Hardware as an Anchor

Below is the ‘Tip of the Week’ from Ep56: The Hands-on Investor | High-Engagement Investing, Part 2 (John Greathouse)

In today’s discussion we talked about Rincon’s specialty in B2B SaaS and the reliable, fast-growing revenue streams that can be created in that segment. This got me thinking about products and business models that create long-term streams of reliable and sticky revenue. And while we talked a bit about software, I wanted to take this week’s post to touch on hardware. And one of the best models, that I have used myself, is the razor/razorblade model.

I’d suspect most of you are familiar with this. If not, simply, the model is to sell a foundational product that uses a consumable w/ some recurring frequency. It’s called the razor/razorblade model b/c that solution typifies the model. Sell a razor into a set of customers that then have to purchase consumbales (blades) on a regular basis that only work with existing razor. Gillette isn’t making money on razors but they’re making a fortune on blades. Other common examples are printers and printer cartridges or a Keruig coffee machine and the pods. Once an installed-base of machines exist in the marketplace, the consumable revenue stream is very predictable and very high-margin.

I’d like to take a minute to walk you through a personal example of a product development that fits this model…

Just before I embarked on startup investing full-time, I spent three years developing a product. From the ideation and requirements definition stage, through concept testing, development, pre-selling and launch. It was a very involved process that gives me enormous appreciation for entrepreneurs developing breakthrough products.

This product was for the water testing market. If you think about the drinking water facility in your city, their goal is to stay off the front-page of the newspaper. They do not want people dying from unsafe water. So, they treat drinking water extensively and then send it out through the plumbing distribution system; all the way to your home. But, while the water is traveling through the system, it can become compromised and the disinfectants in the water can wear-off. So, every municipality has to send employees out in their trucks to travel all throughout the water distribution system and run a series of chemistry tests at many different nodes. A city as large as Chicago or San Francisco employees whole fleetsof people to conduct this testing at thousands of end-points, everyday. This data also has to be reported, with some frequency, to the EPA.

In the existing process, a worker would preform 3-7 different chemistry tests at each node. They may be testing for chlorine, fluoride, nitrites, ammonia’s, PH, etc. Each of these different chemistry tests involved measuring, mixing powders and chemicals, timing and a series of other workflow steps which all had potential to introduced inefficiency and errors in the results. Try and imagine a guy working with small powder packets and tiny liquid bottles, measuring to the microliter on the back of his truck in sub-freezing, Chicago winters. Then, he’d write all the results on a clipboard and move to the next testing location.

You can probably imagine this is a very costly, labor intensive exercise, fraught with errors in the data.

The vision was a future in which the water testing data was 99% reliable and acquired in a fraction of the time. And that’s what we developed. Small microfluidic chips, as we called them, that had all of the chemistry reagents and water mixing channels captive within the consumable. And also a base instrument with all the mixing cycles, heating, measuring, and GPS tracked data all built and programmed in. It was a product that transfered steps from human to machine and automated the workflow.

And on top of the hard products, the data management for the device was a soft solution upsell, functioning as a B2B SaaS product and revenue stream. So it became razor/razorblade+SaaS. While our team was surrounded by skeptics throughout the organization, the naysayers are now big believers. It’s amazing how sales success in the market can change the rhetoric almost overnight.

While the process of raising the capital, defining requirements, doing thousands of customer interviews and executing a very complicated R&D effort was the biggest challenge I’ve ever encountered, it was also the most rewarding. And hardware products, in general, are tough. One can’t just change or fix something post-launch, with a line of code. And many investors I know avoid hardware all-together. It’s expensive, difficult to develop, can be a channel and logistics nightmare and is inflexible. But, circling back to the razor-razorblade concept; if the product is revolutionary and encourages regular use, it can be very lucrative. This is not a one time product sale, it’s an annuity. The product sale is not the end of a low-margin revenue stream, it’s the beginning of a high-margin, repeatable one. And a key benefit here is that once a hardware product is placed with a customer, it becomes embedded. As easy as it is to replace an app from the home screen of a smartphone it’s an order-of-magnitude harder to convince customers to replace a physical device. Installed-base inertia makes the “leaky-bucket” customer funnel, much less leaky.

So before dismissing those hardware startups from consideration, I consider things from a SaaS perspective. Is this product a cost anchor… a one-time, widget sale that a customer will end up using as a paperweight? Or is it a revenue anchor… where each sale is the beginning of a healthy, sticky, high-margin annuity?