe that for a consumer electronics company to be interesting to us as an investment opportunity, it should be establishing a new category of device. Sifteo’s Siftables, Cloud Engines’ Pogoplug. and Sling Media’s Slingbox are a few examples from our portfolio that illustrate this point. A startup has very little to offer in an established category – the world doesn’t need another audio player, smartphone or router. Leave those categories to established players who have the manufacturing, marketing and distribution muscle to compete. As a startup, rising above the noise in an existing category is difficult and expensive. Granted, establishing a new category of device has its own set of challenges, but innovation and disruption are the core mission of startups.

If you’re making a product out of atoms (powered by software magic) that fits the above description we’d love to hear from you. Atoms are the new bits.