Friday, April 01, 2005

Recurring revenue and cleantech: Pros and cons

Recurring revenue is a recurring theme in cleantech investing.

For a couple of reasons, cleantech entrepreneurs and investors often look for firms to develop business plans that bring in annual revenue from services instead of one-time sales.
  • First of all, it creates more stable cashflows for the firm, which makes it easier for management and easier for investors to underwrite.
  • Secondly, it often means that the end users of the technology/ product are signing up for easier-to-swallow annual expenses instead of large one-time capital expenditures; this is especially important when selling to certain types of customers (facilities managers, for example, often have a tough time getting approval for large capex budgets), or in selling long lifetime equipment (e.g., solar power systems with a 20-year lifetime). By amortizing costs and margins over the expected lifetime of the equipment and charging an associated annual cost (using the solar example from above, selling the power over a long-term guaranteed contract), the manufacturer doesn't scare customers away from expensive solutions (as are often found in clean technologies...).
  • Finally, it also puts a lot of the risk in the hands of the manufacturer of often unproven equipment -- if the equipment fails, they are still required to provide the service one way or another, instead of a customer being stuck with a very large, useless piece of equipment.
Makes sense, right? Thus you see companies like SunEdison doing quite well in selling solar services along the lines of the example described above by using innovative financial solutions, and a number of distributed generation companies (e.g., RealEnergy) have set themselves up as "onsite utilties" offering combined heat and power (CHP). There are plenty of examples outside of energy as well -- water technologies offered as services, monitoring technologies offered as outsourced options, etc.

But there are some real drawbacks to this approach. RealEnergy, for example, has had some major difficulties as explained in this Distributed Energy article. In general, the pursuit of recurring revenue can hurt companies in the following ways:
  • If, as noted above, the customers aren't incurring the technology risks... the startup is. And the startup is probably not very positioned to deal with any problems that arise, due to limited financial resources.
  • Such a strategy often forces the startup to guess how the customers will end up using the technology. Guessing wrong, even a little bit, can kill a great technological solution. For example, RealEnergy guessed that large office buildings would pay for the backup power presented by their offerings. Instead, where CHP services are gaining ground, it appears to be in other settings where power usage is close to 24/7, and where hot water is used in higher volumes (e.g., hospitals, colleges) than in offices. It can be a lot easier simply to put the technology out there, and allow people to use it as they see fit.
  • In order to pay for the equipment they are placing at the customer sites, the startup will need additional capital. In some cases, they seek project financing or debt -- but that can be very tough for a startup to arrange. Often, startups are asking VCs for the money -- but as mentioned in earlier posts, VCs often don't like the idea of using their expensive capital to purchase long-life, hard assets. Even if the company is able to arrange the financing somehow, they've got to pay for it over time. So this creates a huge financial risk for the company.
  • Setting up a service organization is very different from setting up a manufacturing organization. So this sets up an additional set of challenges for the startup to tackle, at a time when they should be trying to stay very focused.
So what is the answer? In reality the answer is that there is no one-size-fits-all solution. Some startups will successfully build recurring revenues and be very successful. Others will be very successful simply selling product and growing from there. Entrepreneurs who are experienced in their industries will often know what works best in their market.

Successful VCs also keep this in mind, providing guidance on this issue based on their experiences, flexibility on a case-by-case basis, and strong contacts in the project financing world when needed.


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