Software Founder? Don’t go crowdfunding!

Matt Ward recently wrote a piece for VentureBeat titled “Why hardware startups should screw VC and go straight to crowdfunding”. He presents three main arguments to support his thesis: one, that the contributors themselves are an asset, serving as early adopters of the product; two, that it is getting easier to raise more money through crowdfunding platforms; three, that the crowdfunding community empowers more creative discourse.

While I agree with Ward, I believe his arguments are superficial. The hardware startup is inherently better suited for crowdfunding than the software startup, and should frequently go down that route when the time comes to raise capital. The reasons for this lie in the fundamental nature of the hardware startup itself, as opposed to various niche benefits the crowdfunding markets entail.

The first difference between hardware and software startups has to do with costs. Software takes relatively little money to develop, requiring only developer’s time and several insignificant expenses (servers and software licenses, for instance). Hardware obviously requires much greater resources to prepare materials, supply chains, distribution methods and manufacturing, in addition to the skilled workers who develop and engineer the product itself.

All of this means hardware startups have smaller margins, because another product takes more money to produce than another software license. It also means larger seed rounds, because the companies need more money early on to fund the development of a supply chain, compared to the smaller expenses of software development and distribution (Compare the average seed round — averaging hundreds of thousands of dollars — with the amounts raised by Pebble or Oculus, roughly 10$ million each. The funding in both cases is intended to create an MVP, essentially).

VCs don’t like small margins, and they don’t like spending a lot of money on seed rounds — why would they if they can earn as much investing in software startups? The crowd, in comparison, couldn’t care less about margins, because they own no equity, and they always make a safe bet on the success of the company because they only pay a small, fixed amount (and on Kickstarter, only if the company reaches its funding goal). For the crowd a hardware investment is on par with a software one; For a VC, it is often far more dangerous.

This difference is derived from the interests of the investors. A VC funds a startup because they want to profit from their investment, while the crowdfunding contributor cares about getting a cool product. This is another reason hardware is better suited for crowdfunding: It’s sexier than software, and thus easier to sell to the crowd.

As an aside, have a look at the infamous Silicon Valley “unicorns”: almost non of them are hardware startups. Venture capitalists find that hardware startups have smaller potential for growth, owing in part to the high costs we mentioned before and the small margins. Some may say that hardware has an harder time going mainstream, but I would attribute that to the smaller funding pool available to it. Either way, this is another reason VCs are less attracted to hardware startups: they have a harder time becoming unicorns.

So far, these are rather trivial explanations for the hardware startup-crowdfunding match theory. Hardware has less financial incentive to invest in, so it is better suited for investors who do not care about monetary benefits. It is also somewhat more futuristic, sexier, perhaps easier to market to a crowd. But are these the only differences?

I believe a major distinction between software and hardware startups in relation to crowdfunding has to do with pivoting. Crowdfunding limits the ability to pivot significantly: contributors have been promised a product, and they want to receive that product. Crowdfunding is viewed as a form of pre-order, where the maker promises the contributor that he will receive the specific product exhibited. If he does not provide that product the maker will aggravate his community of early adopters, the most essential users for any startup.

A hardware startup can allow itself to be confined to its original idea. In fact, it often has no choice, because once it puts together everything needed to launch a crowdfunding campaign it is already quite far along the production timeline. It loses too much if it changes, so it might as well go all-in or just kill the production.

A software startup, by comparison, has a much easier time pivoting. Software infrastructure routinely supports different variations of an idea. The software is easy to tweak (imagine adding a software button in another version compared to manufacturing another version of a table with an added button), and the entire mentality of the startup ecosystem is that the company has to be lean and change frequently when it receives feedback from its customers.

If a software startup appealed to Kickstarter or Indiegogo to fund its project, it would be much more confined to its original idea. It would have a harder time pivoting, and thus, it is in greater danger of screwing up. When it is funded by a VC it could easily get approval for an improved direction; when you already have costumers/contributors who paid for your product, approval for change is much harder to come by.

To make non-equity crowdfunding viable for software startups, the startup must only turn to a crowdfunding campaign after a preliminary private funding round, which has allowed it to hone its product to a level it is confident would turn out to be a well-rounded product, which would not require pivoting. I hope we see more of these startups as crowdfunding evolves to become a mainstream way of funding young companies.