How to Take the “Hard” out of Climate Hardware Investing
Investing at the intersection of climate and hardware requires greater specialization for VCs than software investing but offers big opportunities for both returns and impact. And the dearth of specialized VCs means a bigger pie for you. But, where should you start? What commercialization models exist in a software-dominated space? How do you lower the barriers to entry and put more hardware products in the hands of customers? And, how do you find the opportunities with big revenue multiples?
To help you take the hard out of hardware investing, we sat down with Christian Hernandez Gallardo. Christian co-founded 2150 where he invests in technology companies that seek to sustainably reimagine and reshape our urban environment.
Why do many climate VCs focus on software instead of hardware? (It’s the margins)
Short answer: SasS margins are compelling. You build it once, you generate recurring revenue, and OPEX (hypothetically) grows less slowly than revenue, leading to exponentially growing profits over time. The adage is that software is perceived to be simple (relatively speaking), easily scalable, and is not capital intensive.
With hardware, you generally have to build a physical thing to sell on a one-off basis for lower margins than software. On top of that, you have to think about working capital, supply chain, design and production, and a myriad of other issues. In short, the capitalization models are more complicated, which in turns increases business complexity, which in turn reduces investor appetite.
Why hardware? Because BIG financial and impact opportunities.
If you are optimizing for impact (as well as profit), some impact in climate can only be achieved with hardware. To reduce emissions, we must replace inefficient technologies in the physical world. And inefficiencies abound in physical infrastructure, meaning the opportunity for impact is BIG. Moreover, current VC funding in hardware is skewed towards mobility (e.g. EVs, cars, scooters, ebikes). Mobility accounted for 60 percent of VC investment over the past seven years while sectors like buildings that can have a greater impact only received four percent (buildings make up 21 percent of global emissions).
For first movers and big innovators, the financial opportunity is significant. Winning in a sector (e.g. Tesla) carries a premium with it. But to win, you often have to build physical stuff.
Unlike software, hardware is sticky because it's permanent. It generally requires a bigger up front investment for customers than a monthly SaaS subscription (where they can leave anytime), although new Hardware-as-a-service models are changing that paradigm. The sales cycle may be longer for hardware than for software but, once in the door, the customers are much less likely to leave (think utilities and industrial applications). You can even bundle a SaaS offering (to manage the tech) along with the hardware sale, creating very steady returns.
To get started, first do your homework
Having an informed thesis around different hardware verticals is essential to success as a hardware investor. Start by assessing the opportunities in different impact areas (e.g. HVAC, concrete, steel, manufacturing, etc). Ask yourself: is this a problem that can be solved by software only? Or, does it require hardware? Where do significant inefficiencies exist as well as promising hardware solutions with compelling unit economics? Build a thesis and depth of expertise around these opportunities and start forming networks in a few focus areas (hardware requires more specialized knowledge for VCs than software, you can’t invest in all sectors successfully). You can get started with great resources like Project Drawdown and Speed and Scale.
Understand costs (not just revenue)
Once you’ve picked a few impact areas to specialize in, you next need to really understand the costs involved and how they will evolve over time. The costs matter a lot in hardware (more than in software, where it's easier to focus on revenue). For any given product, start with the cost of goods sold (COGS)— what are the costs and what does the supply chain look like today? How do you think costs will change over time? What are the levers for decreasing material and manufacturing costs over time and what is the realm of possibility long-term? It’s important to assess everything from how the product is designed, to where it’s manufactured, to how it’s shipped and delivered. With hardware, cost optimization at every step of the value chain is key.
Value hardware differently: sustainability premiums and carbon costs
To date, there are few sustainability hardware comps to look at. The market hasn’t been around for very long so there is little to compare to. That said, you can make some evidence-based assumptions around greater efficiency (e.g. this tech is 90 percent more efficient than what it replaces). This creates a sustainability premium which can help predict future revenue and outcomes. Ask yourself: Will the market value the product significantly more in five years? You also need to factor in carbon-related revenue (or costs for competitors). While carbon taxes, voluntary carbon markets, and other externality mechanisms remain the exception, not the norm, more and more locations are adopting them (e.g. California, New York, Europe). These incentives are beginning to shift the fundamental unit economics for climate tech hardware and create new revenue opportunities.
HaaS for higher margins
The climate hardware ecosystem requires new revenue and capitalization models. Borrowing from SaaS, hardware-as-a-service (HaaS) can convert the one-off sales model that’s typical in hardware into a recurring revenue stream with higher margins.
For example, new HVAC systems in buildings are typically a one-time purchase and funded via CAPEX. But, the building manager generally has a line item in his P&L for cooling, heating, etc which is usually used to cover fuel and electricity costs. If a startup can show up and say “we can install this new, more efficient heat pump and reduce your energy consumption by X percent and your P&L line by 40, 50 or 60 percent. Instead of paying a big chunk up front, you just need to pay us a fixed amount on a regular basis and we will guarantee you have the cooling you need at a much lower cost.” This is a win for the building manager, win for the startup, win for you, the VC. Financing this model through VC capital is incredibly expensive, but leveraging off-balance sheet financing (see our other Insights with Xavier Helgesen, Mark Paris, and Jen McFarlane) can support large scale with low dilution and low cost of capital.
Christian Hernandez Gallardo is a Partner and co-founder of 2150, a Venture Capital firm investing in technologies that help make our broad urban environment more efficient, resilient and sustainable. Prior to 2150, Christian’s career spanned product, sales and general management roles in technology companies including Facebook, Google and Microsoft. Christian graduated from Duke University and received an MBA from The Wharton School and is a Young Global Leader of the World Economic Forum.