Saturday, December 31, 2005

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").
  • 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.
The key point is that venture capital -- specifically, equity -- is not necessarily the right fit for a lot of great innovations. Venture equity financing is perhaps the single most expensive form of capital available to companies. And yet, companies with new innovations tend to look to VCs first. And then there is frustration when there isn't a fit -- financing the effort with pure venture equity doesn't provide the requisite returns, so the company finds doors closed to them, even when there is a strong underlying technology and business.

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.


Blogger Chris R. said...

You have raised some interesting points here, and I would only add that perhaps the viewpoint we need to attempt is one of "Product" Capitalism vs. "Project" Capitalism. That Cleantech (and Energy for that matter) require a different type of capitalism that what we have experienced for so long. For thirty five years or so we have seen the triumph of "Product" Capitalism based on the ever-growing power of retail consumers who have benefited from:
(1) Moore's Law and the concommitant tech explosion
(2) globalization of labor=less expensive goods
(3) cheap money
(4) low inflation
(5) an installed energy, transportation, and water-sewer infrastructure that was built in the previous 100 years.
(6) women entering the workforce
(7) home value appreciation

The explosion of financial intermediaries such as VC, Private Equity, etc. have all benefitted from the growth of Product Capitalism. But the new century we are in may be seeing the re-emergence of Project Capitalism. China's energy grab, Russia's nationalization of its energy industry, the Kyoto Agreement and a host of other examples point to a world where price/cost is not the only arbiter.

Perhaps the energy and environmental issues we face require the skills of a political economy (in Adam Smith's sense of the word) that is focused on "Project" Capitalism. Your quite right that VC is wrong for Cleantech etl al, and is why most VC has been in "service" companies that work with the energy and/or environmental sector--not blockbuster project companies that can re-make the playing field.

GE has the right idea when it teamed with Chevron for IGCC--one-stop shop turnkey capability.

But what mitigates against emergence of a strong "Project" Capitalism are several factors:

(1) NIMBYism--the triumph of the consumer has gone hand in hand with the ability of small groups to defeat major projects that are desperately needed. I am dubious that we will solve our energy crisis in an orderly and elegant manner after I lived through the destruction of the waste-to-energy business 15 years ago. A multi-billion dollar industry was stopped dead by activist groups who killed hundreds of projects and cost goverment and corporations billions of dollars all on the basis of dubious science. The recent defeat of ANWR and strong opposition to windfarms off the coast of MA give credence to the idea that large projects just cannot get through the regulatory/permitting morass.

(2) Project Capitalism requires a long time horizon--a completely different mentality from the JIT mindset that works so well for product companies and which currently dominates the global business scene.

(3) Project Capitalism abhors and cannot live with "spot" pricing, which is at the basis of so much of the free market rhetoric that is common today in both government and business. Take LNG projects for example, they need long-term commitments on both the supply and the buy side to get over their huge capex hurdle, so very little is left for spot pricing. This will hurt the US, because we think that if we build LNG receiving terminals (a huge battle in itself that is facing huge opposition) we have the illusion "...if we build it, they will come." But they won't come if the LNG has been contracted for under 20 year put-or-pay agreements to Japan, Spain, etc. The contracted price is higher than the market price, but the supply is guaranteed. The US has lost that mindset.

(4) The "financialization" of the energy markets (futures, hedge funds, etc.) and the coming financialization of the environmental markets forces a short-term perspective at the very moment a long view is necessary. Hedge funds are stuffed with "hot' money and the traders live day-to-day that the investors will pull--not an envionrment conducive to Project Capitalism.

In the end, it may be that the national energy companies of China, Russia, etc. will do far better than their US counterparts in undergoing the trasformation to the new model of Project Capitalism.

5:37 PM  

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