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When is a Venture Investment Not a Venture Investment?

Rob Day: May 23, 2011, 8:39 PM

First, a quick note: I've differed with Vinod Khosla a couple of times on this site in the past. But let's give him his due as well.  Read the story I've linked to here, and be inspired. Such drive and audaciousness is what venture capital is really all about -- and what makes great entrepreneurs. Especially in cleantech, where so many customers are change-resistant, all entrepreneurs and VCs should read this story and take it to heart.


What exactly is a 'venture capital investment'?  

A definition seems obvious ('startup capital') but of course becomes devilishly difficult to place within specific boundaries. Generally speaking, VC as a subset of private equity is provided to early-stage companies that are still privately held and are too immature to be able to get debt financing. But even at this level, there are lots of areas of debate. Can't many startups get 'venture debt'? And is funding a raw startup at its inception phase really to be considered in the same category as putting money into a 'final round' before an IPO, for a fast-growth business?

It really doesn't matter (except under Dodd-Frank, I guess) what you label an investment. I hear phrases like "growth equity," "pre-IPO funding," and "seed capital" being bandied about as subcategories, for example, and the differences between them are broad but fuzzy. I think what's more important is that so-called venture capital investments are those that are carried out using venture capital terms, as opposed to majority-ownership type transactions or simple common-share purchases. VC terms are arcane and convoluted to outsiders, but basically boil down to two things: a) making sure that the minority-ownership 'risk capital' gets strong returns at some liquidity event, with some downside protection; and b) making sure that the minority-ownership 'risk capital' gets lots of protections against dramatic shifts to the business by the management team or other insiders. In other words, it's very mechanical, what makes a 'venture capital' round, as typically reported as a "Series [_]" investment, versus what would have been considered another form of capital investment into the same company.  By default, if we're talking Series A or Series B, etc., it's probably not confusing -- only angels and VCs and government would put money into the company at a pre-revenue stage.  But it gets tricky when you see companies with not-insignificant revenue taking in a pre-IPO "Series F" or such. Is that "venture capital"?

Who cares?

It doesn't really matter.  At that point, the terms are being designed according to the VC template versus other templates simply because mostly VCs remain around the table.  So sure, call it VC -- or whatever.  

Except that reporters and numbers-trackers glom onto such deals as "venture capital rounds," because they're labeled as such, and because VCs participate in the funding.  

And then these fundings, which are typically very much larger than the usual earlier-stage venture rounds and have much lower returns expectations, are all piled into the same "VC funding" category when it comes time at the end of the quarter for pundits to declare whether or not things are healthy in the entrepreneurial world.  

You just can't treat these deals that way. If there are 200 $4M Series A investments into a sector, that demonstrates much more investor excitement and optimism about a sector than four $200M Series F investments.  And it feeds into bubble talk, as well -- pundits look at a really large headline number about the total "venture capital" dollars going into a sector and declare it to be over-invested, because there's no way all that capital can achieve "venture capital returns."  But first of all, what are "venture capital returns" anyway? Obviously, it varies greatly by stage, according to risk versus reward (and besides, the VC category has really underperformed against the Efficient Frontier over the last decade, anyway). So if you see a $200M Series F, are investors really expecting to get the 10x return that early-stage VCs typically hope to achieve?  Does that really mean it's a "bubble"?

So because the definition of venture capital is so fuzzy, you just can't look at the top-line totals and expect to glean any knowledge about investor expectations for sectoral growth and returns. Journalists need to remember this.

LPs need to bear this in mind, as well.  They get pitched by "venture capital" funds that declare themselves as such, but are increasingly looking to invest in companies with well-established revenue and clear paths to exit. Not that there's anything wrong with that at all!  We've done some of that investing at my private equity (note: NOT "venture fund") investment group ourselves. But it's easy for LPs to look at such pitches as being "venture capital returns, with lower risk."  No -- it's lower risk, perhaps, but also comes with lower expected returns. That can be a totally justifiable tradeoff. But it's important to realize that it is indeed a trade-off.  And so if the LP is truly looking for the upside of "venture capital returns," they need to make sure they have exposure to the early-stage firms in a sector, not just the growth stage and multi-stage (i.e., 80% growth stage) firms.

As the cleantech venture capital category continues to swerve toward later-stage investing, such distinctions matter more and more to LPs, journalists, and others in the space. Entrepreneurs don't really care -- a Series F by any other name would smell as sweet -- but you, gentle reader, should remember that not every "venture capital" financing you are told about should really be considered as such. Thus, not every "big quarter for cleantech venture capital" is actually a sign of health for startups in the sector. I always say that if you're going to track just one number, track the number of transactions, not the dollar total of the transactions. It's still not a perfect metric, but it's less susceptible to definitional drift.

Some Thoughts on Corporate Cleantech

Rob Day: May 11, 2011, 10:12 AM

I've had a lot of good conversations recently with managers from large companies that are now eagerly looking into cleantech as a potentially strategic area. Many Fortune 100 companies, of course, have been all over cleantech for a few years now.  But it's still significant to note that a new wave of additional corporate strategy managers are looking anew into the sector and trying to determine if there are opportunities within it for growth for their company.  It's a really encouraging signal. And of course, I happen to agree with them that there are opportunities here.

Way way way back in the last century, I actually started my "cleantech" (of course, it wasn't called that back then) career advising large companies on how to think about capturing opportunities in the sector. So for what its worth, here are a few pieces of advice for any corporate managers out there who are tasked with figuring out their company's cleantech startup engagement strategy.

1. Collect your company's own energy- and resource-related pain points first, and address them as a priority.

Building a brand new revenue pathway is hard and takes time. Many great corporate ideas have withered on the vine because the internal champions ran out of rope before the benefits were felt.

But I guarantee that in any large company, there are plenty of opportunities where energy and other input costs are a problem. And quite often there are lots of opportunities to improve operational performance via some of the tools available from cleantech startups today. The best way to help build internal support for a cleantech startup engagement strategy is to first use such engagements to benefit the bottom line, before addressing the top line.

One large utility I've been speaking with recently does a phenomenal job of this. They have delivered to our firm and to several other groups a full list of several dozen identified "needs and wants" in terms of technology innovations that could help their operations. It's a very specific list, which really helps focus their conversations. It helps them qualify the conversations they're having -- are they talking to investors and advisors that can actually help them, as opposed to those with nothing more to offer than lots of opinions? It also gave this utility's tech team an excuse to go talk with the company's operating business units and get buy-in for their strategy for engaging cleantech startups and investors.

Very often I see corporate strategy managers launching into something of a fishing expedition when tasked with developing a cleantech startup engagement plan. They start at a very, very high level and eventually work their way down to sector-level recommendations. But my suggestion would be instead to start with a bottom-up approach, working from real challenges their company already faces. The brand new top-line growth opportunities will become more obvious along the way anyway.

2. Bring some money to the table.

Startups are busy. Investors are busy. Both operate on a vastly different timescale than most corporations. Trying to mesh those different perspectives and make a productive relationship is difficult unless there are incentives involved.

Many corporate managers understand this. But I do see examples of corporate managers looking to engage with cleantech startups and investors in hopes of getting insights and relationships, yet not bringing any financial resources. But with little real value being brought to the table from the large corporation, the conversations don't really go anywhere. And to be blunt, if the corporation isn't willing to put a budget toward this kind of exercise, there isn't really a strong internal mandate for it anyway.

It's important to note that this doesn't mean I'm advocating that all large corporations get into venture capital investments. That's a fit for some companies, but not for others. Yet in most cases, what would be a relatively small amount of capital from the perspective of the large corporation could be a meaningful amount of NRE-type revenue for a startup, and having that kind of potential relationship as a possibility will help sharpen conversations on both sides of the table. That's not to say that the corporation should lead with their checkbook. But it makes the conversations more tangible and meaningful for both parties if there's a potential small (and eventually large) partnership that can be developed, and that means there needs to be a budget allocated for such things right from the beginning.  

This also fits with the first point I made above. Clearly, to justify a budget, there needs to be an IRR, which means addressing real needs.

3. Don't just follow the venture capitalists.

Many of these corporate managers make venture capital firms their first stop. Makes sense -- VCs should have already filtered a lot of information and should be able to help identify trends in the market. They should know about a lot of startups already, and they often have a pre-existing portfolio and can be a good access point into that portfolio.  

But don't stop there.  As we've discussed ad nauseum in this space, the venture capital model is a fit for only a very small share of good business ideas in cleantech.  And given the differences between corporate and venture investment expectations (in terms of openness to different timeframes, different rates of return, different levels of capital intensity, etc.), there's a good chance that the more attractive areas for large corporate growth in cleantech won't overlap with what turns on cleantech VCs.  So if you're only viewing the cleantech market through a VC-colored lens, you're going to miss most of the picture.

For this same reason, don't use venture dollars as a proxy for assessing entrepreneurial activity levels in a sector. For example, just because VCs haven't (yet) gotten heavily into the water tech sector doesn't mean there aren't tons of water tech and water services entrepreneurs that might be interesting to you. Likewise, I talk to too many corporate managers who start off their conversations by discussing solar. Just because VCs have over-invested into the solar subsector doesn't mean it's the right place to start your own investigations.

So do start with VCs, and start a conversation for potential mutual benefit, but don't stop there.  Figure out how to reach beyond and see beyond the cleantech VC community.

4. Find and join cleantech networks.

So if you can't use VCs as the ultimate sherpa, where can you turn?  Fortunately, there are a number of great networking organizations that can be used to both build visibility, and to build a broad array of relationships, to find out more about what's going on across the entirety of the market. Corporations need to be joining these groups, even if they don't yet consider themselves a "cleantech company" -- not only because of the networking potential such memberships would bring, but also because, per the first point above, resource and input cost issues affect all companies big and small, regardless of sector. Joining these groups can be well worth any nominal corporate membership fee, if the relationships are initiated with a strong intent to maximize their value to the corporation, across strategic, sales, communications, recruitment, and potential policy dimensions. Companies like Google and National Grid have been using this type of relationship to great effect, but many other corporations are still figuring it out.  It can be critical, however, to successfully getting a complete picture of this highly fragmented market and industry, where no one knows all the relevant players (not even the VCs).  

Several such national-level organizations I've been involved in and would recommend include the Clean Economy Network, the Cleantech Open, and the Cleantech Group.  Here in New England, there are also regional organizations like the New England Clean Energy Council that play an important role at that local level. There are other groups as well, too numerous for me to list here, that you can find without having to look really hard. Join them. Use them. And deploy those relationships to get real smart and real connected, real quick.

The Smart Grid Will Be Inside-Out

Rob Day: May 2, 2011, 8:02 AM

After two weeks away from everything, I'd planned on writing this post Sunday night. Somehow, I got a bit distracted. The 2011 news cycle has been incredibly intense so far, and shows no signs of slowing down anytime soon.

In any case, there's been a lot of news over the past few years about the smart grid and how utilities and startups and VCs are working to make the grid more data-driven, flexible, automated, etc. Very often, the discussions about the timing and pace of smart-grid rollout are focused predominantly on utilities and major vendors of transmission and  distribution equipment, including smart meters.

But while that's a large and important aspect of the smart grid market, I think it's not going to be the pacesetter for this industry. Instead, smart grid features and applications will likely be driven from inside the meter, out into the grid.

Some years back, in my consulting days, I had the opportunity to work inside a large utility. I got to see how these kinds of decisions are made, and the limits such entities face in trying to quickly roll out anything new. In fact, I helped pull together a business case for a "smart meter" investment by the utility (really, just automated meter reading: this was a while back). The business case included a lot of "soft" cost savings -- those that didn't have a specifically identified cost savings level, but were still likely to drive down costs in areas like improved customer service, more accurate billing, better blackout detection, etc. The problem is, lacking a concrete projected savings level, these savings got heavily discounted by the utility decision-makers because they knew they would have a hard time defending those projected savings to their real customers -- namely, the Public Utility Commission, with which they needed to negotiate for any significant capex program. And the "hard" cost savings weren't any easier -- they basically boiled down to fewer meter-reading jobs required. Plus, the local communities and PUC weren't thrilled about the idea of downsizing of any kind, so that was not an easy "win" for the utility either. In the end, the savings were sufficient that the project would potentially have been warranted, all things being equal; all things not being equal, the utility ultimately passed on the opportunity.

Things have changed in the decade since then.  Many of the "soft" cost savings have more proof behind them by now and PUCs are more open to accepting them in rate case negotiations. Additional functionality from smart meters and the smart grid also bolster the argument. And the aging workforce at utilities means that they're increasingly worried about how they're possibly going to be able to manage their assets going forward, even more than they're worried about having to explain a downsizing due to more automation. As a result, smart grid technologies are doing better now, and will continue to do better over time.

But these same obstacles remain. Talking with one utility's managers recently, they told me quietly that they'd like to do more smart grid investments, but their PUCs won't let them. They estimated it would take two rate cases (at five years for each one) for the PUC to agree to any significant investment. They also said that the PUC was actually allergic to smart grid investments as a potentially risky investment, even going so far as to reject investments in "smart grid" equipment that the utility had been purchasing for 20 years, before the term even existed! Other examples of this include all the negative press that has surrounded Xcel's "Smart Grid City" and the cost and time overruns there, and the recent pushback in California around smart meters and data communications. These don't make me pessimistic for the long-term future of smart grid technologies; progress continues to march on.  But these examples underscore how slowly it will likely happen at the meter and in the T&D grid.

Meanwhile, inside the meter, things are happening quickly. The secret weapon of the smart grid is the "demand charge" -- the fee large utility customers pay the utility for their single biggest spike in demand each billing period.  It is billed separately from overall consumption for the month.  You can find a useful explanation here (PDF).  Demand charges have been in place for decades -- and for large, variable electricity users like manufacturers and even office buildings, they can be upwards of one-third of the monthly electricity bill (the other two-thirds being consumption).

This isn't really something that can be addressed by simple efficiency improvements, or by putting solar on the roof.  Efficiency improvements may not avoid the monthly spike.  And with intermittent power production from solar on the roof, the monthly spike might also be just as high as before, even while net consumption goes down. So demand charges are a major pain point for large commercial and industrial electricity consumers.  And to really address them requires automation -- inside the meter.  Thus, even in the absence of any utility smart grid program, or demand response or dynamic pricing program, such customers can see compelling economic reasons to invest in energy-automation systems for this purpose.  Of course, with such utility programs coming into effect in many regions, the economics get even better.  So we're seeing a rapid uptake of such inside-the-meter systems.

Furthermore, as electricity customers large and small see energy prices going up in the future, there's been a wave of interest by early-adopting building owners in better energy information and automation in general, to reduce the consumption portion of the electricity bill as well. Thus, there's been a rapid rise in the number of existing building services companies looking to get into building energy services (I talked about this in regards to EnerNOC in particular a while back), but they are very far from alone in getting into these services.  But whether it's through a service provider, or just self-managed, such energy automation and information is only enabled by a smart building energy management system, with a lot of "smart grid"-like attributes. So for instance, with our investment Powerit Solutions (as one example among others, I'm sure), we're seeing a lot of inbound interest from many of these service providers who are looking for tools that can simultaneously address demand charges, enable participation in demand response and other utility "smart grid" programs, and also enable the service provider to remotely manage efficiency programs at the customer site.

So while "Utility Time" means a pretty slow pace of roll-out of the smart grid on the utility side of the meter, inside the meter, it feels like it's "off to the races" right now. Lots of systems are being introduced to the market, early adopters are jumping on board, and major equipment vendors are getting involved. What will be critical is for a common set of standards to enable such systems and equipment to easily connect with each other, and also to the eventually automated grid.  But there too, with efforts like OpenADR underway, the groundwork is rapidly being laid.  

And you know what? Having "smart-grid-enabled" customers already in place makes it even easier for the utility to talk to their PUC about making investments in smart grid technology in the T&D network. This is why, when we start seeing massive smart grid rollouts for real, my guess is it will have been really driven from the inside out, regardless of where the smart grid pundits and writers may be focusing their attention today.