A series of posts by Charles Huang

#1 What margins does your hardware product need to achieve?

I'm a fan of comedy. Jeff Foxworthy, a comedian from the south, has a series of jokes that start with "if you're blah blah blah ... then you might be a redneck". Here's a short version of that for IoT startups:

• If your BOM (bill of materials) is between $45 - $55 and you’re losing money selling for $99 retail, then you might be an IoT startup.
• If you have software services for your device that no one wants to pay for, then you might be an IoT startup.

Why does this happen?

Most likely, you started out to build a consumer IoT device that gathers valuable data. So you have an SOC(system on a chip), plus sensor(s) to gather data, plus wifi / bluetooth to upload your data. Your BOM is probably $45 - $55, depending on the price of your sensor(s). You should be selling at a minimum of $150 - $200 SRP (suggested retail price) to have sustainable margins. But you are selling at $99 in order to get faster user growth. You hope to make up for lost margins by converting users to a paid software service. But the data you're gathering may not be useful enough for users to pay monthly / annual recurring fees. If I had a dollar for every IoT I have met that went down this path, I could probably fund their seed round.

So what margins do you need to build a healthy, scalable, consumer IoT product?

For retail, a good rule of thumb is the SRP should be at least 3X COGS (cost of goods sold). That gives the retailers enough margin to carry your product which means you have good SELL-IN. And it gives you enough margin to do good marketing programs, which means you have good SELL-THROUGH. You'll need both sell-in and sell-through to be successful.

Some of the most successful consumer hardware products have a 4X or 5X SRP to COGS ratio. Beats, GoPro, Fitbit are examples of products that probably hit these ratios.

If you offer software services, don't count on subscription revenues to provide a meaningful contribution to your margins from the start. Getting a meaningful percentage of consumers to pay a subscription is like finding a black swan. Even if you are certain that your product is a black swan, be conservative and plan as if you needed to survive on hardware margins alone.

#2 "Swimming with sharks" - getting into retail ...

Wading into retail distribution is swimming with sharks in treacherous waters. You need a thoughtful retail strategy because there are dozens of ways to lose money quickly.
 
The first decision you need to make is e-commerce vs. brick-and-mortar. E-commerce companies tend to run similar operations, so selling to two different etailers is not double the work - it's more like 1.25 to 1.5. The same goes for selling to brick-and-mortar. But selling to 1 e-commerce plus 1 brick-and-mortar retailer will double your workload. So you can maximize your limited sales resources by focusing on one segment first.
 
It's easier for almost all startups to begin with e-commerce. In e-commerce, Amazon is the 800lb gorilla. So I'm going to focus on a few key Amazon strategies for this article. I will cover brick-and-mortar in the future.
 
You can sell your product on Amazon through one of several programs: Seller Central, Fulfillment by Amazon (FBA) and Vendor Central. There's not enough room here to cover the differences, but I prefer Vendor Central, where Amazon actually buys your product for resale. Find a good manufacturer's rep to help guide you through the confusing Amazon process and programs. They're worth every penny in commission you pay.

One reason I prefer Vendor Central is that you have more channel marketing options vs. the other programs. Channel marketing is key to driving sell through to consumers. You need to optimize your product page for Amazon search SEO. You also need to try and get into as many sales programs (Deal of the Day, Lightning Deals, Prime Day, etc.) as you can, as this helps with discovery. A good sales rep earns their commission by assisting you with SEO and optimizing sales programs.
Once your product is on Amazon, you may be surprised that Amazon has a pretty small “load in”. Be patient, as they ramp orders when their system sees positive sell through data. Amazon operates ~100 distribution centers vs. 500-1,000 stores for some retail chains. So your inventory only needs to sit in 100 warehouses to cover the entire US market - that's a pretty efficient spread of inventory and the primary reason for the small load in. Inventory efficiency is another reason why I recommend startups to try e-commerce first. I don't have stats to prove this, but I think Amazon is more efficient with inventory and better at forecasting, because they have more data than any other retailer.
Over the course of a year, however, Amazon's sell through is amongst the top 2-3 in the US in almost every category. I'm involved with a product where last year's sell through on Amazon beat Target (and its ~1,000 stores). That's unfathomable growth from comps I saw 10 years ago during the peak of our Guitar Hero retail sales. I guess there's a good reason why Jeff Bezos is the 2nd richest person in the world.

A final point. If you make the decision early to go down the e-commerce path, you can save yourself some headaches in product design and manufacturing. For instance, you don't need a color, retail box for ecommerce. It will save you some BOM costs to use a brown / white cardboard box. Additionally, you've got enough of other things to worry about just getting your product into production. Deferring package design and printing logistics reduce unnecessary risk for your first production run.
It's an exciting time to see your product sales expand into retail. But retail is a red ocean because there's a lot of blood in the water. Have a good, conservative plan and seek help. We'll talk about brick-and-mortar in the next post.

#3 Too Much Tech Limits Your Market ...

A few years ago, I was at a convention in New York City and saw a connected, smart toilet - named the “Royal Flush”. I love the catchy name, but does a toilet really need to be connected? Does more technology equal better products?

Just the opposite, I believe too much tech limits your TAM (total addressable market). Let me give you one of my favorite examples.
 
GoPro and Dropcam both make cameras. GoPro is an HD camera that action sports enthusiasts can strap onto almost anything and shoot videos anywhere. Dropcam is a home security camera. It uploads videos to the cloud and you can watch remotely. Both products are well designed and have great product market fit.
From a tech standpoint, Dropcam packs more in its product. Dropcam is connected, there's a cloud video software service, etc. Engineers, product designers, and often investors are attracted to this sophisticated tech.

But consumers have a different view. Dropcam needs wifi, which limits it to in-home use and makes the TAM smaller. And if you wanted to store past videos, Dropcam requires a paid subscription service, which limits the TAM further. This plays out in consumer sales. Go Pro probably sells more cameras per quarter than Dropcam has ever sold.
To make matters worse, Dropcam has higher BOM costs because, in addition to video cam components, they also need an SOC (system on a chip) and a wifi chip (to transmit the video to the cloud). For hardware startups, the combination of higher BOM + lower TAM = bad unit economics.
So the next time you sit down to design a product or a new version, remember the Royal Flush. Think about the impact of technology on your TAM and your BOM.

#4 A Segmented Approach to Brick-and-Mortar Retail Distribution

So you're ready to pitch your new product to retailers. It's an exciting time, but U.S. retail can be confusing. This is how I approach retail distribution.

I'm a fan of comedy. Larry the Cable Guy loves to tell jokes about his favorite store, Walmart. When Walmart started offering medical services, Larry joked, “I walked into a Walmart and they told me I had a polyp. I told them, "I'm going to Target to get a second opinion." Jokes aside, he has one insight for hardware - stores aren't the same. You should segment retailers.
 
Let's use video game retailers to illustrate my point. During my Guitar Hero days, 5 chains (Walmart, Target, Best Buy, Gamestop, Toys R Us) represented ~80% of the US retail market for video games. I segmented the 5 retailers as follows:

• Gamestop is specialty retail. They cater to the hardcore gamer by promising the biggest selection - “anything you want in games, we have it.” Gamestop is easiest for sell-in because they carry almost every game. As for sell through, Gamestop is strongest for presales and launch, because they cater to the hardcore gamer (and early adopter). This is where people queue up overnight for new releases.
• Best Buy. This big box CE retailer caters to the tech savvy consumer. This is the second easiest retailer to sell-in. If Gamestop carries the top 500 games, Best Buy might carry the top 150. As for sell-through, Best Buy sales are strong from month 1 to month 2 after launch.
• Walmart / Target. The big box stores cater to the mass market. They might only carry the top 50 games. So sell-in is very hard, unless you have a proven product, e.g. a big sequel. As for sell-through, we see the strongest sales at Walmart / Target from month 2 onwards.

Today, Amazon would be top 5, but market concentration is probably similar. Amazon sell-in is easy, just like specialty retail. This retailer can carry everything because they don't have shelf space constraints. However, logistics to online retailers can be very different from brick-and-mortar. So I would recommend a new startup with a 1st time release to stick with either brick-and-mortar retailers or online retailers. It'll help simplify your work.

Managing the sales channel is one of the hardest things for people in the hardware business. Segment retailers and take a staggered approach. You'll reduce the complexity and ensure a well managed retail rollout.