Physical-product businesses face manufacturing risk, inventory, lower gross margins and large capital needs. Many climate companies also depend on policy and on project finance to deploy their technology.
11 min read · Level 4
I think the most useful habit for evaluating physical businesses is to ask where the cash goes when sales double. For software the answer is often mostly into more growth; for hardware and climate projects it is frequently into inventory, factories and deployments before any profit arrives, and that changes how much capital the company will really need.
Hardware. A company making physical products has costs a software company does not:
Cost or risk Effect Bill of materials parts and assembly cost per unit Inventory cash tied up before products are sold Warranties and returns costs after the sale Manufacturing scale-up quality and cost problems when volume rises
A product priced at 500 with a bill of materials of 300 has a gross margin before other costs of:
(500 - 300) / 500 = 40%
If warranties and returns cost 25 per unit, the margin falls to (500 - 325) / 500 = 35%.
Inventory ties up working capital. Holding 10,000 units at 300 each before sale ties up 3,000,000 of cash.
Climate. Climate technology spans energy, transport, materials and carbon removal. Common additional factors:
Policy dependence subsidies, mandates and carbon prices that affect demand Project finance large deployments may need debt or infrastructure capital Commodity exposure prices of inputs and outputs Long cycles pilot, demonstration and commercial scale can take many years
Venture capital is often a poor fit for the later, capital-heavy stages, which can create a funding gap between proving technology and deploying it at scale.
Because hardware and climate businesses consume capital differently from software. Growth requires building and holding physical products or projects, so fast growth can drain cash rather than generate it.
Policy dependence also adds a risk outside the company's control. A change in subsidies or regulation can reshape demand quickly.
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A hardware company doubling unit sales.
Year Units sold Inventory held Cash tied in inventory at 300 per unit 1 5,000 2,000 600,000 2 10,000 5,000 1,500,000
Revenue doubled, but the cash tied up in inventory rose by 900,000. If gross profit per unit is 175 (500 - 325), doubling sales from 5,000 to 10,000 units adds 875,000 of gross profit - roughly the same as the extra cash needed for inventory, before any operating costs. Growth was not self-funding.
Applying software growth and margin expectations to hardware or climate companies, and overlooking the cash consumed by inventory, manufacturing and deployment.
Include bill of materials, warranties, returns, shipping and installation.
Estimate inventory and working capital needs as volumes rise.
Identify which stages need venture capital and which need debt, project finance or partners.
List subsidies, mandates or regulations the business depends on, and the effect if they change.
When evaluating hardware, energy, transport, materials or other climate-related companies.
Do not dismiss hardware or climate companies because margins are lower than software. Many build durable businesses; the analysis simply needs to reflect their capital needs.
Research and commentary, including an MIT Energy Initiative working paper analysing venture capital investment in clean energy technology between 2006 and 2011, found that many clean technology startups from that period struggled to reach commercial scale and returned poor results to venture investors, partly because capital needs and timelines did not fit the venture model.
Ask whether a climate company's path to scale matches the funding sources realistically available at each stage.
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