Year end thoughts: Why good technologies don't get funded
As with the previous year-end thoughts column, this post will depart from the usual relayed news updates to provide one man's conjecture, and thus should be read with a lot of caveats attached...
One common complaint from entrepreneurs is that their compelling technology isn't getting the attention it deserves from the venture community. They have an advantaged technology, a strong management team, and huge market potential -- so why is it proving difficult to raise VC funding?
Amidst all of the increasing capital flowing into cleantech, and talk of finding the "next Google," it's easy to forget that there are some significant differences between many clean technologies and traditional VC-backed tech areas. Some of the differences are gaps that are quickly narrowing, if not already bridged: Strong entrepreneurial leadership, significant M&A activity, etc. Cleantech already has developed, or is rapidly developing, these and other key success factors.
One feature that is unlikely to change, however, is the industrial-equipment and project-based nature of many clean technologies. In contrast to technologies such as software, Internet services, biotech, etc., many clean technologies are material-intensive mechanical devices (or their components). Successfully introducing such devices requires significant inventories, right-sized manufacturing capacity, and appropriate sales models. Even in comparison to other similarly manufacturing-intensive VC-backed tech areas such as hardware, telecom equipment, medical devices and semiconductors, the heavy industrial nature of clean technologies such as water treatment equipment, electricity generation and transmission equipment, etc... is distinctive.
Furthermore, unlike those other manufacturing-focused traditionally-VC-backed industries, in many cleantech markets the major buyers of the technologies haven't yet demonstrated rapid adoption when presented with an innovation that is "evolutionary, not revolutionary." So that investors can't be assured of very fast penetration of a winning new technology throughout the target market, even if eventual market adoption appears likely.
This is, of course, an over-generalization. There are plenty of clean technologies that are not capital intensive, there are plenty of rapidly-adopting customers of clean technologies, and certainly there are innovations in cleantech that all would agree are revolutionary, not evolutionary. But as a generalization, these two factors (capital equipment, and less rapid adoption) help explain a few key unique challenges for both cleantech startups and cleantech investors.
There is a lot of venture-backable dealflow in cleantech, and it appears to be increasing over time, just witness the statistics that show the capital is flowing in. However, what I want to address is why I have also seen compelling clean technologies that have had trouble attracting venture capital investments.
First of all, venture capital and capital equipment manufacturing, regardless of industry, are often a difficult fit. Venture equity is very expensive. Thus, VCs need "scalable" investments -- ie, if a VC is looking to achieve targeted returns from their investment, they need to see a company that is poised for stratospheric growth. For software, once the code is written, every incremental sale comes at a low marginal cost. So the scalability is limited only by the company's ability to sell and implement product. Additionally, recurring revenue is a standard part of the industry's business model, through annual fees. So the very expensive VC capital can go primarily into R&D and sales and marketing, and (if the company and their product are successful) drive strong growth. Even for a hardware company, if the industry is one where rapid adoption of new innovations is commonplace, then the anticipated growth may warrant using venture capital for other purposes as well.
Contrast this with a company that has developed a new water filtration technology and is looking for capital to sell equipment to slower-adopting end users. Assume it is a clearly advantaged new technology, targeting a very large market, with good exit potential, strong management team, etc., so management feels they present a strong investment opportunity. They are planning on deploying some of the capital toward the classically "scalable" sales and marketing and R&D efforts. But some will go to parts and other inventories so as to be in a position to supply increasing demand for the equipment. And if the company is looking to develop a recurring revenue stream from their equipment, by for example leasing the equipment to customers instead of a one-time sale, then they'll need even more working capital to build up and carry a fleet of assets as well.
In a few cases the growth potential will be strong enough to warrant venture equity financing of all of the above. But for many cleantech innovations, even if they are compelling technologies with strong value propositions, VC may not be the right fit for 100% of financing needs. Thus, it's important to remember that there are other forms of capital potentially available as well (emphasis on "potentially").
My personal thought is that there is a need for more technology lending in cleantech. In the above example of the water filtration company, a combination of venture debt financing (convertible, and secured via assets and inventories) and venture equity financing may be a good fit, if the technology has been proven. There are a few emerging such lenders, including GE Technology Lending and Blue Hill Partners among several others. Some VCs are even starting to look at doing convertible debt financings themselves. But from my perspective, it still appears to be a bit of a gap.
The venture debt and equity bundle is not a perfect solution, and there is no one-size-fits-all. Many VCs wouldn't want to invest in any transaction involving debt, which would subordinate their own investment. The specifics of the technology and company may not lend themselves to venture debt. And in almost all cases, such a transaction would require a company which had already largely proven out its technology, it is not a "beta stage" vehicle.
So take this for what it's worth. But in an era when the pundits are lamenting the available opportunities for private equity investing, and when clean technologies are in the ascendency but remain unique in certain respects, it is not surprising and very welcome to see the emergence of clean technology lenders to work with clean technology equity funders. The more types of funding available to cleantech startups, the more likely there will be the right fit for each financing need.
One common complaint from entrepreneurs is that their compelling technology isn't getting the attention it deserves from the venture community. They have an advantaged technology, a strong management team, and huge market potential -- so why is it proving difficult to raise VC funding?
Amidst all of the increasing capital flowing into cleantech, and talk of finding the "next Google," it's easy to forget that there are some significant differences between many clean technologies and traditional VC-backed tech areas. Some of the differences are gaps that are quickly narrowing, if not already bridged: Strong entrepreneurial leadership, significant M&A activity, etc. Cleantech already has developed, or is rapidly developing, these and other key success factors.
One feature that is unlikely to change, however, is the industrial-equipment and project-based nature of many clean technologies. In contrast to technologies such as software, Internet services, biotech, etc., many clean technologies are material-intensive mechanical devices (or their components). Successfully introducing such devices requires significant inventories, right-sized manufacturing capacity, and appropriate sales models. Even in comparison to other similarly manufacturing-intensive VC-backed tech areas such as hardware, telecom equipment, medical devices and semiconductors, the heavy industrial nature of clean technologies such as water treatment equipment, electricity generation and transmission equipment, etc... is distinctive.
Furthermore, unlike those other manufacturing-focused traditionally-VC-backed industries, in many cleantech markets the major buyers of the technologies haven't yet demonstrated rapid adoption when presented with an innovation that is "evolutionary, not revolutionary." So that investors can't be assured of very fast penetration of a winning new technology throughout the target market, even if eventual market adoption appears likely.
This is, of course, an over-generalization. There are plenty of clean technologies that are not capital intensive, there are plenty of rapidly-adopting customers of clean technologies, and certainly there are innovations in cleantech that all would agree are revolutionary, not evolutionary. But as a generalization, these two factors (capital equipment, and less rapid adoption) help explain a few key unique challenges for both cleantech startups and cleantech investors.
There is a lot of venture-backable dealflow in cleantech, and it appears to be increasing over time, just witness the statistics that show the capital is flowing in. However, what I want to address is why I have also seen compelling clean technologies that have had trouble attracting venture capital investments.
First of all, venture capital and capital equipment manufacturing, regardless of industry, are often a difficult fit. Venture equity is very expensive. Thus, VCs need "scalable" investments -- ie, if a VC is looking to achieve targeted returns from their investment, they need to see a company that is poised for stratospheric growth. For software, once the code is written, every incremental sale comes at a low marginal cost. So the scalability is limited only by the company's ability to sell and implement product. Additionally, recurring revenue is a standard part of the industry's business model, through annual fees. So the very expensive VC capital can go primarily into R&D and sales and marketing, and (if the company and their product are successful) drive strong growth. Even for a hardware company, if the industry is one where rapid adoption of new innovations is commonplace, then the anticipated growth may warrant using venture capital for other purposes as well.
Contrast this with a company that has developed a new water filtration technology and is looking for capital to sell equipment to slower-adopting end users. Assume it is a clearly advantaged new technology, targeting a very large market, with good exit potential, strong management team, etc., so management feels they present a strong investment opportunity. They are planning on deploying some of the capital toward the classically "scalable" sales and marketing and R&D efforts. But some will go to parts and other inventories so as to be in a position to supply increasing demand for the equipment. And if the company is looking to develop a recurring revenue stream from their equipment, by for example leasing the equipment to customers instead of a one-time sale, then they'll need even more working capital to build up and carry a fleet of assets as well.
In a few cases the growth potential will be strong enough to warrant venture equity financing of all of the above. But for many cleantech innovations, even if they are compelling technologies with strong value propositions, VC may not be the right fit for 100% of financing needs. Thus, it's important to remember that there are other forms of capital potentially available as well (emphasis on "potentially").
- Depending upon the stage of the company and technology, angel and/or strategic partner funding may be attractive.
- Venture debt (sometimes called "technology lending") may be available.
- For proven technologies going into large projects, project financing can be tapped.
- Customers may be willing in some cases to supply financing or pay up-front fees.
- Also, and increasingly used, it may be possible to do a go-public move through a reverse merger with a shell company that is already listed (or through a similar process). Feelings are mixed about this approach, which is a topic to be addressed in another post.
- There are other forms of financing that can be tapped as well.
My personal thought is that there is a need for more technology lending in cleantech. In the above example of the water filtration company, a combination of venture debt financing (convertible, and secured via assets and inventories) and venture equity financing may be a good fit, if the technology has been proven. There are a few emerging such lenders, including GE Technology Lending and Blue Hill Partners among several others. Some VCs are even starting to look at doing convertible debt financings themselves. But from my perspective, it still appears to be a bit of a gap.
The venture debt and equity bundle is not a perfect solution, and there is no one-size-fits-all. Many VCs wouldn't want to invest in any transaction involving debt, which would subordinate their own investment. The specifics of the technology and company may not lend themselves to venture debt. And in almost all cases, such a transaction would require a company which had already largely proven out its technology, it is not a "beta stage" vehicle.
So take this for what it's worth. But in an era when the pundits are lamenting the available opportunities for private equity investing, and when clean technologies are in the ascendency but remain unique in certain respects, it is not surprising and very welcome to see the emergence of clean technology lenders to work with clean technology equity funders. The more types of funding available to cleantech startups, the more likely there will be the right fit for each financing need.
posted by Rob Day at 9:55 AM
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