If you want to build a multibillion-dollar consumer IoT company, copy the iPod – the original IoT thingy. Most brilliant “Internet of Things” ideas are quicksand for capital unless you have the branding, vertical integration and customer lock-in that Apple achieved. The iPod model will separate IoT platforms from fads.

20 years ago, a majority of “Sand Hill” venture capital went into enterprise-focused startups. Only the most daring and risk-tolerant investors bothered with consumer startups. However, the rise of the Internet equalized if not flipped the ratio as the web (and mobile) created a new product category and distribution platform. For the first time, entrepreneurs could build consumer services AND distribute them at scale with almost no physical middle men and inventory costs.

Still, that tilt towards consumer startups was limited to software and services. Investing in consumer hardware was not the business of most VCs (exceptions like the CueCat and Palm proved the rule) until “Internet of Things” became a thing.

VCs used to stay away from consumer hardware for six reasons:

1. Going from design to manufacturing is a long, imprecise, circular and human-dependent process (even more so than writing and deploying code!)

2. Inventory holding costs create significant working capital requirements and risk

3. Intense price competition at the retail level creates low margins

4. Consumer trends are fickle (see Flip Video)

5. Low switching costs and built-in product “half-life” demolish customer loyalty

6. China

Take the example of MP3 players. Before the iPod debuted in 2001, MP3 players became a billion dollar business led by companies such as Creative Technology. A couple of years into the MP3 craze, Chinese factories began churning out cheap knock-offs at scale, and eventually MP3 players became tchotchkes given away at conferences and conventions. Creative Technology would discontinue its MP3 player business less than 5 years later.

Nonetheless, Apple launched the iPod and dominated the market, taking out both high end incumbents and low end Chinese imposters. The iPod redefined the category. When was the last time someone called the iPod an MP3 player?

The iPod won the MP3 melee with a strategy that consumer IoT startups can and should emulate today. First, Apple branded a new culture of music. From the unmistakable white earbuds to the silhouetted dancers in iPod commercials, Apple created a visible and seductive in-group. They made Walkman owners, with their foam earphones and bulky booklets of CDs, feel left out of this invented community.

Second, Apple vertically integrated the user experience, business model and distribution model. The company made all the software and core hardware you needed to enjoy an iPod. Moreover, consumers could buy the iPod online or through the tactically designed Apple Store, which today has higher sales per square foot than any other U.S. retailer. Like the SaaS companies that would arrive years later, Apple also created a recurring revenue model through iTunes (although they had to compete against pirated music sites). Apple had the foresight to launch the iPod, iTunes and the Apple Store all in 2001.

Third, iTunes locked in loyal customers from one generation to the next. If you had thousands of songs painstakingly organized into playlists on iTunes, switching to another device or music service became unthinkable. Microsoft Zune arrived five years too late to steal away Apple customers.

At Mucker Capital, we use the iPod (and iPhone) as our template for investing in consumer IoT companies. Who can build a premium consumer brand, vertically integrate the entire model and make loyalty the default choice for every customer? We look for teams that have repeatedly shipped hardware and software products. They also need experience in consumer branding.

Like Apple, the best IoT startups will view hardware as simply the delivery platform for a ‘differentiated software experience.’ This allows the company to monetize not only as a hardware company selling widgets but as a “SaaS” company that generates recurring revenue and, as a result, creates generational lock-in from one product cycle to the next AND protects their revenue stream on a ‘continuously accretive basis.’

Put simply, VCs like consumer hardware companies with software-like business models. Apple perfected that category with the iPod. So yes, I am arguing that you should copy the model that turned Apple into the world’s most profitable company. Is that too much to ask?

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