Revenue & Growth
10 minute read

Climbing the IoT Value Chain

Peter is a former investment banker and served as the COO of a marketing software startup. He enjoys working with high-growth companies.

In recent years, the Internet of Things (IoT) has become a meme thanks to a plethora of wacky consumer-oriented devices. (Who needs an internet connected toaster?) Impactful applications for enterprise and industrial businesses, however, will unquestionably blossom in the coming years. The very nature of “Internet of Things” emphasizes connected hardware or physical assets. I want to encourage finance professionals to explore how the real IoT value lies in data and intelligence software applications managing the back-end of these systems. In a world of “asset-lite” business models, IoT applications can transform heavy assets (real estate, equipment, fixtures) and humans into data-rich intelligence and, more importantly, generate recurring services revenue.

In this article, I will provide background on the makeup of IoT systems, including long-term trends boosting the space with tailwinds. Second, I will provide a framework and hierarchy for IoT software applications, including their relative potential to drive value across the enterprise. I will then present a thought framework to help you translate these nebulous concepts into uncovering real applications or opportunities for you to implement in your business and realize the IoT value chain. Lastly, we will look into the potential impact for IoT enable services to increase enterprise value for your organization.

Background

It has been 20 years since visionary Kevin Ashton coined the term Internet of Things in a presentation to Procter & Gamble. It took nearly a decade of developments in cloud infrastructure to enable widespread IoT applications: It was then 2011 when IoT first appeared on the Gartner Hype Cycle. Now, thanks to burgeoning infrastructure and support services ecosystems that provide operating professionals with a more robust toolkit, compelling applications will be coming to market in the next few years. If you haven’t seen SpaceX’s plan for global T-1 internet via a network of 1,500 low orbit satellites, it’s a sign of things to come. Bringing the conversation back down to earth, IoT is the core of industrial companies’ efforts to bridge the divide between the physical and the virtual realms. As the boundaries between man and machine become more blurred, the role of IoT as a connecting block will become more prominent. For consumer-facing businesses, IoT has huge implications—for instance, for the future of retail, whether we talk about audience recognition, personalized offers or content, or completely self-serve outlets such as Amazon’s Go store.

So What Is IoT Anyway? IoT Explained

The Internet of Things (IoT) is the extension of Internet connectivity into physical devices and everyday objects. Embedded with electronics, Internet connectivity, and other forms of hardware (such as sensors), these devices can communicate and interact with others over the Internet, and they can be remotely monitored and controlled. - Wikipedia

For this article, we’ll focus on commercial and industrial applications, as consumer-focused products are an entirely different species. A whole new layer of data, sensors, and information allows for the potential to transform rather staid, asset-heavy businesses into software-first organizations via machine learning and other analytics tools. Perhaps the most successful IoT-enabled application to date has been Uber, which ultimately turned the global transportation industry on its head, completely dismantling the taxi industry that was mired in gross inefficiencies, a central dispatch model utilizing radio communication.

A series of long-term technological trends bode well for advancing groundbreaking IoT apps. Thanks to 1) increased connectivity, 2) low-cost hardware, and 3) machine learning/artificial intelligence applications, there is no more suitable time to examine your business for implementation opportunities. Think of IoT as an intelligence tool to not only measure your business but, more importantly, to unlock new business models and sources of high-value revenue streams. It is here that building new service offerings on top of a new IoT enabled data layer has the potential to create a realm of high value of opportunities and ecosystems.

Throughout my investment banking career, many of the clients I worked with were old-guard media companies getting displaced by technology (radio, TV, newspapers, publishing). I watched firsthand as industry incumbents let their startup rivals race past them to forge more everlasting relationships with their audience through data and personalization. When my career turned to entrepreneurship, I helped design technology solutions to connect physical locations and assets with technology and data, my immersion into IoT began, and I quickly recognized its potential to displace old industries while creating new ecosystems.

The potential to transform businesses can have a significant impact on long-term company valuations.

Functional Pyramid of IoT Applications

When evaluating the core functionality of an IoT deployment, the latter can be segmented into four essential layers; connect, control, analyze, and build—further illustrated in the graphic below, or what I call the functional pyramid:

functional pyramid of IoT applications

When only looking at vendors or suppliers to help implement a solution, numerous firms specialize in one or more of these functions, in addition to dominant players such as IBM, Microsoft, and SAP, which provide end-to-end solutions. On the surface, most of the attention via tech press and mainstream media focuses on the lower levels of the pyramid. Sourcing aside, I view this framework as a constructive lens to evaluate where and how IoT solutions could help drive value and opportunities for your business.

When moving up the pyramid, one transitions from basic connect and control (hardware) functions up through analyze and build layers (software). It is in this layer where you will find high-value opportunities in what I like to call second-order applications.

It is said that, back in 1982, the first IoT device was created when a group of Carnegie Mellon students connected a coke vending machine to ARPANET. To illustrate how compelling IoT apps can potentially transform a business as seemingly simple as soda vending, let’s look through the lens of four components to IoT systems:

Connect Enable two-way communication, most simply allowing for debit/credit card payments.
Control Remote diagnostics signal when Sprite is low or the machine is unplugged/offline.
Analyze Compare sales of different products across different types of locations to optimize product mix and to interpret seasonal and demographic patterns.
Build Use transaction data to connect with supply ordering systems, optimize stocking and delivery routes, and prioritize site acquisition pipeline and sales initiatives based on profitability.

The focus here is on the pinnacle layer, which allows uncovering new business models, data, and intelligence revenue which will, in turn, drive the most significant increase in enterprise value.

Underlying Economics

As you move up the value chain within the IoT functional pyramid, you see that compelling and transformational value for a business is all realized through intelligent software applications built on top of a base layer of data and monitoring. For this reason alone, I suggest that IoT should be reframed as the basis for software projects, characterized by fixed costs and (nearly) unlimited returns, versus a simple variable cost equation typical of the capital planning for traditional hardware/fixed asset deployment. Further supporting this view is the actualization that the cost of sensors and hardware is plummeting rapidly. To illustrate this, look at the expense of various components over time:

As an example, a past client I worked within the retail sector was evaluating an in-store customer experience design implementation across 1,000 stores in the US and Canada. The initial software development included $1.5 million in year-one development/integration, with a variable cost component for each “set” of hardware at $500 per location. Utilizing a simple algebraic equation:

underlying economics of IoT

When evaluating return on capital for the whole $2 million budget, including the human capital needed for program development and pilot trials, it is clear that with an incremental unit cost of $500, a project such as this is composed primarily of fixed costs with a highly leverageable base for return on capital invested.

Thought Framework

In the abstract, this all sounds great, but you may be wondering how to uncover opportunities like this in your business. For this reason, I have created a brief five-point outline of critical questions to consider when evaluating how to discover opportunities for hidden services to deliver value in your business.

A. What assets are you tracking?

The answer may range widely and may be as simple as connecting a smart device or developing a greenfield sensor network. Perhaps even wiring up your personnel or human assets could be a solution. Most straightforward may be bringing industrial machinery online—for example, mixing or portioning equipment in food manufacturing. In this instance, a sensor/device network may be used to transform “offline” assets into real-time intelligence tools. In a retail setting, this might include running video analytics software to measure in-store foot traffic and demographics across retail location portfolio. In bringing people online from the factory floor, consider the use of specialty gloves that track assembly line workers’ movement to analyze productivity and monitor safety standards.

B. Efficiency or Expansion Opportunity?

Evaluate the expected underlying impact on the bottom line of your business. Typically, this would be either a cost reduction or revenue enhancement, although sometimes both. Often, you will find that those expense reductions more likely characterize the first two layers of the pyramid. If you were looking at a piece of assembly-line equipment which proactively communicates needed maintenance or support to eliminate production downtime, that would reduce costs by optimizing production efficiency—for example, if you were a fuel or propane supply company monitoring customer tanks to alert when it was time to refuel, thereby driving increased revenue velocity. Challenge yourself and your team to think through areas in which you can “build” upon the initial core functions to find new service revenue opportunities.

C. What data or insights can I unlock across my organization?

By their very nature, these projects often span departmental silos. Think through all the key decision-makers in your organization, department by department. What would HR want to know? A sales manager? Customer service representatives? Answers may vary widely and are likely to be cross-functional in nature. In the retail tech example outlined earlier in this note, we engaged the merchandising, social media, marketing, and store general managers to uncover a “wish list” of desired information and reporting capabilities. It is from here that we then moved to refine project requirements and to determine critical areas of importance in which to measure overall program success.

D. What would this data or system enable me to do over time?

Father Time is the greatest judge of all. Illiad, Mozart, or that vintage Porsche 356—all of them have survived the test of time for masterful work and revolutionary new ideas. In the case of your IoT implementation, consider what insights or opportunities this could unlock over a period of five days. What about after five months? Five years? The longer the duration considered, the more impactful the possibilities. This area is particularly where machine learning systems have the potential to generate outsized returns. Evaluate seasonality, cohorts, and product versioning, where exciting insights and value is unlocked.

E. What information does the outside world want to know?

After jogging the mind a bit, put yourself in the shoes of your customers or new customers you would like to service. Harnessed with new layers of data or potential insights, what unique value propositions can your organization deliver? If you don’t know, don’t be afraid to ask. Customers appreciate heightened attention, make calls, to speak with them and solicit their feedback. To further expand the scope, continue the exercise to include your competition, suppliers, and regulators.

Developing a Model

After a thought exercise, it’s time to put your thinking into practice. Now that you have uncovered new value propositions, new customer segments or sub-segments, you can begin building out a model for a unique service opportunity. A couple of examples:

  • Market intelligence tool offered as additional value to existing customers
  • Targeted product line, with a tailored product to a specific segment of customer needs
  • Anonymized benchmarking analysis across industry players

What products could be translated into ongoing services or support revenue? If you are unsure, you may want to work with consultants who have IoT experience. One spectacular example of this is the lending platform which Square has built on their installed base of point of sale terminals. After launching with their simple iPhone credit card reader, Square has become a fixture at small businesses and coffee shops across the country and globe. Now they are offering loans with immediate underwriting decisions made via proprietary algorithm within seconds. How are they able to do this? With historical and real-time sales data for their customers at their disposal, they can view the underlying trajectory of the business in the long term, seasonality, and benchmark versus similar companies by geography or business type. However the case, they have an incredibly valuable data set to evaluate creditworthiness and thereby underwrite an ability to pay.

Valuation Considerations

When valuing a business with diverse revenue streams or segments, a finance professional will utilize a sum of the parts analysis. For example, a business selling hardware or technology equipment likely trades at 1.0x revenue multiple. Meanwhile, a market intelligence business currently trades at a 4.0x revenue multiple. To illustrate this is a sample showing a business with 75% hardware sales and 25% information services:

EV = Line A % * Line A Multiple + Line B% * Line B Multiple
EV = .75 (1.0x) + .25(4.0x)
EV = 1.75x revenue

Looking at your own business and product services mix, the impact of data-enabled revenue streams can yield dramatic results. As shown in the sample above, a sum of the parts analysis applying a premium to services revenue has the potential to enhance shareholder value significantly.

Conclusion

Hopefully, you can see that, although much of the attention in the world of IoT is focused on connecting “things,” the excitement for future applications lies in the data and intelligence that lies behind the scenes. The modern business world and investors often penalize business models with a physical footprint or fixed asset infrastructure on valuation. The ever-dropping cost of hardware, coupled with the power of machine learning capabilities for software development, enables all owners, investors, and finance professionals to reposition their physical assets as tools for data and intelligence and benefit from IoT value creation. Toptal can support you in your digital path with IoT application design services and other experts who have previously worked in IoT projects for leading companies.

Understanding the basics

What is IoT technology?

IoT is the use of internet connectivity and data for everyday objects. There are many advantages of IoT use for firms with asset-heavy businesses that want to transform themselves into software first companies. IoT trends mean that many successful applications will be available in the near future.

What is IoT and how does it work?

Four layers can be used to evaluate the core functionality of an IoT implementation. Connecting allows for two-way communication, controlling means allowing for remote diagnostics, analyzing data allows for optimization, and building means taking current data and using it to create new applications.

What does a value chain consist of?

Moving up the IoT value chain, transformational value is realized through software applications built on top of data. IoT should be reframed as the basis for software projects, characterized by fixed costs, and (nearly) unlimited returns versus a variable cost equation typical of traditional hardware deployment.