Smart home products like Google Nest, Ring, and smart refrigerators have kept consumers ahead of the curve of the Internet of Things (IoT), which refers to the interconnection of everyday objects via the internet. As household and commercial items gain added functionality by connecting to a wireless network—through software or other technology—our home lives, businesses, and cities are being reshaped.

According to McKinsey & Co., the global number of IoT-connected devices is expected to almost triple from 2018 figures, reaching 43 billion by 2023.

a vice president at McRock Capital, a Canadian venture capital firm specializing in industrial IoT, is among those who call this shift the fourth industrial revolution.

“A lot of people believe that IoT is the power behind such a revolution, which is going to drive increases in productivity, transform business models, and redefine the way that organizations relate to their customers and suppliers,” she says.

Industrial IoT connects smart devices, machines, infrastructure, and analytics to offer insights with potential economic benefits, such as added efficiency or productivity. Now it’s emerging from the shadows of more imagination-grabbing consumer products, Nguyen says, as companies demonstrate “bigger and better understood” use cases and investors take notice. 

“Now we see the acceleration in adoption of technology in the industrial market, and the customers, which are big corporations, are stepping up with their own innovation projects in-house,” Nguyen says.

The International Data Corporation (IDC) reports that IoT spending will surpass $1 trillion in revenue in 2022, up from an estimated $726 billion this year. In 2023, the process manufacturing, discrete manufacturing, and transportation industries are expected to account for one-third of global spending totals.

Here’s what Nguyen says investors need to know when entering the emerging industrial IoT space.

Get Comfortable With Hardware

“In the Internet of Things, we cannot shy away from the things,” Nguyen says, even with a move to more software plays in the information technology sector. “Hardware is going to still be a very big part of the whole ecosystem and the kind of hardware in the space is going to keep evolving.”

In Silicon Valley, Nguyen says people “run away” from investing in hardware because investors used to software, like apps, want to make quick returns with light capital.

Investing in IoT hardware usually involves bigger round sizes and higher working capital requirements than other investments. Nguyen says she often faces a CAD$3 million to CAD$5 million (US$2.28 million to US$3.8 million) initial check size when investing in hardware as part of a syndicate. 

“So if you are not a deep pocket investor and can’t play it for a longer term, then hardware is not going to be the ideal kind of product for you to invest in,” she says.

But for those who are willing, there’s room to grow. The 2019 IDC Worldwide Semiannual Internet of Things Spending Guide puts hardware spending at US$91.6 billion for 2019, whereas US$39.3 billion was spent on software this year. 

Understand Ideal Growth

In the consumer market, an app can have a single user one day and a million users the next. But this exponential growth isn’t found in the longer sales cycle ofindustrial IoT markets—a space with a smaller customer base, even if they tend to write bigger checks than other industries.

“You cannot go from a million in revenue today to $100 million in revenue tomorrow,” she says. “And so having the right expectations in terms of what kind of ideal growth companies should have in this space is also very important.”

One misconception Nguyen notices is that some investors ask startups about recurring revenue immediately, then judge them to be unattractive investments when they don’t have it.

“Asking a startup in the IoT space to immediately have a big percent of Software as a
(SaaS) revenue at this stage is, I would say, impractical,” she says. “It’s not really feasible for a lot of startups.”

Know How to Value IoT Investments

Nguyen’s firm looks for three key elements when investing in industrial IoT: customer conversion rates, a culture of frugality, and the employee team.

She says evaluating startups in today’s market warrants “an extremely detailed case-by-case analysis.” This includes considering factors like the strength of the use case, scarcity, and the company’s track record and partnerships. There’s also a need to understand how blended margins from hardware and software sales paint a truer picture of an investment’s potential. 

“Usually in the IoT offering, hardware and software come as a unified offering,” Nguyen says. “There’s always going to be the brain on top of the hardware.”

In software, Nguyen says margins can be around 80% to 90%, with hardware margins ranging as low as 30% to 40%. But in IoT, blended margins tend to be higher than the traditional hardware market that comes to mind for many investors.

“It’s not always just about the hardware, and hardware is not always telling the story and reflecting the right kind of margin and potential margin that the company’s going to have in this space,” she says.

Nguyen adds that large industrial IoT contracts are going to relatively small companies—meaning big balance sheets don’t dictate the potential for dealmaking and return on investment.