"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.
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.