The Smart City Ecosystem Is on Life Support

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For decades, governmental technocrats had envisioned a future where the smart city would usher in a new era of efficiency of city management and improve the overall happiness of the citizenry. Imagine the beauty of the vision: autonomous buses and cars shuttling city dwellers to their destinations with utmost punctuality; street lanes reconfigured through the state-of-the-art techniques for traffic analysis to optimize the flow of cars; city funding reallocated to the services that would have the highest positive impact on citizens. In the name of the Internet of Things, everything would be connected. Smart cities would take data — from sensors on trash cans, streetlights, and even city-sponsored mobile apps — to not just understand but solve the precise pains of citizens. The possibilities for city improvement would be endless.

At $625B worldwide in 2019, the smart city market was gargantuan and expected to grow to $1,712B by 2025. Investments were pouring into a growing ecosystem of startups that included everything from smart technologies like connected parking meters to IoT platforms for helping cities better manage interactions between citizens and infrastructure. The future for the smart city was looking rather rosy. The major metropolises — from Los Angeles to New York City — were competing to take the medal in innovation, and the number of smart-city-focused venture capital funds and accelerator programs grew in number.

But as smart city investing flourished over the years, I watched with skepticism. I never understood the bullishness of the trend. Excepting certain cosmopolitan hubs in Asia, smart city bullishness — particularly in the United States — made little sense. The reasons for my skepticism had to do with the particular hurdles smart city startups faced in trying to sell into sluggish, often irrational governmental bureaucracies. From my analysis of the market back in late 2019, I identified these hurdles as follows:

  • A Small Number of Potential Customers and the Small Market: There are 775 cities in the United States with population sizes above 50,000 and of which would be potential purchasers of smart city solutions. If we only look at metropolises in the United States, the number of potential purchasers of such solutions drops to 392 possible customers. No matter how you look at it, there’s simply not enough customers to grow a huge business for most startups, unless you can sell millions of dollars of product to a city, a highly unlikely prospect for most such startups. The market for most smart city products is just too small.
  • Long Sales Cycle: Whereas the typical enterprise sales cycle is 6 months, selling into municipalities can take 1–2 years. Each city, moreover, has special rules for procurement, and, in the worst case scenario, whatever elected governing body ruling the municipality may actually have to vote on whether to approve a new expenditure, lengthening the sales process. In short, because of the long sales cycle, smart city revenue growth does not follow the type of growth curve of enterprise sales that venture capitalists like to see.
  • Tight Purse Strings: Cities have tight budgets and their elected officials have every incentive to continue investing in the status quo and not invest in new innovative technologies. How much money can a startup expect to wrangle from a city? Not more than a few hundred thousand dollars a year at best, and when there’s few cities as potential customers, this compounds the problem of the small market size.
  • Business Model Limitations: For software startups, one of the biggest boons to their growth trajectories in recent years was the advent of recurring revenue streams, enabled by the rise of the cloud. Cities, however, hate this business model and tend to push for one-time fees during negotiations over the higher sought-after recurring revenue schemes, limiting the upside potential for incoming revenue.

For me to get comfortable with any smart city investment, I told myself back in 2019 that the above hurdles would have to be resolved. Accordingly, despite the wariness, I saw potential. The economy was booming, unemployment was low, and more and more cities were getting onto the smarty city bandwagon.

But then the coronavirus pandemic hit.

The magnitude of the loss has been historic — not just in death toll but in the repercussions across the economy. Skyrocketing unemployment. Corporations teetering into bankruptcy. Record permanent closures for small businesses. State and city budgets — the lifeblood of smart city startups — are now facing shortfalls of historic proportions due to the decline in tax revenues and mounting costs to combat the pandemic. It’s become so bad that even Congress, anticipating an estimated $650B shortfall in state budgets by next year, has begun debating whether states should be allowed to declare bankruptcy. Cities, the local microcosms of state government, are in severe disarray. Seattle’s budget shortfall is expected to hit $400M this year. San Francisco faces a $1.7B budget deficit over the next two years.

Source: National League of Cities analysis of US Census Bureau data

The coronavirus-induced devastation means that the vision of the smart city is on life support. Smart city startups will be hit hard. Many will not survive, as the hurdles that I’ve identified up above will be compounded in this new normal. Even if such startups can weather the storm until the pandemic ends, the recovery of state and city budgets will take years longer. Strapped for cash, cities will prioritize (and understandably so) budget allocations to core services like healthcare, education, homelessness, and employment. Meanwhile, smart city innovation will take many, many steps backwards.

How about when things return to normal though? Won’t they recover? I don’t see it happening anytime soon. At least in the United States, smart city startups are facing what I would consider some insurmountable headwinds. First, unless any significant congressional stimulus plan occurs to reinvigorate state and city budgets, it will take many years for cities to recuperate their losses from the coronavirus pandemic. When their budgets do stabilize, innovation — the luxury of budget surplus — will be last on local leaders’ minds. Second, a glorious economic recovery from the pandemic does nothing to change the fundamental obstacle facing smart city startups — that selling into municipalities is at its core a slow, unpredictable process that is antithetical to the fast-growth mantra of startup land. The hurdles facing smart city startups I listed above will not go away in a world where the power over purchase decisions rests in bureaucratic local governments that are not rational actors and, unlike corporations, can survive the next couple millennia without significant innovation.

What we can expect in the near future is not just an insignificant number of startup casualties in the smart city space but the emergence of a growing cohort of zombie companies — those that exist merely in a sort of in-between state of not completely dying into obsoletion but not growing enough to ever hit an exit, the desired pinnacle of startup life. Unlike their comrades in other sectors hit hard by the coronavirus pandemic, smart city startups will not benefit from any miraculous bounce back from reopening. It’s an unfortunate fate for an ecosystem built with the vision of improving civic life, but hey guys, it’s 2020…

Principal at BMW i Ventures. VC trends. AI themes. Social commentaries. A personal blog bridging tech, business, and human issues by a curious mind.

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