Tips for Raising VC Funding for your Early-stage Climate Hardware Startup

Fundraising can vary dramatically depending on the business model. Entrepreneurs building a software business will encounter different requirements and expectations than founders who are building hardware, launching a CPG brand, or developing frontier deeptech.

We sat down with Michael Luciani, Managing Partner at Climate Capital, to talk about fundraising for hardware companies in climate. We specifically focused on a few key elements that founders often find challenging, including understanding key milestones, setting a valuation, and more!

Milestones

For early stage climate hardware startups, 3 key elements are required to successfully raise capital:

Team – The people on your team are crucial to your success. Generally, you’ll want to make sure you start out with a small complimentary team. At least one member should be a technical expert: this may be the person who owns the intellectual property surrounding your hardware, and is an expert on the physical product itself. Another person on your team should be an expert on the market you’re selling to, including marketing, distribution, and sales. In general, VCs will look favorably on founders who bring on early hires that fill in gaps in founder knowledge/skills.

TAM – Your total addressable market (TAM) should be big enough to warrant venture scale returns. At the seed-stage, most VCs are looking to have any individual investment return the fund (often a 25X+ markup at exit). Do your homework to validate your TAM and get a firm understanding of who exactly you can sell to. Calculating TAM can get complicated– for more tips, check out Tanya Boyko’s insight here.

Early technical and commercial validation – You should be able to demonstrate a path towards technical and commercial viability for your product. Get into the nuts and bolts of economics of the solution – what are the margins and how do they change over time? What does the supply chain look like and what are key manufacturing and distribution risks? Talking to your customers is also a big part of technical validation. Are people willing to pay what you want for your product? Do you really understand the problem you’re solving for your consumer? Getting Letters of Interest (LOIs) or a Memorandum of Understanding (MOU) from a couple of ideal customers are strong indicators that you’ve done your homework.

When to raise your pre-seed

While you may be able to raise friends and family funding with just an idea, raising your first institutional capital is a whole other ballgame. You’ll need to hit certain key milestones to be successful:

• You should have a functional prototype or some physical version of your product that supports external validation. An outside expert should be able to review your work and agree with your conclusions about viability.
• Your overall commercialization plan should also be relatively complete and verifiable, and include all the key elements to show the underlying economics of your business. All early stage investors understand that this plan will change (sometime dramatically) as you grow, but they want to see the seriousness of your thinking and that a valid path exists.
• Last but not least, at this stage you should have the core team locked down and a clear view of your hiring needs for the next 1-2 years. Where will you need engineering, design, and other talent? Where will you likely leverage external experts rather than build capacity in-house? Where will partnerships be key for commercialization? It’s important to think through all of these questions and have solid answers before approaching institutional investors.

Valuation

When thinking about pricing, your valuation will be a function of your TAM multiplied by your “moat–” that is, your ability to maintain a competitive advantage. You may have a huge TAM, but if you don’t have a credible way to make a defensible business, it’s a lot less compelling.

Most of the time, your initial value will lie with your intellectual property, its defensibility, and how investors view the long-term commercialization potential of your product. For example, having a patent on your solution can be a powerful driver of valuation, as it gives you more defensibility than non-protected IP.

A key element of understanding the aforementioned defensibility is competitive analysis (see our longer piece on this here). Key questions for a hardware startup include:

• What product(s) do customers already use that you're hoping to replace?
• Who in the market is using a similar or different approach to you?
• What makes you better?
• How can you protect yourself if competitors pivot into your space?

In the end, you want to be fluent in all the ins and outs of your competition. Make it your mission to understand the path they took and learn from their mistakes. Networking is an important way to get this information. If you’ve already raised money, an angel or pre-seed investor can be a great source. They’ve likely worked with enough companies in your sector and at your stage to help you figure out how your peers came to market and where you can find your niche.

Your competitive analysis will also yield insight into pricing for your round. Spend time talking to founders and investors in your network to understand pricing trends in the market today. You can then take those inputs, and adjust according to the progress you’ve made on commercialization and your defensibility.

At the end of the day, there are no absolutes when it comes to valuation. There are many different types of technical risk and timelines to deployment and capital intensity, so every hardware company will have a unique experience. Ultimately, the right valuation is going to be specific to who you are as a founder in the context of your project. For most companies, it’s driven by understanding your moat and the three Ts (team, TAM, and tech), as well as your risks and ability to de-risk. Most importantly, you should work on gaining a very deep understanding of how these factors affect your business before looking outwards. It's better to come to the table with a partially formed –but informed– perspective than to come without one at all.

Your ability to raise and get a competitive valuation at the pre-Seed and Seed stages will often come down to how you tell the story – approach the conversation in a thoughtful way, acknowledging risk factors and your plan to mitigate them. At this stage, hardware companies live or die based on the narrative– you may have limited evidence of growth at pre-seed or seed stage, as well as limited traction. Make sure you can still tell a compelling story to commercially-driven financiers– if this isn’t something you’re comfortable with, hire a pitch coach or a brand firm to help you shape it. This can be one of the best investments you’ll make early on.

Ultimately, many early hardware companies will find that their company is less valuable than their software-focused peers in the market (which is ok). Many VC investors shy away from capital intensive business models (like hardware), which results in a downward pressure on pricing/valuations across the market. Don’t despair, you can still raise capital efficiently as a hardware company and over time, you can more easily source non-dilutive capital that many software companies can not (like inventory finance, working capital, asset-backed facilities, etc).

Michael Luciani is an early stage climate tech investor with a focus in deep tech and synthetic biology. He is managing partner at Climate Capital. He founded and exited a venture back startup prior to working in venture. Michael received his Bachelor’s degree from William’s College in Political Science and Government.