Why Hardware + Software Combinations Create Great Businesses
How hardware + software results in valuable & differentiated products, sticky customers, and attractive margins, building off of a post by Marco DeMeireles.
Recently, @MarcoDeMeireles published an eye-opening piece on his investment thesis around physical products or experiences that integrate software and a subscription model to deliver value for consumers.
The punchline is that many of these companies have been ignored by investors despite exhibiting incredible economics, as shown below:
To better wrap my head around this idea, I wanted to understand some of the underlying components behind some or all of these companies. I believe that there are three main components that help contribute to their superior economics:
The products are valuable, differentiated, and hard to copy because of the difficulty of and lack of attention on combining hardware and software
A physical product, switching friction, and emotional psychology lend to customer stickiness
The hardware enables distribution for recurring, high-margin software services
Let’s dive in.
Valuable & Differentiated Products
The most important aspect of these products is that they are valuable. They are able to serve the needs of a market because they bring a new business model that better aligns with consumer interests or they simply create their own market entirely.
Software can add a lot of value to our lives, but the fact is that we don’t live in an entirely virtual world. We still interact with the physical world for the overwhelming majority of the day.
Hardware has scared off investment due to its less attractive gross margins relative to SaaS. As a result, the software and hardware worlds are disassociated, with few products straddling the two. This has left an opportunity to embed software services into physical products to offer a 10x improvement over its analog alternatives through new business models and better value propositions.
For example, Peloton’s combination of hardware and software offers a superior “price-to-value” ratio as:
the service isn’t pay-per-use, resulting in superior costs per workout to studio classes (better price)
Peloton provides higher-quality and more convenient fitness experiences relative to gym subscriptions (better value).
The net effect is that Peloton’s offerings have better value proposition relative to competitors, by way of a better price, value, or both and is enabled by the integration of hardware and software.
Playing into this, Peloton offers a “calculator” to compare your fitness options — play around and see for yourself!
Furthermore, because of the inherent difficulty of creating and integrating hardware and software products into a single, seamless offering, incumbents and upstarts will stumble in trying to go to market with a comparable offering. Layer in the company’s headstart, competitors may even become discouraged before even making an attempt.
Sticky Customers
Because of the value and differentiation of products, customers love them and want to continue using them. But in addition to a love for these products, there is also a stickiness that comes with a physical product.
For example, replacing Peloton Digital for Apple Fitness+ is just a few clicks on the internet away, but replacing a Peloton for SoulCycle Variis bike is a whole process — it requires selling and shipping the physical product to bring in a replacement. There is inherently a lot more friction to switch to an alternative.
Furthermore, something that many of these businesses share is that they have key emotional and social contexts that further entrench themselves in the lives of their users.
In the case of Alarm.com and ADT, it is incredibly hard to part ways with your alarm system. This is partly because ripping out your alarm system and installing a new one is not a quick and easy process, but also because of the emotional psychology that comes with keeping you and your family safe.
As eloquently characterized by Clayton Christensen:
It’s easy to fire things that simply offer functional solutions to a job. But when the decision involves firing something that has emotional and social dimensions to solving the job, that something is far harder to let go. No matter how frustrated we are with our current situation or how enticing a new product is, if the forces that pull us to hiring something don’t outweigh the hindering forces, we won’t even consider hiring something new.
— Clayton Christensen in Competing Against Luck
To change out the alarm system that keeps you safe or to change your fitness service that provides daily ritual, community, and perhaps even spirituality requires a tremendous amount of certainty that a substitute will be significantly better.
This effect is amplified with hardware products since reducing uncertainty is difficult or, in some cases, impossible. With software, you might use a free trial of an alternative before making a full switch like trying Apple Music before churning from Spotify. But, with physical products, this is not a seamless experience (if it is even rational or possible). It’s not practical to “free trial” a new alarm system while keeping your old one in place or to try Nordic Track’s treadmill while keeping your Peloton Tread in your home.
Thus, the potential improvement must be that much greater to offset the increased uncertainty, making customers less likely to switch.
Attractive Margins
The increased adoption from valuable & differentiated products, in addition to increased retention from switching friction inherent in physical products, sets the stage to distribute recurring, high-margin software services.
Tren Griffin calls this concept Software in a Box:
I got this idea, for a thesis, I called it software in a box, which is basically sometimes you have to sell a box to sell software…you sell this thing, which enables you to sell this service...and so software, it becomes critical, but sometimes the hardware is an enabling thing…So, software is truly eating the world as Andreessen says, but sometimes hardware is enabling to distribution.
— @TrenGriffin on Invest Like the Best; condensed for conciseness
Apple, known for its vertical integration of hardware and software, is a prime example of this. Of late, a big focus for the company has been on their services business. Having captured customers with a valuable and differentiated product ecosystem, the company is looking to leverage its install-base to push higher-margin software services, culminating in its latest launch of Apple One.
Another great example of this is gaming platforms like Xbox. Customers purchase gaming consoles that are valuable standalone, but the install base is enabling the distribution of Xbox Live and Game Pass software subscriptions. Of note, this is so powerful that consoles are sold at a loss to better enable distribution to these software offerings.
End Results
When executed well (which, again, is no simple feat) produces high-quality businesses. The result of this is that you end up with:
adoption of product through differentiated and valuable products
sticky customers resulting in long customers lifetimes
attractive margins from the software components, resulting in high customer value
defensible businesses as copying is difficult, given:
the complexity of getting both hardware and software right
the benefits of first-mover advantages and the associated economies of scale and network effects.
Peloton, Microsoft, Apple et al. are some of the first to demonstrate this, but surely will not be the last.
If you have any questions, thoughts, or would like to connect, please don’t hesitate to reach out via Twitter or LinkedIn!
I think this is enormously insightful. I see a lot of success in the gaming industry going forward for the reasons you mention - i.e. increasingly sophisticated graphics cards for PCs require some labor to reinstall and must be compatible with your core processor. great article