In recent years it has become dramatically less expensive to design, build, and bring a consumer electronics device to market. The emergence of low-cost and low-power processors, DSPs and SOCs (systems-on-a-chip), the declining cost of all forms of memory, and Asian-based outsourced manufacturing (primarily in Taiwan, China and increasingly, Indonesia) has made investments in companies offering a consumer-electronics device a much more compelling opportunity from a VC perspective.

These cost-savings have enabled the companies we’ve invested in to maintain 40% – 60% gross margins on their products (while selling at sub $300 price points) sold into the retail channel, even at wholesale pricing levels. When these companies sell direct-to-consumer via their websites, the margins can be even higher. Contrast this with earlier venture-backed consumer-electronics companies like TiVo (whose DVR we essentially a PC in different packaging), which initially had to sell its product at negative margins and hope to make up the difference with service/subscription revenues.

Most venture capitalists would not agree with our view that gadget companies can present compelling investment opportunities, and there are certainly challenges associated with a business model that involves building widgets overseas and shipping them around the world to third-party logistics companies, distributors, and retailers. To name but a few: there is more operational complexity around manufacturing, distribution and sales, there are increased working capital requirements, the margins are lower relative to software or SaaS models, the cost of product defects is much higher, and there can be less real-time visibility into sales and the customer base, given that a retailer sits between the company and its users, at least up until the point of purchase.

There are some special things that we look for in a consumer electronics investment. First and foremost, we focus on the software element of the consumer electronics product. When we were on the road raising our fund, we’d often be asked by potential investors what it was the made the Slingbox special, and why we had decided to invest in a device play. We’d reply that the magic behind the Slingbox was the software and that Sling Media was a software company that just happened to package its software in a cheap plastic box.

Second, for any consumer electronics device to be successful, it must be dead simple to use and to set up. The out-of-the-box experience has to be seamless and just work, hiding all configuration complexity from the user. Not to pick on TiVo again, but rumors are that in the early days of TiVo, the return rate was well over 50%, primarily because of the great complexity of setup. Customers gave up in frustration before they were able to experience the magic of TiVo. Even today, upwards of a third of wireless routers are returned to the store because of difficult setup procedures.

We think the Slingbox set a new standard of usability and ease-of-installation in its day, while the setup process of the Pogoplug currently sets the gold standard for an install – it can be done in under two minutes, requires zero knowledge of network configurations or firewalls, and is literally as easy as typing in a URL and signing up for an account. Naturally, most any modern device should be network-aware and work closely with web-based services to provide an integrated experience. A software-powered consumer electronics device should also evolve – regular software updates mean that a good gadget gets better over time.

Finally, we also believe that for a consumer electronics company to be interesting to us as an investment opportunity, it should be establishing a new category of device. Sifteo’s Siftables, Cloud Engines’ Pogoplug. and Sling Media’s Slingbox are a few examples from our portfolio that illustrate this point. A startup has very little to offer in an established category – the world doesn’t need another audio player, smartphone or router. Leave those categories to established players who have the manufacturing, marketing and distribution muscle to compete. As a startup, rising above the noise in an existing category is difficult and expensive. Granted, establishing a new category of device has its own set of challenges, but innovation and disruption are the core mission of startups.

If you’re making a product out of atoms (powered by software magic) that fits the above description we’d love to hear from you. Atoms are the new bits.

We are hopeful that as a result of this case, business method patents will be forever dead and gone.  Given the tenor and body language of the court, we would be surprised if it turned out any other way.  Perhaps most interesting was the courts’ investigation into software patents, even though that was technically not the issue at hand.  We, individually at the Foundry Group, are not fans of the current ecosystem surrounding software patents and would be happy to see the court take action on this front too. 

We anxiously await the ruling. 

As part of this approach we look to meaningfully participate in the ongoing conversation taking place within these thematic areas. To that end we’ve teamed up with Eric Norlin to work on a few conferences that bring together thought leaders from across the technology industry.  Our first attempt at this is Defrag – a conference now in its third year that is focused on how technology has evolved to help people and organizations better organize, interpret and consume disparate information (thus the name "Defrag").  While the conference wasn’t theme specific, the conversation has tended to tie closely to our Implicit Web and Email themes.

In 2009 we’re introducing another conference to the mix that we’re calling "Glue".  If Defrag is a high level discussion about meta-information, Glue is a more nuts and bolts discussion around the actual technologies that we use to pull this information together.  As you can imagine, it also fits nicely with our Glue theme. Presuppose the notion of cloud computing/platform as a service; assume the web as a platform.  Now what?  Glue is going to bring together technologists to start to answer these questions. The discussion is generally going to be "below the browser" and if you check out the agenda you’ll see plenty of topic areas that relate to the details of the changing technology and architecture landscape. And while we’re still putting the final touches on the agenda, we can confirm that keynote speakers will include Mitch Kapor (long time software luminary and private investor) and David Heinemeier Hansson (creator of Ruby on Rails) along with many sessions that are designed to encourage meaningful interaction between conference attendees.

We hope you’ll join us at the Glue – May 12^th and 13^th at the Hyatt in Denver. Use the code "early1" to get $50 off the regular conference price of $395 (but there are a limited number of discounts available, so best to register right away).

1. Don’t buy a television for the next 6 months. This is certainly counter to what retailers and producers would want us to say, especially given the current state of the economy, but all the major brands are introducing exciting technologies in the first half of 2009. The TVs are thinner (some less than 1mm!), brighter (LED backlighting rocks), faster (240mhz refresh rate) and offer superior contrast ratios (1,000,000 to 1 and even higher). Next to the best of today’s generation of panels, there is no comparison. Having been to CES a few years in a row, this year seemed to demonstrate the biggest improvements on imaging. If you don’t buy a TV in this generation, hold on a couple of years until OLED TVs are commonplace and then sit a back and look at the best displays we’ve ever seen. For now, we’ll geek out on LED backlit generation two screens.
2. Everyone is trying to make things easier on consumers. It only took 20 years or so, but consumer device manufactures, both large and small are finally focusing on the consumer experience. Maybe this is the effect of Apple’s entrance into the consumer device ecosystem, but this year, in particular, showed many instances of deep thinking about usability. What was of particular interest to us were some of the startups that attended the show and instead of presenting groundbreaking technology, rather have executed on current technologies to bring the consumer a needed digital solution with the ease of use never seen before at an unexpectedly low price.
3. 3D on TV. Full HD TVs and projectors that have incredible 3D-images (glasses needed) are now consumer available. Clearly the amount of content available will drive how popular these devices become, but the technology is really impressive to experience. We played a VW racing game in 3D and would have been happy to sit there all afternoon, or at least until the inevitable headaches set in. There was also a prototype of a 3D TV that didn’t require the viewer to wear glasses. It was pretty rough, but cool at the same time. We have our doubts that the entire universe of content will ever go 3D, given how different the production tools and processes are for live-action movies and television. However, for media like video games and CG animated content which are largely “3D native” already, there should be less of a hurdle to create appropriate 3D content, and probably better justification from a user-experience perspective as well.
4. SanDisk has a power marketing department. SanDisk had their usual large presence and this year the big announcement was a 2GB Rockband-branded SD card. All for the low price of 13 bucks. Yes, you can buy a regular SD card for about 4 bucks, but why not pay an extra $9 for a cool sticker? Well done, SanDisk. Also, similarly, one can now purchase a cool looking Godfather-branded USB thumb drive, (not from SanDisk) but it does contain some Godfather content, at least. Speaking of content, SanDisk also brought out a new MP3 player for lazy people called the slotRadio. The MP3 player comes with 1000 preloaded songs based on standardized genre playlists chosen by the company, not the user. Over time, a user can order new cards to put into the MP3 player’s slot, each card having a different genre of music pre installed. The only controls on the device are play and skip (i.e. no “back”). Call this the MP3 player for people who really don’t like music.
5. It was virtually empty at the show. Okay, that is a gross overstatement, but the hotel rooms were half the price of last year and it was definitely easier to navigate on the convention floor. The folks at CES claimed there was only an 8% drop in attendance, but it felt like a lot more. Our bet is that folks who registered beforehand didn’t buy plane tickets and hotel rooms and didn’t show up. CES probably included these folks in their numbers. After all, they have booths to sell based on attendance. Some reports have the attendance at 22% down.
6. Nobu is still excellent. Enough said. Guy Savoy was also scrumptious.
7. Human Computer Interaction. We were excited to see the continual refinement and presence of next generation human computer interactions. Frequent readers to our blog will note that we are huge fans of HCI. We wouldn’t say there was anything earth shattering, but it was nice to see multi-touch and other similar technologies progress.
8. Connectivity matters. Connecting more devices to more content in more places was a big theme. On the wireless front, there was a wealth of smart phones, LG’s new Dick Tracy-esque watch cell phone, lots of in-car connectivity (satellite TV, in-dash computers with mobile Internet, etc.), and a push to deliver more relevant content (traffic, weather, sports, etc.) via traditional GPS devices. And while the idea of accessing the Internet on a TV seems a bit passé (WebTV pioneered the idea about 14 years too early), 2009 just might go down in history as the year that this idea truly came to fruition. TV manufacturers seem to have embraced the idea—we think having this built into TVs is a big step forward when it comes to the average consumer—and the wealth of newly available content like NetFlix streaming movies and Yahoo’s widgets should make for a more compelling experience than WebTV’s original email-on-your-TV proposition.

For those of you who aren’t familiar with Pandora, it’s an Internet music streaming company that allows listeners to discover new music based on what they already like. And best of all, it’s free. Jason wrote a post about his affection for Pandora recently and we all like Pandora here at Foundry Group.

Recently, Pandora has been on the brink of death, due to the threat of increased royalty payments on songs that they play. Now, it may make sense that Pandora should pay for broadcasting music, but keep in mind that traditional radio stations (AM/FM, with no static at all) pay nothing to play tracks. Satellite providers like XM and Sirius pay about 1.6 cents per hour per listener. Pandora, as an “Internet radio station” was due to pay about 2.91 cents for the same songs beginning in 2010. Of more immediate concern, the royalty rates were to go up nearly double by order of a federal panel that would have charged Pandora and other Internet radio stations on a per song basis. As a result, Pandora has been seriously considering shutting down.

So why does this discrimination between terrestrial, satellite and Internet radio stations exist? Simple. Politics. The big music labels have lobbied hard (through the N.A.B. and other organizations) to the U.S. government to increase Internet radio station royalty rates. Rationally, it would appear that the labels are better off having their tracks played as much as possible in hopes that people will either buy the music or concert tickets, but economic rationality isn’t one of the labels’ strong points. Record companies seem to think everything digital is “bad.” Furthermore, it appears that the record companies are still in the pocket of Clear Channel, the country’s largest owner of terrestrial radio stations.

We are consumers of music, whether we purchase albums/tracks, go to concerts or buy merchandise. What continually amazes us is how difficult the labels make it to buy and discover their product. We’ve watched for the better part of a decade their inability to adapt and their willingness to use strong-arm tactics to cling to their old and outdated business models. Their attack on Internet radio stations is just another example of these antics. In fact, labels’ unwillingness to adapt to the digital age in part drove our decision to invest in Topspin.

There may be some good news on the horizon, however. On Friday, September 26^th, the House of Representatives passed a bill putting a moratorium on royalty rate increases and gave Internet radio a fighting chance to negotiate a fair deal with the record labels. The Senate still needs to vote for the bill and with all the current financial upheaval, it’s not clear when that will happen. That being said, we strongly encourage the Senate to pass the bill, and then we can all cross our fingers and hope that the labels and Internet radio stations can negotiate on more equal footing and structure a deal that is fair to all and keeps the customers’ best interests in mind.