Why cleantech venture investments fail

I have been spending time sitting down with a variety of cleantech VCs on both coasts lately, and I find it to be always a very humbling experience.  Hearing how all these smart investors approach this unique sector -- and in a variety of different ways, I might add -- always serves to remind me how much more I have to learn about venture investing in this sector.

And that's one of the things that's broken about venture capital in general: The relative dearth of learning opportunities.  An investor may look at hundreds of investment opportunities per year, but they only invest in a handful of them.  And while nothing teaches like failure, very few investors talk openly about their failures.  Even successes are viewed through a distorted lens -- and the skeptic would say "what successes?", since huge cleantech exits (as with all venture exits) have been so hard to find over the past couple of years, which happen to be a couple of pretty formative years for this sector.  So as an individual investor, it's difficult to learn by watching what other investors have done, either successfully or unsuccessfully.  And while there's no substitute for learning by doing, it doesn't happen quickly.

However, for those active investors in the sector, we know that there have been plenty of stories of failure (or at least highly mediocre outcomes) that just aren't broadcast very widely.  It's just that none of the insiders talk about them very much.  And for very good reason... 

But in the interest of sharing and learning, I thought I would describe some of the basic reasons why I've seen cleantech investments "fail" over the five years I've been an active investor.  Not in terms of specific examples, of course, but as a means of trying to understand the key risk factors involved in doing cleantech venture investing. 

Some caveats: It's important to note that this is also an exercise in evaluating those investments that have hit some tough times, but aren't necessarily down for the count quite yet -- there have probably been more examples of successful outcomes in cleantech innovation among those companies that had to restart or retrech, as those that sailed through from Series A through exit without any restarts.  So you'll note I'm being particular about using "failed venture investments" instead of "failed cleantech startups", which can be very different data sets.  And of course, this is just my own personal take on lessons learned so far in the sector... and as can be inferred from the opening graph of this column, smarter investors may disagree with me heartily.

At a basic level, all such failures are the same:  The company in question runs out of capital, and either no one is willing to put in any new capital at all, or the existing investors are pretty much wiped out when the new capital comes in at a significantly reduced price.  But there are a myriad of reasons why this happens.

I see three basic factors that have led to failures in the past:

1.  Technology

• The technology being developed by a startup may just plain not work.  However, this happens a lot less frequently than journalists' coverage of the sector would have you believe.  VCs are typically smart enough to want to see technical proof of concept before making an investment.  So they won't invest before, at least in the lab, the bugs make the fuel, or the device makes some power, etc.  So while there are undoubtedly some examples to be found of venture-backed innovations that simply failed to work at a conceptual level, none come to mind.

• The technology works in the lab, but takes too long to scale up to a point where the economics work.  This happens a lot more frequently.  The bugs make the fuel, but even after a lot of effort they can't make the fuel in sufficient volume to achieve a low-cost position versus incumbent fuels.  The solar cells produce power, but not at a high enough efficiency, or low enough production cost, to achieve a cost competitive result.  This is tougher for a VC to diligence, and is somewhat un-knowable from the beginning anyway.  There have even been companies that have gone public in the past who have subsequently fallen short because of this factor.  Certainly in solar and biofuels and a couple of other sectors, there are examples where VCs ended up seeing their investments go toward technology maturation efforts that haven't panned out.  Some of these efforts have been significant, in terms of dollars and time.  However, the VCs I speak with are getting much more cautious about this.  Once bitten, twice shy.  This kind of failure is one of the major differences between cleantech and other venture sectors, and being able to identify promising lab-scale or even beta-stage techs that won't be able to "graduate" to commercial scale very easily has quickly become a very specialize skillset among investors, and a vital one.  

• The technology works, but something better comes along.  This is another factor that really hasn't been seen as much to date.  The market needs are so intense, and so much that's gone on remains pre-commercial, that even when a technology is on a "dead end path" many of the companies developing them have been able to transition to a new approach, or target their innovation to a better-suited (albeit smaller) market opportunity, so we haven't seen too many examples yet of venture-backed technology efforts that have become completely obviated by new innovations.  However, this will start to happen more and more often, as the markets continue to mature and commercialization leaves some efforts by the wayside.

2.  Market

• The dogs won't eat the dog food.  Cleantech is typically an engineering-led sector, where innovators come up with a new solution that would appear to provide superior economics (price and/or performance) versus incumbent technologies.  But what VCs have been quickly learning is that many of the purchasing decisions in the sector are not overtly driven by economics.  A superior building efficiency solution, for instance, may not gain purchase in the market when the target buildings are owned by one party but occupied by another.  In many markets, even if the new solution provides a cost advantage over the status quo, the purchasers may have bigger things to worry about and thus may be unwilling to let bigger issues be risked by a more minor cost-saving opportunity -- this can happen, for example, in industrial markets, where the facility manager would rather continue to pay a higher cost for energy, rather than take a risk that a newer "low cost" energy solution could disrupt their factory's production.  Or it may simply come down to lack of awareness.  Homeowners may rather pay for expensive bottled drinking water than to adopt a new in-home drinking water treatment technology that would achieve the same results.  For example.  All of which are examples of markets where "better" innovations see much slower adoption than VCs and entrepreneurs have expected at times in the past.  However, this is another factor where investors are starting to get more cautious when selecting investments.

• Existing solutions may be "sticky" because of existing infrastructure.  This is a very important factor across a number of energy, water and materials markets.  The innovation that a VC backs may make good sense from a technology and economics perspective assuming an agnostic infrastructure, but that's rarely the case.  A fuel cell car needs to find an H2 refueling station.  Ethanol infrastructure doesn't co-exist perfectly with incumbent gasoline infrastructure. Biomass-gasification efforts require a new waste processing infrastructure that may not exist in many cases.  Net metering has been an issue for solar PV installations in some places.  Etc. Cleantech investors are learning just how important it is to consider the entire value chain before making a bet in one segment of it.

• The hoped-for market never materializes within the investment timeframe. This has tripped up more than a few overly optimistic entrepreneurs and investors, as the hype around a new market (for example, electric vehicles in the US) gets out ahead of the actual market development.  The technological innovation may be superior, the market need may be clear, the economics may be favorable... and yet it still just doesn't happen very quickly.  So the investors find themselves backing a company going after a small market niche instead of being the "next Google" of some anticipated market revolution.

3.  People

• Gaps in the management team skillset.  It's rare that a startup will have a fully-baked management team in place as of the time of a venture investment.  And it's even rarer that such a management team will have the right skillset to see a startup through from inception to exit.  So VCs are used to working with founders and management teams to insert new managers at all stages of a company's development.  However, it's still not a skill that most VCs are good at (and yes, my house is made of glass as well).  So I have seen numerous examples where an early stage CEO didn't step aside at the right time, and the delay in finding the eventual right next CEO ends up being hurtful to the company's commercialization efforts.  Even worse, some CEOs have seriously over-promised and then under-delivered, seriously hurting the company in the eyes of prospective customers, business partners, and follow-on investors.  Or below the CEO level, the failure to bring in the right manufacturing and operations expertise, or especially the failure to bring in strong sales management at the right time, can mean commercialization delays and slower than anticipated sales growth.  And with a venture investment, the pace of growth is critical, for cashflow reasons described below.  Note that even though I am describing this as a failure of management, the blame lies with the VCs, who ostensibly have the skills and pattern recognition to identify and address such gaps before they become a problem.  Nevertheless, I still see it becoming a problem quite often.

• Management teams that don't know how to use their Board.  Venture capital is a pretty unique and opaque industry, so many first-time venture-backed entrepreneurs don't really know how to use their Board for maximum benefit.  They may view their investors and their Board as an unnecessary group, or worse as some "dumb money" parasite that's only along for the ride.  This is especially true when the management team are serial entrepreneurs but first-time venture capital recipients -- they know how to grow a startup, but don't really recognize the demands and capabilities that come along with a VC investment.  Which can be a problem, because it can affect growth path, ability to raise more funds, etc.  Venture capital is very expensive capital.  It only makes sense to take in venture dollars (as opposed to angel or other early stage funding) if the amount of capital needed isn't available elsewhere, or if the benefits the VCs can bring make the costs worthwhile.  Thus, VCs pitch themselves as being "value-added investors", and most do mean it, bringing pattern recognition, networks for customers and for hiring, PR, access to expertise, etc.  When it works, it's truly a partnership, not just a financing arrangement.  Nevertheless, I have seen a few management teams who have taken in venture dollars but then attempted to keep their Board at arm's length, and it never ends well.  Alternatively, the management team may overly buy the "value-add" pitch from their new investors, and expect the VCs to deliver customers and business relationships on a silver platter, but it's never that easy.  Such mismatches in terms of expectations between management and investors can really mess things up.  It's perhaps more of an issue with cleantech, since so many of the innovations and entrepreneurs are found outside of the typical VC-heavy regions, so you get a higher proportion of experienced entrepreneurs who haven't dealt with VCs before, so both sides walk in with entrenched and yet divergent expectations.

• Investors who push for a more capital-intensive growth path.  Many VCs only make an investment if they see huge returns potential to the opportunity.  This means that, when they make an investment, they expect the company to achieve very big, very fast growth.  And for some, the solution has been to throw more money at the situation.  If higher cashburn can lead to bigger engineering teams and more salespeople, the theory goes, then the company can get to market and grow faster than the competition, so go ahead and raise a big round and then spend that money.  But of course, for all of the reasons described above, there's often at least one additional limiting factor that more money cannot solve.  It may be a slow-adopting market, it may be a tricky technical issue going from the pilot line to full scale production, etc.  But no matter what the immediate cause is, the fact remains that in cleantech, higher spending often doesn't speed up development and growth.  But now the company is locked into burning significant capital.  Which not only means they run out of money ahead of necessary milestones, it also makes it tougher to raise new money.  The larger round the last time around probably meant a higher post-money valuation, which means valuation expectations for the next round are high.  But new prospective investors are asked to put money into a company that is burning cash quickly, with missed milestones, at a high valuation.  It may be the entrepreneurs who pushed for a high cash burn model, but in many cases the investors are really the ones driving that kind of model.  And it's been a very important failure factor for many unsuccessful cleantech venture investments.

There are more factors to note, but these are the major ones that I've observed, read about, and heard about from colleagues.  Some of these factors are common across all venture sectors, not just cleantech, and so as generalists come into the space we see a steep learning curve for the sector, which is a good thing. 

But some of these factors are particular to cleantech, at least in terms of their relative importance in terms of determining success and failure.  In such a relatively young sector, group learning is critical.  Few investors will talk openly about their disappointing investments, and it means many of these lessons are having to be learned repeatedly and separately.  I hope the above anonymized and synthesized list of failure factors is helpful to all of you gentle readers out there.  But more importantly, I hope it provides a little more context for prospective cleantech entrepreneurs...

The “what if” factor

Perhaps the single biggest difference between cleantech and other venture sectors is the "what if" factor.  As in, what if something comes out of left field and blindsides an entire investment thesis.

Last week Earth2Tech profiled 13 different lithium ion startups, most of them venture-backed, all vying to make a big dent in the market for the batteries that are presumed to end up powering future cars and other vehicles.  Each has a different technological solution that they think will give them an advantage on cost or performance or both versus other lithium ion batteries.

But what if EEStor is for real?  If you haven't read it yet, read the highly entertaining transcript (Tyler swears it's real) supposedly of EEStor's CEO giving an interview on what the company is up to.  I'm personally a bit skeptical of the company's prospects, for a number of reasons, and the UL certification effort that bloggers are going ga-ga over really doesn't validate anything.  But if you believe Weir, the company's products will soon obviate all other energy storage options, including lithium ion.

I'm not trying to either slam or boost EEStor (so direct your flames elsewhere, people), it's just a really vivid example of the "what if" principle I'm describing.  What if EEStor's products are for real and as ready as promised?  What would that mean to lithium ion investment theses?  Or other energy storage investment theses?  After all, there are a million different ways to store or regenerate electricity.  Even if EEStor's technology isn't all it's promised to be, what if there's some other breakthrough waiting in the wings?  VCs have backed any number of battery chemistries, after all.

In areas like biotech this "what if" factor appears to be a bit less of an issue, because there's more openness about what people are working on, and the research tends to take place in more well-known places.  There aren't a lot of biotech entrepreneurs working on a new drug discovery platform in their garage.  But there are lots of garage inventors in energy tech, and even with the more well-known research institutions they can either be very close-lipped (like corporate R&D shops), or the substitutionality described above might mean that the "killer app" comes from an entirely different discipline, so simply knowing everything going on in the world of chemical engineering (for example) might not be enough to mitigate the "what if" factor.  Or it might not even be a new technology; as in solar, where an expected flood of really cheap "Gen 1" panels out of China might obviate a whole lot of "Gen 2" efforts...   All of which makes it just about impossible for investors to know everything that's going on that could blindside their investment theses.

This is also driven by the fact that most clean technologies are, in the end, involved in the production of a really basic commodity like kwh, drinking water, energy storage, etc.  There are so many different ways to accomplish the intended goal, that a mono-disciplinary approach will leave out many otherwise unanticipated competitive threats.

The only solution as an investor is to be deeply, deeply networked across a very wide range of markets and disciplines and geographies.  And to be really disciplined about valuations and capital efficiency (so that even ancillary markets can yield good outcomes), due diligence, and most importantly the need for strong execution. 

Good management teams need do their best to know everything that can be known about potential competitive threats (and don't just trash the competition), and understand that it's not always the best technology that wins...

Here are deals from the past week or so -- we're starting to see the return of some bigger deals:

• Carbon-zinc battery developer Blue Spark has raised $1.5mm of a planned $5mm Series B, from insiders.

• eMeter has raised $32mm in new financing from Sequoia and existing investor Foundation Capital.

• Quercus and 21Ventures have put a second round into Advanced Telemetry.

• FRX Polymers, a developer of more environmentally-appropriate flame retardant additives, has raised a $6mm Series A co-led by Israel Cleantech Ventures and Capricorn Venture Partners.

• Fuel cell developer Intelligent Energy has raised a $30mm round of financing from unnamed existing and new investors.

• Suniva has raised a $75mm Series C from new investors Warburg Pincus and Apex Venture Partners, and including existing investors NEA, HIG, and Advanced Equities.

• Smart home startup iControl has raised a $23mm Series C, with participation from new investors ADT Security Services, Cisco, Comcast Interactive Capital and GE Security, alongside existing investors Charles River Ventures, Intel Capital and the Kleiner Perkins Caufield & Byers (KPCB) iFund.

• Flagship has presumably made an investment in recently-unstealthed Joule Biotechnologies.

• Produced water treatment company Ecosphere Technologies has taken in a $10mm PIPE from Bledsoe Capital Management -- and there's another retired QB in on the action, too!

• NEAH Power has raised a $500k PIPE.

• SunRun raised a $18mm second round of financing, led by Accel Partners and including existing investor Foundation Capital.

• Solicore has raised $12.2mm of a $13.3mm Series D, led by Rogers Corp., and including existing investors Draper Fisher Jurvetson, Rho Ventures, Braemar Energy Ventures, OPG Ventures, and Firelake Capital.

• Cleantech investors in the news:  Khosla's reportedly soon to announce closure of $1B in new funds...  DFJ is also raising...  And here's some info on 21Ventures' investment approach.

Other news and notes:  CleanLaunch, a new cleantech incubator in Colorado...  Interesting take on a secondaries market for privately-held cleantech shares...  This sounds like a relatively soft landing...  Finally, who do you believe, the Nobel laureate or the politicians?

That big sucking sound you hear…

... is the sound of China deciding to become a big player in solar project installations, overnight.

It's clear that China is going to be a dominant force in cleantech in the coming decades, starting immediately.  But what that will mean for cleantech VCs remains very much unclear.  What is clear is that cleantech VCs need to start getting smart about that factor, asap.  And thus, so should their LPs.

But should cleantech VCs start investing in China?  It's not apparent that US-based investors do very well investing in China, at least without having a local presence on the ground.  Since most cleantech-specialist VCs don't have that, are they vulnerable to being left out?  There are specialist funds (albeit very few) focused on cleantech in China, are they better-positioned?  Or are the markets themselves so specialized (US firms having trouble selling into China, Chinese firms having trouble selling into the US) that they really are totally separate questions?

It will be fascinating to watch how this dynamic continues to develop.  Solar and coal-related techs will be where it gets felt first.  Every coal-related startup CEO I know is paying a huge amount of attention to China.  Many solar CEOs already are, too.  Wind and LEDs and industrial efficiency techs will also need to pay close attention.

China has the potential to radically change the way we think about cleantech venture capital and private equity.  But I'm not yet smart enough to figure out exactly how...

Tidbits from the past week

It continues to feel like things are picking up a little bit in the cleantech venture world, but if so, just a little bit.  I continue to see lots of cleantech startups that are having a surprisingly hard time raising capital, given decent internal progress and good market prospects.  What deals are happening appear to be pretty small ones, some smallish Series A rounds, some smallish follow-ons, some extensions of previous rounds: deals done simply to pad out cash reserves or add a strategically valuable investor.  Not a lot of "inflection point" deals, ones where the capital is intended to dramatically accelerate a company's internal development and growth.  Entrepreneurs would do well to continue to focus on lean growth plans and capital efficient operating models when approaching investors over the near term.

With that in mind, here are deals and other items of interest from the past week or so:

• Solar panel inverter startup GreenRay has raised a $2M Series A from Quercus Trust and 21Ventures.

• In another example of a cleantech startup looking outside of the traditional VC financing path, MSW gasification startup Enerkem has taken in an asset-backed financing facility from ATEL Ventures.

• In China, Nature Elements Capital is looking to raise a $350mm fund to target investments in regional clean energy projects.

• Apparently, at least two Asian-based solar IPOs are planned for Q4.  Apparently.  We'll see...

Other news and notes: 

Here's a great follow-up on the NECEC's inaugural class of Clean Energy Fellows... 

Here's a good perspective from Joel Makower, who always is worth listening to -- but I do disagree with his concept of energy becoming cheap and plentiful anytime soon.  While we are bringing cost curves down on new energy sources, the scale disparity versus incumbent energy techs, and the continuing challenges, mean that even as alternative energy sources start to get close in some cases to incumbent energy benchmarks, we're still a long way from achieving "grid parity" with these new resources.  And crossing that threshold is a long way from energy being virtually free.  Basically, information is a virtual good and energy is a physical good, and as such requires a lot of capital expenditures to produce even when the "fuel" (photons, sugars, etc.) is free, so it'll always be costly.  If anything, I would expect energy prices to go up over the coming decades, not go down.  But others are encouraged to disagree.  What I do agree with is that diversifying our sources and virtual sources (ie: automated efficiency and demand response) of energy may well launch a period of amazing entrepreneurial and innovative efforts even outside of the energy industry, just like the internet has helped usher in a period of "creative destruction" across many different markets... 

Finally, I'd love to chat with any entrepreneurs working on biochar-related businesses -- just drop me an email if you are one.

The hidden dealflow:  Secondaries

While we discuss the numbers being tracked around new venture capital dollars into cleantech, in the background there's a totally different type of deal that goes on, and especially right now. 

In a "Secondary" transaction, a new investor buys the existing equity of a current investor in a startup.  It can be done in conjunction with a new funding, but often doesn't bring any new capital into the company at all.  It can be a specific acquisition of a company's equity from an existing investor to a new investor, or it also can happen more indirectly as an entire venture portfolio gets sold from a VC firm to a new institutional investor. Typically the seller of the equity or portfolio is facing a liquidity crunch and needs to sell off some of their holdings, even if at a discount, in order to raise some cash.  But it also can happen at the tail end of a VC's fund, in order to give their LPs some near-term finality and close out a fund even if some of the investments haven't exited.

And we'll never know just how much of this is happening in cleantech venture capital.  Because it doesn't get talked about very much, for obvious reasons.

But from all reports, it's happening quite a bit right now, especially as VCs continue to have trouble raising new funds.  There are some hints of the secondaries taking place, in such news as Daimler has already sold off 40% of the stake they recently bought in Tesla Motors.  But we're not hearing about the vast majority of secondary transactions that are taking place.  Nor will we.

Just something to keep in mind as we discuss the talked-about deals:

• SolFocus has added yet more to their Series C, with the final close at $77.6mm.  

• Water membrane developer inge watertechnologies has raised EUR5mm in venture financing, from new investor BayTech Venture Capital and existing investors Taprogge Watertech, Emerald Cleantech Fund I, Sustainable Performance Group, Siemens Venture Capital, StoneFund and Entrepreneurs Fund.

• Turbine Air Systems has raised at least $15mm of a targeted $50mm round of financing, with Element Partners participating.

• Algae biofuels continue to get a lot of buzz, and now Solix Biofuels has announced a $16.8mm Series A.  Shanghai Alliance Investment Ltd. (SAIL, but not to be confused with SAIL Venture Partners, another cleantech venture investor) led the round.

• Speaking of Sail Venture Partners, I missed reporting last month that they invested in Xtreme Power, as part of a $5mm round that the CEO of Xtreme describes as "not that big of an event for us".

• Pyron Solar has been acquired / rescued by Ellis Energy Investments.

• Finite Carbon has raised a Series A including $2mm from TL Ventures.

Other news and notes:  WHEB Ventures has held a 3rd closing on their second clean tech venture fund... Overall, however, fundraising by VC firms is way down, which is bad news for many startups since that means fewer checkwriters...  Finally, can a VC-backed startup cause earthquakes???

Back in the saddle

Over the past week or so, we've gotten the initial Q2 cleantech venture tallies from GTM (85 deals, $1.2B), the Cleantech Group (94 deals, $1.2B), and NEF (note: link opens pdf) ($1.4B), and the picture is that investors are starting to get back into activity again.

Granted, in terms of dollar amounts the activity remains below the pace of a year ago, but the number of deals is comparable to that from 2008, with GTM's Eric Wesoff counting 85 deals around the world in Q2 2009, compared with 350 deals for all of 2008.  In GTM's full Greentech Innovations Report for the quarter, Wesoff notes that while investment activity is rebounding, the quarter didn't see any huge $100mm solar or biofuels deals, which is why the dollars haven't caught back up to where they were. 

The NEF data is a bit dissonant, in that it shows a slight decline from their Q1 2009 total VC dollar tally of $1.8B, but we've talked a lot here on this site about the compounded challenges of trying to get consistent data across different analysts' methodologies and dollars vs. deal counts.  So if nothing else, it's somewhat gratifying to see all 3 tallies somewhat in sync for at least this one quarter, even if their Q1 to Q2 trend lines are a bit off from each other.

Interestingly, both GTM and the Cleantech Group show signs of a bit of tempering of VC enthusiasm for solar, although as always the data is tough to compare without full details (GTM pegs the sectoral subtotal at >$300mm, while Cleantech Group puts it down at <$150mm).  Still, in both cases, the dollar totals slipped a bit for the sector, while sectors like smart grid, transportation and energy storage saw increases.

We'll check back in and do a full comparison after the other tallies come out in a few weeks, but the overall story for Q2 appears to be that cleantech VCs are still being cautious, but are slowly starting to get back into the game.

Speaking of which, I am excited to be taking on a fun new challenge of my own, starting this week.  Thanks to the many of you out there who've sent kind messages over the past couple of days since the news came out...  Looking forward to digging into deals and once again rolling up my sleeves to help clean energy companies grow, in this new context.  Cheers!