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Risk vs. Reward

Rob Day: May 27, 2010, 7:49 AM

One thing that non-VCs typically don't have a good understanding of is how different venture investors view the risk versus reward tradeoff when it comes to managing portfolio companies.

How do VCs get compensated, besides salary?  "Carry", a/k/a profit-sharing.  And except in very few cases, carry on an entire fund, not on a per-deal basis.  Everyone in the industry is familiar with the studies that have shown that fund performance is typically determined, at least on the upside, by a handful of deals across an entire portfolio.  In other words, 1 or more really big wins drive all the performance.  And, by the way, 1 or more really big wins really drive a VC's career as well, because of the visibility they bring.  

It all sets up a dynamic where individual VCs, and overall partnerships, are motivated not to try to produce steady returns across an entire portfolio, but instead to try to maximize the slim chance that each deal becomes a blockbuster.

Let's put some really oversimplified math to it:  

$100M fund, 10 portfolio companies, each with $10M committed.  If each one creates a 2x outcome, that's $100M in return.  But if just one company creates a 10x outcome, then you could only break even with all the others and still come close to creating the same return ($90M).  If you get two 10x outcomes, or one ten-bagger and one 5-bagger, then the VC fund is sitting pretty almost regardless of what anything else in the portfolio does.  

This has a lot of implications for how VCs typically manage their portfolios.  To overgeneralize a bit:

First of all, it explains why VCs would so often pass on investment opportunities with good chances to double or triple their money.  Not that any one as an individual would pass up on the opportunity to double or triple their own money all things being equal, but if you're more motivated to find the 5-10x opportunities you'll pass up on attractive but smaller ones.  I interact with entrepreneurs all the time who have good solid businesses with good growth prospects, and yet they're frustrated at their inability to get VC interest.  Basically, this is one major reason why that happens.

Secondly, it means VCs will spend more time on their portfolio companies that are doing well, versus the companies that aren't doing well.  If they can help turn a 3x outcome into a 10x outcome, that's worth a lot more to them than working hard to turn a 0.3x outcome into a 1x outcome.  Many VCs I know have a hard time sticking to this rule, because at the end of the day as individuals with personal relationships and a sense of obligation they want to help out all their companies as much as possible, but the more hardnosed VCs will admit that this is how they try to spend their limited available time in portfolio management.  I've even heard of some big-name VCs who simply stop showing up for board meetings once the company gets off-track.  

Thirdly, it means that around the boardroom, many VCs will tend to push their companies into riskier situations when it means a better likelihood of an upside outcome.  Let me illustrate:

If the VC starts out with each company having a 30% chance of a 0x, a 30% chance of a 1x, a 30% chance of a 2x, and a 10% chance of a 10x, then if they can shift that to be 50% chance of a 0x, 15% chance of a 1x, 15% chance of a 2x, and 20% chance of a 10x, that can end up being a better odds-weighted return.

But note that, to the entrepreneur, that just became a much riskier scenario.  

How does this play out in reality?  Well, the other day someone was telling me about one cleantech company with two big-name generalist VC firms as investors.  And they were describing how, around the boardroom, there had been major disagreement between the two VC firms -- one wanted the company to be burning several hundred thousand in cash per month, the other wanted the company to be burning more than a million in cash per month.  With the real disagreement being around how quickly to push the company to bring a commercial product to market.  This is a natural outcome of all of the motivations described above, along with an expectation that one way or another these brand-name VCs could attract additional follow-on capital into the company if and when it ran out of cash.

On the other hand, I know that many of the "original cleantech crew" of sectoral specialist VCs, and some other specialist and generalist VCs with lower-risk approaches, tend to want the companies to get to cashflow breakeven as quickly as possible.  And thus they want to keep the company expenses lean.

I typically favor that last approach (albeit on a case by case basis).  I just think in slow-moving cleantech markets, rushing a product to market doesn't have the same likelihood of creating customer uptake and first-mover advantage as is often seen in other technology sectors.  So you can easily put a company in a high cash burn situation to successfully bring a product to market, and still fail.  Venture capital is risky enough, without adding further risk into a company... 

But no one knows which approach is truly best for producing investment returns.  In the boardroom anecdote above, those investors were deeply experienced and VC-savvy (certainly more so than me), and not dumb about cleantech either.  And until we see a wave of exits, no one in this industry will have proven that they know how to consistently make money.  So the right risk/reward tradeoff approach to cleantech venture investing remains a very open question.

However, to those out there urging that major amounts of government dollars be simply handed over to VCs to invest as they see fit... Make sure you really understand and are comfortable with all of the above dynamic, and what its implications would be for the successful commercialization of a broad range of clean energy and other technologies.  I am absolutely a strong proponent of government support for commercialization of clean technologies.  But not as a carte blanche to VCs... 


In 2020: When China Rules the Clean Energy World

Rob Day: May 20, 2010, 8:07 PM

I've been most recently reading When China Rules the World.  A fascinating treatise on what happens to the world economy when, over the coming decades, China's economy becomes paramount in the world economic system.  China and cleantech is something I've been thinking about and investigating for some time now.

Timely then to see the report from New Energy Finance (note: opens pdf) that in Q1, China was the biggest recipient of clean energy project finance, nearly double that of the amount invested in clean energy project finance in the U.S., nearly two-thirds again more than that invested in Europe.

I think it's safe to say that China will be a major driver of clean energy and water technology adoption over the coming decades.  Not only because their economy is growing so quickly.  Not only because China has only 1/5th the water per capital, as well as much less domestic energy supply and arable land, than the U.S., thus necessitating wiser use of natural resources earlier in their economic development cycle.  But also because now they've visibly committed themselves to becoming leaders in the sector and, as one regional GP told me today, "they don't want to lose face by not meeting that target."

So China will be a major mover in cleantech markets.  But what does that mean?

I believe that the developments will impact cleantech investors in three phases:

1. The rapid-growth market phase

At first, the major impact on the cleantech economy will be China as outsourced manufacturer, and China as fast-adopter market.  We are already seeing this happening.  With such strong economic growth comes strong resource needs, and many cleantech startups I speak with are already in discussions in China about potential early rollouts of technology.  Using local distribution or other types of partners, they are looking to build early projects and find early customers there.  

This requires establishing such local partnerships, however, as it's a lot easier said than done to sell cleantech goods and services into this market.  So I know many entrepreneurs and investors who are racking up lots of frequent flier miles getting back and forth.  And spending a lot of time establishing strong partnerships there as a stepping stone to actual sales.

Furthermore, as cleantech hardware markets shift toward a fabless model using contract manufacturers for their device businesses, China will naturally increasingly become the actual manufacturer of cleantech hardware systems and components, just like has happened in the IT and telecom industries.

2. The homegrown innovation phase

China is awash in liquidity.  There is a lot of external capital chasing the opportunities presented by the market, but there is a lot of internal capital as well, looking for good domestic investment opportunities in China.  Plus, there is the national commitment to establish more homegrown technology leadership in this sector.

In the next few years we will see the emergence of more homegrown Chinese clean technology startups that are developing proprietary IP.  It is already beginning in sectors (such as large-scale wind turbines) where the technology is readily adaptable from technology developed elsewhere.  But with a steady source of strong technical expertise and domestic markets available, Chinese cleantech entrepreneurs will increasingly be among those developing first-to-commercialize solutions across a number of cleantech sectors and subsectors.

For cleantech investors, finding out how to access these entrepreneurs, and develop winning deals from such relationships, is the still-unanswered question.

3.  The China-sets-the-standards phase

As the Chinese market becomes the most important global market, and especially as homegrown producers become more independent producers of technology themselves, China will hold increasing sway over the development of entire industries like smart grid communications, smart buildings, distributed generation power management, M2M communications, and other subsectors of cleantech where standards-setting will be important.  

In smart buildings, languages like Bacnet are important standards that have been brought to market by European and U.S. technology developers to date.  But in the future, what the Chinese market settles on a standard will often be what the world settles on.  

And thus China will shift from being an attractive market for western cleantech entrepreneurs to think about servicing, to a critical must-address market that will be addressed by both domestic and foreign innovators alike.


All of the above will happen a lot more rapidly than many might expect.

By 2020: Green Homes

Rob Day: May 11, 2010, 6:54 PM

Why on earth would anyone care about new homes right now? Isn't that a dead market?

Yes, in the U.S. the new home construction market is down 75% from its 2005 bubble levels.  The industry is badly hurting and won't go back to bubble levels.  But that still represents around 400,000 new home starts per year.  This is still a huge market.

During the last decade the way to make money in U.S. home construction was obvious:  Just throw up some homes and let people buy them.  It was a seller's market.  But now in the "new normal" where existing home sales are down and new home sales are way down, this puts pressure on builders and developers to think more creatively as market power shifts more to the buyers who are going to discriminate not only on price, but on value.

Meanwhile, we are seeing the early signs of backlash against commuting in this country.  The decades-long trend of suburbanization and exurbinization appears to be somewhat reversing itself.  It took the downturn to reveal this, but available market data indicates that the biggest price and default hits have taken place in the exurbs, and urban and near suburbs have been the most insulated from such effects.  Basically, as the real estate market has gotten softer, overall people have preferred to take advantage of availability closer to the downtown areas to migrate inward (or at least abandon the further out properties).

As people expect energy prices to continue to rise, this trend will continue.  So-called "smart growth" and "urban infill" are going to become more widely-heard buzzwords.

But energy prices don't only hit on the commute, they hit on the home itself.  Homeowners are going to increasingly care about the energy usage of their home... and they're going to be caring about other attributes (eg: indoor air quality, overall use of "sustainable" materials, etc.) as well.

All of this is on the margin.  I mentioned that the new home construction market in 2009 was around 400k units -- compare that with around 5M overall existing home sales per year.  And 72M in total owner-occupied homes in the U.S.  Any analysis of green homes in the U.S. needs to account for the fact that change is hampered by the deep installed base of existing inefficient homes.

Nevertheless, I think we can expect to see some significant changes over the next ten years.  

On the existing homes side, as energy prices do indeed rise (or at least become more volatile), we will see new residential construction further emphasizing efficiency and dense growth.  Oil price future are indicating long-term price expectations above $80/barrel.  Natural gas price futures indicate expectations of price rises of at least 50% over the next couple of years (and this will also drive marginal electricity prices).  Potential homeowners -- and even renters -- will start caring more about the energy efficiency of their homes.  And not just because of the energy costs themselves, but because of that as an indicator of construction quality overall.

There's a limit to how much premium potential homeowners and renters will be willing to pay for energy efficiency, but bear in mind two other factors: 1) as "smart growth" drives shorter commutes, that will free up more wallet-space for home "green-ness"; and more importantly 2) green attributes will be increasingly important to the developers themselves as it will help accelerate necessary approvals.

It's this latter point that's often forgotten, but all real estate markets are incredibly local, and any developer will tell you that construction is actually relatively easy to manage -- it's siting and getting necessary approvals that are the huge determinant of their profits.  The time it takes to get a development started and the costs along the way.  And the fact that evidence suggests "green buildings" have lower vacancy rates than other buildings. So even in the absence of a "green premium," developers have strong incentives to adopt green building attributes.

Not to mention new laws in many places like California that are often requiring zero energy homes and other similar mandates by 2020.  I expect that such deadlines will get pushed back.  But they still are important market signals.

Meanwhile, in the existing homes market, energy efficiency can be retrofitted, with compelling paybacks.  In a low energy cost market this type of activity has lapsed, but it is clearly coming back strong.  Again, it's on the margins, but even if only 1% of homes got energy efficiency audits and basic retrofits (air sealing, insulation, etc.) it would make a huge difference overall -- and certainly would be rewarding for that 1%.  And new government incentive programs designed to encourage such efforts are only now starting to have an impact and will not go away quickly even if the programs are not re-upped.  

So what does this all mean?

Well first of all, we can expect significant activity in the green homes market.  But it won't be geared around "sustainability", it will be focused on location and energy efficiency.  "Sustainability" implies environmentally-sensitive materials (ie: bamboo, or certified wood) and above-standard environmental performance (ie: water re-use, etc.) that appeals to a certain small high-end niche of the market, but most homeowners won't be willing to pay for (because of long payback periods, if any paybacks are even applicable at all).  But many more homeowners will care about the energy efficiency of a home because of aforementioned cost and quality indications.  And, barring a long-term drift downward in gasoline prices, on the margins new homeowners will increasingly care about shorter commutes as well, driving increased interest in denser, closer-in neighborhoods.  Mid-range "green homes" are a relatively untapped niche, but with strong latent demand.

Therefore, developers who can address energy efficient new home construction in a cost-advantaged way will be rewarded.  And developers who can do this in a dense-housing format will be doubly rewarded.  This is a tiny part of the market now, but I wouldn't be surprised to see a quarter of new residential construction in the U.S. (mostly on the coasts, but also in places like Chicago and Dallas) qualify under such concepts by 2020.  This will create an entirely new industry in new home construction done to tighter tolerances, using new processes and designs to improve energy efficiency, and with intelligence and automation built into the home from Day 1.

But this will add up to only a small dent in the installed base of homes.  But we can also expect a significant chunk of existing homes to start to adopt such technologies as well.  It will be hard to retrofit core designs to be more energy efficient.  But air sealing and insulation is easy.  And HVAC will be increasingly intelligent, able to incorporate retrofitted, very small (and cheap) sensors to more efficiently meet required comfort levels.  Home automation will be flirted with, but really boils down to HVAC controls from an energy perspective, and it would make sense that it would eventually be integrated into central HVAC rather than be a standalone add-on application.

All of this will be only a "niche" even by 2020.  But with such a huge overall market, even as a niche it will be measured in the billions of dollars by then.  And it will be growing quickly.


By 2020: Plug-in vehicles

Rob Day: May 6, 2010, 7:25 AM

Back in my consulting days, at one point I was part of a major project with a regional investor-owned utility, helping them do an overall strategic and operational review of the entire business.  It was a great learning experience to see what such utilities think about and have to deal with from the inside perspective.  One thing that always stuck with me was when we looked at revenue-growth opportunities for them.  The answer was that there was really little that the IOU could do to significantly grow revenues within their regulated gas and electric utility business, other than to generally work to promote economic growth in their region -- not a lot of top-line high-CAGR possibility there...

But things have changed.  Among other reasons, the past decade has seen the emergence of a new significant growth opportunity for such IOUs:  Plug-in vehicles.  By transitioning energy demand away from gas stations and into plugs in garages, utilities could boost their revenue growth significantly.

Right now what I'm mostly hearing about are the fears from T&D (transmission and distribution) engineers at utilities about such a prospect.  They argue that putting a car on the grid is tantamount to putting a new house on the grid.  And they worry that clusters of early adopters creating hotspots of demand that would create local distribution problems.

This is a natural part of the utility adoption cycle.  Utilities are paid to provide electricity, but since in the U.S. electricity is seen as a god-given right of every citizen, utilities are heavily incented to avoid disruption first and foremost.  And T&D engineers are the ones most tasked with keeping the lights on.  So whenever there's any new concept available for adoption by a utility, it usually gets pushed over to the T&D engineering group for evaluation.

These engineers are often very smart.  But they have no incentive to go out on a limb, their pension rests on their ability to keep the lights on, and in my work with the utility I found that financial considerations like revenue growth were something they could nod their heads at but never truly embrace.  So the first reaction from these T&D engineers is always to highlight the potential downside scenarios, no matter how minor.

This is where we're at with utilities and plug-in vehicles, here in 2010.  Really, utilities can't handle adding more pseudo-houses to the grid?  Isn't that what happens with a new subdivision development in any case?  And especially because recharging a commuter's plug-in vehicle can be managed to occur mostly during the off-peak hours in any case.  These are the concerns of someone who's paid to think up concerns.  And they will be addressed and will pass.

Because soon, CEOs of investor-owned utilities will realize that adding new pseudo-homes to the grid in the form of plug-in vehicles is a really good way to grow revenue in a regulated business where other growth opportunities are few and far between.

I think we'll start seeing this shift happen over the next couple of years as all the moderately-priced plug-in vehicles start to enter the marketplace.  Right now when the vehicles aren't available to consumers in any case, it's easy for the conversation to be dominated by downside scenarios.  But once consumers start adopting plug-in vehicles -- even in small amounts -- the upside potential will start to get the attention of utility CEOs.

As always, it takes a few years for such mindsets to change.  But by 2020 I believe we'll be seeing this in earnest. 

  • Forward-thinking IOUs will be embracing plug-in vehicles and encouraging -- even providing incentives for -- their customers to purchase such vehicles.
  • This shift will be most rapid in states where retail-level deregulation allows homeowners to determine their electricity provider. Incentives for plug-in vehicles will become another point of marketing differentiation for the various electricity retailers vying to grab customers.
  • A couple of more advanced utilities will partner with a provider of recharging stations (maybe a startup like a Coulomb, but more likely over time it will be one of the larger, already-established T&D equipment vendors) to come up with a low-cost solution they can push on their customers that will also have very simple timing rules so as to make sure and push the recharging into off-peak hours.
  • We'll see the emergence of startups vying to establish recharging stations at major corporate HQs and other major commuter destinations, where consumers can plug in their vehicle and swipe a card and the recharging station will be intelligent enough to have the charge show up on their residential electricity bill.  But most consumers will still do most of their charging at home -- so you'll be seeing these stations over at the far corner of the parking lot, not at every single space.  The alternative vision is that of battery swapping stations -- this may happen more rapidly overseas but I don't see it having much momentum in the United States quite yet.
  • Utilities, who to date have largely taken a live-and-let-live approach to dealing with the oil giants when it comes to legislative efforts, will start to more heavily promote gasoline taxes and other disincentives for the consumption of imported oil.  As major IOUs like Duke Energy, et al, start to see their future growth being in part impeded by the presence of low gasoline prices, they'll start trying to adjust the playing field so that they can more effectively cannibalize that market.  This will mean further efforts to differentiate natural gas (which the utilities will be increasingly relying upon) from oil (which they'll be trying to steal market share from) in the overall regulatory scheme.
  • Electric vehicles and PHEVs will see adoption happen more rapidly than pundits currently expect, toward the latter half of the decade, driven by all of the above dynamics.  More vehicle volumes will help drive down up-front costs, particularly in the battery packs.  And utilities will be helping to defray, either directly or indirectly, the upfront infrastructure costs of purchasing and installing recharging stations.
  • Adoption will be slower in areas where the utility is a muni or otherwise not profit-incented, as the fears of grid disruption aren't trumped by desires for revenue growth.  And also because such utilities are often found in rural areas where commuter cars are less prevalent in any case.  But as the successful examples of IOU programs demonstrate the viability of integrating these kinds of systems into the grid, such utilities will slowly start to accommodate customers who want to go in this direction.

By 2020, I believe a significant minority of the new-sale U.S. commuter car market will be plug-in vehicle.  And investor-owned utilities will be leading the charge.


This is how it happens

Rob Day: May 1, 2010, 4:57 PM

Pretty timely re: my last post on water, this afternoon they declared a major water emergency in the Boston area, thanks to a huge water main break.  One million people, including everyone in my town, are under a "boil water" order.  I got a call from my local water district, a recorded message telling everyone not to use any water at all, not even lawn sprinklers, until they have it fixed.  Since the water main break is dumping 8 million gallons of water per hour into the Charles River, doesn't sound like it'll be fixed very soon.

I make sure and keep backup water supplies at the house just for such eventualities, but I was curious, so about an hour after the emergency was declared I went over to the nearest grocery store, one of those that's so large you can get lost.  And almost their entire supply of water was already gone.  Empty shelves, almost everything grabbed, and people were milling around the aisle in front of the empty shelves looking around as if more water was going to be found.  No panic or anything, people were nice enough, but wow nonetheless...

The phone message said something about the emergency taking only a "couple of hours", and people can boil water to drink, and yet this was still the immediate reaction.  Can't imagine what would happen if something actually serious were to happen to the water supply.

Yep, water's "free".