Business Models and Recurring Revenue for Hardware Startups

Business Models and Recurring Revenue for Hardware Startups

The business model you select will determine how much revenue you can generate, how quickly you can scale up, and ultimately how valuable your startup will be to investors.

In this article we are going to look closely at different business models for hardware startups. Your business structure is a legal entity for tax and liability purposes, whereas the business model is how you’re going to make your money, which is really, really important.

You shouldn’t spend but a brief amount of time deciding on your business structure (an LLC is almost always the best option), but you should give considerable time to formulating your business model.

With a hardware company, there are two broad types of business models, but with subtypes within them.

The first type is the most common type that you associate with hardware companies, and was likely your first thought on how your business will make money. The model that you most likely envision is the one-and-done.

That means you make a product, sell it at a profit, and then you’re done. After the initial sale, you are done with that customer. They use your product, but you don’t collect any more money from them besides the initial sale.

This is in comparison to a recurring business model. With a recurring model, the customer pays upfront for the product but they also pay a recurring fee each month, for example.

I cannot stress enough the benefits of finding a way to add recurring revenue to your business model. It is much more challenging to grow a hardware startup that doesn’t have any specific recurring revenue.

The old model of one-and-done has a lot of downsides compared to a recurring model. I’ll get into those more specifically in a moment.

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Benefits of Recurring Revenue

100% of your business revenue won’t be recurring, but you need to generate at least a percentage of your revenue on a recurring basis.

Recurring income adds stability to your business by improving cash flow, but it also increases the value of your company.

If you are making a million dollars in profit on a one-and-done model, or a million dollars on a recurring model, every investor will prefer the recurring model.

In fact, you’ll get a much higher valuation on your company if it has recurring revenue versus generating the same amount of profit from a one-and-done model.

Investors love predictable revenue which is exactly what is provided by recurring revenue, so they place a much higher value on your company.

Customer relationships and recurring revenue

Another commonly overlooked advantage of having recurring revenue is that you are less likely to have a competitor jump in and steal your market share.

Let’s say you’ve successfully introduced your product, but your sales are following a one-and-done model.

Imagine a competitor comes out with a similar product, maybe with a small improvement or a slightly lower price. Then they begin stealing your market share.

A competitor can do that when you don’t have a relationship with your customers and your market. This happens when your relationship with your customers is short and fast. They buy your product one time, then they are usually forever gone. Soon they will forget you even exist.

It’s much better to have a recurring model, because it creates an ongoing relationship with the customer, since they’re paying you on a monthly basis, perhaps for some type of software license or ongoing service.

That builds a much stronger connection between you and your customer, which really lowers the chance of someone coming in and undercutting your price.

A critical aspect of building successful businesses is building protective moats so as to make it much more difficult for competitors to move in on you.

One of the best business moats that exists is having on-going relationships with your customers.

Customer acquisition and retention

With a recurring business model, the initial sale isn’t really where you’re making your profit. Instead, you’re making most of your profit on the back end by charging, say, a monthly fee for your software or for a regular service that goes along with your product.

With the recurring model, selling the hardware product isn’t the end point, but rather it is just the starting point of your customer relationship.

It is expensive and requires a lot of work to acquire brand new customers. Whether you use paid advertising or organic marketing there is always a cost to acquire a new customer. This is called the Customer Acquisition Cost (CAC).

It is always much easier to resell to a current customer than it is to acquire a new customer. It varies between industries, but you can expect to pay seven to ten times more to acquire a new customer versus selling to an existing customer.

You’re much better off retaining existing customers for as long as possible. You don’t just generate ongoing revenue from them. You also build loyalty and trust. This in turn makes it easier to sell to them.

So when it comes time for them to replace your hardware product, or buy additional ones, you’re going to be top of mind because they still know and trust you.

They haven’t forgotten about your company like they would with a one-time product purchase. They see your company name on a recurring basis, since you have kept the relationship going.

Recurring revenue provides financial stability since you can predict your revenue in the future. But there are other huge advantages, like getting to know your customers better.

This is exactly the case with my Hardware Academy platform which uses a recurring payment model where customers pay on a monthly or annual basis.

Due to the long-term, ongoing relationship aspect I have gotten so much closer to members who have joined the Hardware Academy in comparison to clients that hired me in the past for a one-and-done engineering service.

I get to know everyone in the Academy, and no matter what business you are running it is extremely beneficial to know and understand your customers better.

Improved cash flow and revenue stability

Another reason so many businesses and investors love recurring revenue is that it helps with cash flow. A hardware business is very cash flow intensive.

This is a real problem when you’re trying to scale up because you have to pay for your inventory well in advance of getting paid for it by your customers. That creates a lot of cash flow issues.

Having recurring revenue on the back end can really help ease a cash flow problem by generating revenue that’s not associated with inventory.

Therefore, you can reinvest profits from your recurring model back into potentially paying for inventory. That will eliminate, or drastically reduce, any cash flow issues.

Recurring income provides stability and allows your growth to be predictable. With a one-and-done model, you start from zero every month. You have to constantly find, and sell to, new customers.

With a recurring model, you essentially keep most of your customers from the previous month while you also find new customers. You just keep building up and up, like a snowball rolling down a hill.

That stability is one of the biggest benefits to a recurring model. With the recurring revenue model you can fairly accurately forecast how much money you will make next month, in three months, or even six months into the future.

Your startup’s growth becomes very predictable once you know your growth rate and your retention rate. Retention rate is how many recurring customers are sticking around versus leaving.

This makes it much easier to plan, strategize, and hire people because you know that you have money coming in for the next few months.

Recurring Revenue Models

Hardware-as-a-Service (HaaS) model

There are different recurring models for hardware startups. The first one I’m going to look at is hardware as a service.

You’re probably used to hearing about software as a service, or SaaS, but hardware as a service is the most common recurring model for a hardware startup.

It typically includes either recurring software licenses or services. Your app or your software will have a monthly fee for licensing, for example. Or you could provide extra customer support, or hardware replacements, in exchange for a recurring service fee.

With the hardware as a service model, your profit comes from the recurring side of things instead of from each unit sold. You might even lose money on the initial sale, which doesn’t matter if you’re making all your profit on the recurring software or service that goes along with that hardware product.

This gives you a little more wiggle room in terms of your manufacturing costs, since you don’t need to make all your profit from selling the actual hardware unit. Instead, you’re making your profit on the back end.

You could even sell your hardware at cost or even at a small loss, as long as you understand your customer lifetime value, which depends on how long a recurring customer stays around.

Once you have that customer lifetime value data, then you can make better decisions. You will know what type of profit margin or loss is required on your initial hardware sale, knowing that in the long-term your recurring income will be profitable.

There are two different ways to do hardware as a service. You can either make the recurring service/software required or optional.

If it’s required, then a larger percentage of your income will come from the recurring aspect of your business.

If you make the recurring model optional, only a percentage of the customers that buy the hardware product will sign up for the recurring service. That’s going to push more of the profit requirements onto the hardware product itself.

Either optional or required recurring services can work well, but it’s ideal if your hardware requires a recurring service like software licensing. That’s going to be your best bet for creating stability and predictable growth.

Consumables model

The other model for recurring revenue for a hardware company is what’s called the consumables model. You’ll also hear this perhaps called a razor blade model, or sometimes the printer cartridge model.

Gillette doesn’t make money selling the razor itself. They make all their money selling the razor blades that go with their razors. Because razor blades wear out, they need to be constantly replenished, creating a recurring revenue stream.

There’s a ton of different ways to set this up, from ink jet printers selling ink replacement cartridges, to pet food dispensers that come with a recurring delivery of the pet food.

You can make these sales automatic, where each month a customer gets 10 new razor blades, for example.

The downside with consumables is it adds complexity. It’s more complex than the hardware as a service model because, well, physical products are always more complex to deliver.

If you are physically selling something that goes with your hardware product, you are now essentially selling two products – the hardware product and a recurring product.

If you’re selling razor blades or dog food, it will be more complex to scale your business because now you have inventory and cash flow headaches that are always associated with selling physical products.

With the consumable model, you also need an efficient distribution system to regularly ship your recurring products to customers. However, either of these recurring business models is better than having a one-and-done model.

Summary

Most physical products are sold on a one-time basis, but as we’ve discussed in this article your chances of business success are much greater if you can add an element of recurring revenue to your business model.

This is generally something that you need to consider at the beginning when you are defining the products and services you will provide as well as the market you will target.

So my advice is to give this considerable thought now, before you proceed too far down the old fashioned route of one-and-done.

Not only will recurring revenue help solve your cash flow headaches, and make your company more valuable and more scalable, but it will also allow you to form deeper relationships with your customers which is always massively beneficial.