I've been thinking a bit about water lately.  So much media attention and investor and entrepreneurial interest are expended on looming energy shortages, but water shortages are perhaps even more acute.  A recent article in Fortune gave a good brief overview of water from a global standpoint.  If you're looking for water statistics and updates, the website of XPV Capital (a water tech specialist) has some good info.

There are clear looming issues with water use in the U.S.  And there are lots of uncoordinated actions going on in various parts of the country, and some hand-waving in general, but I haven't seen anyone really start to play out what's going to happen.

But it's clear to me that water is going to get more expensive over time.  It likely won't be because of any proactive water price increases by the governing bodies.  Indeed, local governing bodies appear to be just as allergic as ever to doing any kind of forward strategic planning around water.  And historically, in the U.S. people view water (for drinking, agriculture, or industrial purposes) as some kind of god-given right that shouldn't really need to be paid for.  So I think water pricing will only be affected by local and regional shortages and crises, not by any overarching strategic approach.

But such local and regional shortages and crises are happening.  In parts of the American southeast and southwest water shortages are already acute.  Here where I am this week in Texas, The Aransas Project has sued the governing state bodies for failing to manage water properly and thus endangering the whooping crane.  Take a step back and think about this one -- this is a group of Texans from all political persuasions, filing a lawsuit under the Endangered Species Act.  Water issues break across political lines, in other words, but they're also very local.  It's a really good illustration of what's likely to start happening lots of other places around the country where water withdrawals are starting to exceed water supplies.  (And an effort I've supported, btw)

And what will happen in the Southwest when the upstream states on the Colorado River start demanding access to their existing water rights?  In fact, California, Arizona, Nevada, etc. are all only able to access the water they need, thanks to upstream states like Wyoming and Colorado not fully using their own rights.  But that can't happen for long.  And even if it could, the water usage is already at unsustainable levels as it is.  We've built out some pretty major population centers in the Southwest that are dependent upon unsustainable levels of water demand. 

So I don't expect to see any forward-looking strategic policy shift at the national level that would result in any significant shift in the pricing of water.  But I do expect local water shortages (and the resulting legal, economic, etc. challenges) to rise up over the next couple of decades, and thus de facto raise the cost of water where they occur.

What does this all mean?

1. Water will be a sub-regional issue.  Which means that future water price rises will happen in isolated fashion, on a watershed basis in many cases, but certainly by region.  It will be a lot cheaper to access water in some places (like New England, for instance) than in other places (like the Southwest, for instance).

2. As such price disparities arise, it will start to affect the location of manufacturing operations.  Water-intensive manufacturers will have to trade off locating close to cheap water and energy supplies (mostly: far away from cities) with transportation costs to deliver to demand (generally: cities).  Easily transportable end products that are water-intensive, like pharmaceuticals, will relocate where water remains cheap.  

3. As water gets to be more of a strategic issue, corporations will lead the way in terms of adoption of new water treatment technology and water "microgrids" with significant re-use of water.  It'll be easier for corporations to adopt to the "new normal" in such situations than the local politically-driven processes affecting municipal drinking water, etc.  So selling new water tech to corporations will continue to be a key entry point for innovations.

4. Water efficiency will be increasingly important for agricultural use.  Water efficiency will be increasingly important for energy generation.  Both are very large consumers of water, but startups that can address either or both issues in a scalable and low-cost way will see entry points.

5. During the NEXT economic downturn, water infrastructure may be given the same government subsidies as energy infrastructure saw during this economic downturn.  Ditch-digging and pipe repair are good jobs creators, they just didn't get the necessary attention this time, but when people in swing states start being told they can't water their lawns because of infrastructure issues...

6. Local water districts will be pressured to encourage more intelligence at the end of the pipe -- the water analogy of demand response in energy.  So far the local government response has been necessarily binary: When there's a shortage, no one gets to water their lawn, etc.  But faced with more such instances, I expect we'll see more startups start focusing on "smart use" of water, and then they'll start pressuring local cities to grant exceptions for consumers who implement such solutions.

These are just some shallow thoughts around water, but it's interesting to think about how water shortages will specifically play out.  And that will affect entrepreneurs and investors in the water space as well.

Happy tax day, everyone. 

Silicon Valley Bank put out a must-read study yesterday, examining returns from more than 850 VC funds in the U.S., looking specifically at returns by fund size.  And what they found out was that smaller funds do better than larger (>$250M) funds.

This won't be a surprise to some limited partners out there that I speak with, in my current dual role as both an LP and direct investor.  These LPs see smaller funds as being more focused and hungry.  As the SVB report states:

"Managers of [small] funds often have industry-specific expertise and focus on particular strategies or sectors compared to those of larger funds which usually target multiple stages and sectors.  Small funds tend to have a strong general partner commitment, which heightens the alignment of interests with limited partners and potentially increases investment discipline."

Smaller funds also are less susceptible to the kind of minimum check size restriction I described in my last post, with its implications for capital efficient investments.  I caught a little bit of grief from some colleagues at smaller funds after that post, because they thought I was talking about ALL venture capital firms getting caught up in check size inflation, but really I was only talking about the larger funds and their need to shovel dollars out the door.  Indeed, this SVB report adds further support to what I was talking about -- with smaller VC funds, you can put less dollars at work in a single investment and still get the kind of outsized return that can "make the fund".

So if smaller funds are so great, why don't they get more favored by LPs?

First of all, their performance is probably more volatile.  The SVB report focuses on the portion of funds that returned high multiples.  They state that smaller funds (those under $250M) were seven times more likely to provide a 3x return or better to LPs, than larger funds.  But that's 22% vs. 3% of each population, respectively, so the comparison leaves out a lot of lesser performances.  In their study, more than a third of smaller funds returned less than 1x, meaning they lost money for LPs.  Of course, in the pool of larger funds, more than HALF lost money!  But it's unclear from their report how many of each category lost a LOT of money versus losing a little bit.  LPs may be more willing to back a larger fund that has a more limited downside, than a smaller fund that could end up with more volatile results.

And what's also true is that smaller funds tend to have less experienced managers.  Most first-time funds will be under $250M, naturally.  And LPs are often leery of first-time managers.  I've spoken with some accomplished LPs who take an opposite approach, but generally speaking LPs have a difficult time determining the caliber of a first-time fund's managers, lacking a track record to refer to.  This obviously is related to the volatility/ downside point from above as well.

And furthermore, someone did the limited partner community a great disservice at one point by doing a study showing that top quartile performers among venture managers tend to stay top quartile performers over multiple funds.  I'm sure the study was totally valid and accurate, albeit backward-looking.  But what that study did was provide all the air cover any LP manager ever needed to simply pile capital into any big-name venture firm's latest huge fund.  It'll be interesting to me when that study is eventually revisited, to see if the effect remained valid over time, because I believe it provided fundraising momentum to larger funds that encouraged them to get unsustainably big and drift in their investment strategy, in some cases.  In the fund size retrenchment SVB identifies, I believe we're seeing the results of this.  But that having been said, there are certainly some large funds that have figured out how to make money at that scale -- as the SVB report shows, less than 10% of large venture funds returned 2x or better, but in that small group I bet there's some repeat performances by the same very few fund managers.

Finally, many LPs are of such a size that they really can't engage with small fund managers.  If you are managing a multibillion dollar pension fund with hundreds of millions of dollars allocated to private equity, can you really afford the time to identify, evaluate, and manage a $5M or $10M commitment to a small, specialist venture fund?  Some can, but many don't have the bandwidth to do so.  It's the LP analogy to the venture fund size dilemma I mentioned in the last post...

So smaller funds are, according to this SVB study, a better bet for LPs.  But LPs still find it hard to effectively engage with smaller funds, as a rule.

What does all of the above mean in cleantech in particular? 

It helps explain why cleantech-interested LPs have been drawn to larger cleantech funds, and large generalist funds who are getting active in cleantech.  This has exacerbated the shift over time toward more growth stage cleantech investing, and away from early stage cleantech investing (although there are some signs this shift has mitigated recently). 

The study suggests, however, that investing in smaller cleantech specialist funds may be a winning strategy for LPs -- if they have a rigorous way to effectively identify, evaluate, select and oversee those venture managers.  We'll have to wait and see if LPs actually do this more often.  But I believe they should.

And kudos to the team at SVB that did this study.

"My job is to look for entrepreneurs who want to change the world," one young cleantech VC told me in an engaging twitter conversation last night, "and build bigger companies."

Very true words!  But how do we define "bigger companies"?

I've seen someone mention that only two percent of startups get their financing from venture capital.  I don't know the accuracy of that number, but it does ring directionally true.  That doesn't mean 98% of startups are bad businesses, however.

Let me describe two basic types of startups:

1. The big game-changing startup that is going to be manufacturing or otherwise producing something very new.  They're going to need some significant level of capital in order to accomplish this, because R&D and commercialization efforts and then production capacity don't come cheap, but they do come before revenues. 

2. The small local startup that is going to be a nice personal business, perhaps growing over time into something a bit bigger.  These tend more to be service or retail companies going after an established market, perhaps with a new twist.  These can be really compelling businesses for the entrepreneur, and if pursued in a lean way they won't require millions of dollars to get started.

The first type of company is the purview of VCs like the one I cited above.  The latter type of startup is the one that is classically self-funded by the entrepreneur (and their credit cards), as well as friends and family, and perhaps a community bank.

But what about the companies in the middle?

Let's better define the upper end of the problem...  What many entrepreneurs often don't realize is that large VC firms typically have a pretty significant minimum check size they'll write -- quite often the bar is set at $2M or $5M, depending upon the firm.  Even funds that will do smaller seed stage checks need to see enough capital intensity in the model that they'll have the opportunity to put significant money into the company over time.

Why?

Simple math.  The larger the venture firm, the more pressure to put significant dollars at work.  And the single most limited resource for that company is the time of the partners in the firm.  Each company in the portfolio requires time to manage, whether they hold a Board seat or not.  And there are often companies in the portfolio from previous funds that haven't exited as well.  They can't have a 100 company portfolio and claim to be "value add" with a straight face.  So these larger funds are pressured to invest only when they see the opportunity to put significant dollars in either up front, or over time.

In other words, IRRs are not enough.  If you have a $400M fund, and you put only $1M into a company, even if that returns 10x it's nice but not going to move the needle in terms of aggregate fund returns (not to mention the chances for glory for the GP who did the deal, btw, which is no small consideration for some).

You can't just add more partners because GP salaries and support staff have to be paid out of the management fees, typically 2%.  So this is why most large VCs I speak with -- even early stage and seed stage ones -- tell me they need to see the potential to put something like $10M into a company over time, at a minimum.  

That's a long way of explaining why VCs need to see some level of capital intensity in a startup before they can get involved.  And yet, if a company is going to need $1-3M of capital over time, that's probably too much for credit cards and friends and family to support. 

Where does this all hit in cleantech?  In Web2.0, people are already used to capital efficient businesses, so they've had to invent efforts like Y Combinator to compliment the bigger check-writers in the space who won't touch certain sized deals.  But in cleantech the gap remains.  If you are trying to develop something like a new solar cell, or a smart-grid network, or a new LED chip or fixture, that will require some significant capital before you get to cashflow breakeven.  But what if you're just developing something purely software-based?  Or a scalable service model?  If managed well, often these won't require such large amounts of capital.  And yet they can grow to be decently-sized businesses, even if they probably won't be the "Google of cleantech".

For outside observers tracking cleantech VC dollars, to a certain extent the reason they tend to declare that ALL of cleantech is capital-intensive is because they see all the VCs flocking to capital-intensive businesses because of the above dynamics.  Even in areas like energy efficiency and smart grid, where VCs now say they're interested because it's less capital-intensive, they typically are backing businesses that will "only" require tens of millions before an exit, instead of the hundreds of millions that have been required for some of the bigger named startups that were the focus a couple of years ago.

But there are indeed truly capital-efficient businesses in cleantech.  I get contacted by entrepreneurs all the time who are only looking for $1-3M or so to get started.  They're entrepreneurs, and they read about certain high-profile VCs who are interested in cleantech, so they reach out to those investors to raise their funding.  They have a business that, with a little bit of money, might turn into a $20-50M company, resulting (they believe) in very nice IRRs for the investor with such a light capitalization.  In many cases, they may already have significant revenues, and they just need a little bit of capital to hire up some more sales and implementation teams, or to shore up the balance sheet.

And then they're surprised they can't get any big name VCs interested.

In some cases, these entrepreneurs are simply underestimating the amount of capital they'll really need -- I'll write about that sometime soon as well (short version: take more money than you think you need, especially in the current fundraising environment).  But there are a lot of solid service, software, web-based, etc. cleantech businesses out there, that are having real trouble raising the capital they need.

It's a serious capital gap, if you care about more than just innovation in cleantech -- if you care about actual near-term implementation.  Because these businesses are the ones positioned to make an impact today.  To go back to the initial quote, these are companies that are poised to change the world... even if they're not poised to become a "big company" of the massive scale that young VC thinks he needs to see.

If you are one of these entrepreneurs, however, there are some underexplored options you should focus on instead.  Don't waste your time with the big-name firms who structurally won't be able to engage with you.  Instead, look to regional, smaller VCs -- such as the network of Village Ventures firms.  Reach out to local angel groups, and local smaller family offices.  And if you are indeed already at a revenue stage, local commercial bankers may be able to do a venture loan alongside any equity you might be able to bring in.  In other words, don't waste your time flogging your plan up and down Sand Hill Rd., spend your time networking locally to find the investors in the right check size range.

My point isn't to knock the perspective of the VC I quoted at the beginning of this overly-long column.  He's looking for a certain profile of investment that is right for his firm's size and strategy.  And I'm certainly not saying there aren't big-dollar VCs who won't write smaller checks.

But as this same VC wrote elsewhere in the conversation, "VCs want to be involved if the entrepreneur wants to build to a big outcome.  If you are happy selling [your business] for $20M, surely go to angels."  A snarky comment, but I would say it's completely valid at the $50M exit level and below, not $20M.

When the average venture-backed M&A event is well under $100M, a $20-50M exit can be considered a real win for the vast majority of startups.  Entrepreneurs need to acknowledge to themselves when their business is most likely going to be a <$50M exit down the road -- if it even exits at all, it may instead become a cashflow producer for the entrepreneur and angel investors.  That's NOT a bad business.  It can be a phenomenal business that makes the entrepreneur and angel quite wealthy, and makes a significant impact on their community. 

But it does mean you have to be smart about what types of funders you approach when you need startup and growth capital.