It's been a while since I've last had the chance to do so, but I always look to try to draw out lessons learned from successes and failures that I've witnessed firsthand in this sector over now something like 12 years of being a cleantech investor. In particular, over the past year or so I've gained a lot more of these lessons, for better or for worse. (Last week we covered exits.)
The limitations of the venture model
We have a reflexive tendency to believe that venture capital is a key ingredient for many world-changing solutions. After all, that's been the case so many times in the past! But it's easy to forget that for most successful startups, getting venture-capital backing wasn't actually necessary. And in fact, for many cleantech business models, we're finding that it's simply not a good fit.
Just a decade ago, there was a strong sense that venture capital was the primary source of solutions-capital for the cleantech world. Across the cleantech subsectors, venture capital was being applied to all segments of the value chains, from deep upstream innovations through manufacturing to distribution and service models. And of course, given the relative capital intensity of all of these, manufacturing and production came to dominate the dollar counts and thus to define the sectoral investment strategy. This was, in retrospect, an error.
There are several reasons why venture capital cannot be applied universally to the innovation needs of these markets.
First of all, these innovations tend, one way or another, to be related to physical assets. And "steel in the ground" isn't a good fit for venture capital investments in general. Looking broadly across the economy, physical asset investing tends to see somewhat limited upper-bound returns, from single-digit IRRs to the low twenties. This can still be very attractive, by the way, if the risks of the deployed assets and their economics are low. But nevertheless, it compares poorly to the returns expectations of venture capital. In short, the "Cleantech VC 1.0" story was basically one of taking in very expensive capital and then using it to deploy assets providing much lower expected returns. Spending money to make less money.
This isn't as dumb as it sounds. Many startups face a major chicken-and-egg problem where they need to access available less-expensive asset deployment capital, but they can't do so until they've made some initial progress. Venture capital, while more expensive than would be ideal, can at least be available before the less-expensive capital is. And by eventually "graduating" to that less-expensive capital, the broader startup platform can become more valuable. So even if the use of venture capital to fund "steel in the ground" doesn't make sense, in the bigger picture, it can serve as an investment that unlocks a lot of additional value, at least in limited applications. This was the theory of Cleantech VC 1.0. Unfortunately, in many cases, those investments didn't work out, but it's not an inherently dumb idea.
A second problem is the simplistic math of venture capital valuations, matched with the preferred equity status of such investments. Basically, startups rarely give away more than half of the company to a venture capital round. So at a basic level, if a startup raises $10 million in Series A venture capital, they probably are "post-money" valued above $20 million. Not always, but usually. Then they raise another $10 million in a Series B, say, and give away 25 percent of the company to do so. Hey, now it's a $40-million-valued company -- great! OK, then later down the road after making good revenue progress, they raise $20 million of Series C and give away 20 percent of the company to do so. Now they're valued at $100 million. This is not an atypical raise/valuation story for companies that are doing pretty well.
This is the valuation math, and for the success-minded startup CEO, that's not so bad. If the company is eventually sold for $200 million, the CEO and the other founders still make $60 million just based upon their initial ownership (not counting possible option pool refreshes along the way). Not too shabby.
But the returns in a venture capital stack aren't always determined by the ownership level. Especially when liquidation preferences get involved. Let's say that each of those early venture rounds had a 1x preference and the Series C had a 2x -- again, not atypical. And what happens if this startup successfully grew to $25 million in revenues and gets an acquisition offer for 2x revenues from an industrial equipment OEM, which is pretty standard for such old-school acquirers. Well, unfortunately, that $50 million in value at exit gets completely eaten up by the Series C and Series B preferences. Series A and Common see none of it.
This is admittedly an overly simplified example; my apologies to my colleagues out there who are probably shaking their heads at the details. But hopefully, it gets the point across. If you are that startup CEO, having successfully grown a company from $0 to $25 million in revenues in four years, seeing valuations go up along the way, given such "standard" exit opportunities, are you going to take any of them? Heck no, not if you won't see anything yourself out of all that effort. Keep growing. Keep growing. At all costs, keep growing.
No, the venture capital math only works if you either sell for a very large amount of money ($200 million valuation for a $25 million revenue company, say), or you didn't raise many VC dollars to get to that exit point (the math in the example above looks very different if only $10 million in venture dollars were raised to get to that point, after all). But as noted, the problem in many of these businesses is that you need to access significant capital to deploy the assets in order to unlock the inflection points of value.
The answer, I increasingly believe, is to avoid leaning upon venture capital for much of the asset deployment financing at all. We need asset investment categories and VCs to work collaboratively with each other, including more early asset deployment capital alongside venture capital.
I had one entrepreneur come to me seeking a $30 million Series B round. He had only a couple of working units out in the market at that point. I pushed back on him (politely, of course). "Why are you raising so much venture capital at this point? You're not worth $60 million or more, right?" He explained patiently to me that he really only needed $10 million of venture capital, but that his customers didn't have much capital budget, so he also needed $20 million to be able to finance deployments at customer sites off of his own balance sheet. "Why don't you just raise a $10 million Series B and a $20 million side deployment fund," I asked him. "I would love to!" he replied, "But no one will do that for me!"
Well, that was a couple of years ago, and now such investors are starting to appear. This gives me a lot of hope for the next wave of cleantech investing, and in fact, it's become a focus for my firm as well. Venture capital, while crucial, shouldn't be the dominant story in the cleantech sector, in my opinion. The deployment of cash-generating assets should be financed by smart investors willing to take lower returns on such lower-risk investments, alongside and in alignment with correspondingly smaller amounts of venture capital. And as a result, the startup's capitalization tables will look a lot more reasonable to acquirers. Entrepreneurs will face less dilution and smaller preference stacks, and investors will get better returns as well. If the deployment capital is available and separate from VC capital, the VC math starts to make a lot more sense.
The basic challenge here is that VCs can't easily put capital into deployment capital pools, structurally. And the traditional project finance firms can't go so downscale in the manner we're talking about here, at least in the early stages. But those structural obstacles suggest that there's a big opportunity for investors with the flexibility to play both of these roles.