As the Greater China Investment Partner for 500 Startups, I have been finding myself fielding an increasing number of questions about the manufacturing process in China, especially as we see more investments in the hardware and connected devices space.
Based in Beijing, I have made numerous trips to southern China in the past year, specifically Shenzhen — I even shared in an earlier article some of what I learned about the typical manufacturing process timeline. Below are a few things that I learned along the way that I hope can help both entrepreneurs and investors alike understand the unique challenges of making and investing in a hardware product.
Factories Are Not, In Fact, Dying To Take Your Order
The better the factory, the more discerning they are. There is, in fact, very little willingness on the part of reputable factories to work with startups.
I learned an incredible amount from Ben Yeung, executive director at Fujikon, a publicly listed manufacturer of high-end speakers and headphones. Yeung took me around his 4,000-worker and 600-staff main factory in the town of Humen, southwest of Dongguan city. For folks like Yeung, who are used to working with tier-one brands that I am not allowed to mention due to strict NDAs, there is little incentive to work with startups — especially arrogant and ill-prepared ones who come in believing that factories will take any work they can get.
This, according to Yeung, is absolutely untrue (unless you are talking about fly-by-night operations that primarily source customers from Alibaba or GlobalSources and have no real engineering or scale). Factories do not like to take risk, and are highly cognizant of opportunity cost. They do not want to lose out on a client with steady recurring orders and choose the one that is just a few runs at best.
Good factories will build in resources to grow along with you, whether that be in the form of human or monetary capital. Like in any business, the best will require multiple levels (read: weeks) of due diligence, including detailed analysis of your financial standing. Likewise, a smart entrepreneur with manufacturing experience will perform an audit on the factory, which generally means an on-site visit lasting 1-3 days and includes not just a comprehensive review of the equipment and manufacturing capabilities, but also specific skill sets of the in-house design and industrial engineers.
A Few Thousand Pre-Sold Units May Be Still Well Below MOQs
Many crowdfunded startups wrongly believe that a few thousand fully backed units (perhaps a few million U.S. dollars in pre-sales, which would generally be considered very successful) “warrants a multi-supplier sourcing strategy for key components or even the product itself,” says Yeung.
However, the reality is that such “puny” orders cannot meet the MOQ (Minimum Order Quantity) for many components, resulting in a much higher BOM (bill of materials) than projected. Furthermore, such demands essentially tell the factory that the team is not ready for primetime and are frustrating for both sides.
Pushing Out Physical Product Is Expensive … And NREs Are Usually Grossly Underestimated
Many startups focus on BOM (which, as you’ve seen above, is often wrong anyway, even assuming the product is designed for manufacturing), and grossly underestimate their NRE (non-recurring engineering) costs.
These costs include trial runs, the factory’s engineering costs, product verification, tooling/fixture costs and even liabilities that arise when a product goes EOL (end-of-life, when remaining materials may become obsolete). These engineering costs cannot be skimped on because die and plastic tooling work, for example, which are often some of the greatest expenditures during product development, cannot be altered easily after production has begun.
There Are Many “Not-So-Incidental” Costs
So, you have some nifty gadget that connects with the iPhone. Is it MFi? MFi stands for Made for iPhone/iPad/iPod, a licensing program that a product must belong to if it wants to use the proprietary connectors for Apple iPhones and iPads.
Byron Hu, a long-time Dongguan resident, manager of a high-end audio equipment factory and consultant to many hardware startups, told me there are many startups in the field with the delusion that they can get a Lightning connector for $0.25, not realizing that approved connectors are regulated and can only be sold to authorized factories — and that knock-off connectors can actually end up damaging an iPhone or iPad.
How about packaging? I learned from Adam Melton, CEO of award-winning packing firm Green Packaging Asia (GPA), that not only can retail packaging cost upwards of 5-10 percent of a product’s wholesale price, but that certain large retailers each have their own packaging standards, and it is best to work with someone like GPA early on to make sure that the packaging is designed for the product, inexpensive, withstands stress tests and fulfills retailer requirements. Complicated designs can take weeks to complete, but can make a big difference in the ability of one’s product to command eyeballs from the shelf.
Certifications are relatively straightforward, but are legally required for products to be sold in certain countries. The most common ones are UL, CE, CSA and ETL, which are described briefly here. Have Bluetooth functionality? You will need separate certification, which will also cost a few thousand dollars. The same with Wi-Fi. There is also the problem of product liability insurance, which varies, but is still something like an average of $0.26 per every $100 of your final retail price.
As of this writing at least, hardware has become one of the new darlings of the VC industry. Yet investing in the sector is fraught with danger, not least because of the many non-obvious costs and difficulties associated with putting out a physical product, as I have outlined above. Thus, before jumping into your next hardware investment, early stage investors might consider asking the following questions:
- Has the founding team industrialized a product before? If not, does the team have (or plan to hire) an experienced industrial engineer who has worked with a factory to commercialize a technology?
- How did they find the factory and what was their process in selecting the factory? Did they at least perform an audit on the factory?
- Last but not least, for those who are claiming to be “manufacturing in China/Taiwan/Etc.,” does the engineering team have a core member stationed there, at least part-time? Note that even if the team claims to rely on third-party consultants, having a physical presence there ensures that “the squeakiest wheel gets the grease.”
Best of luck to all of us, hardware investors and entrepreneurs alike.