In case you missed it, Flybridge's Jeff Bussgang wrote a pretty interesting column last week with some thoughts on how entrepreneurs should be thinking about valuation.
It's a very good piece that makes an important point, that the way to think about valuation is much broader than just the stated pre-money. I do have some quibbles with it, in the spirit of adding to a good idea... First off, the principle is right but should be considered even more broadly, since the overall valuation picture is affected by much more than stock option refreshes. Secondly, while the column argues that the larger option refresh makes the effective economic value roughly equivalent to the entrepreneurs, a larger stock option refresh is by itself a good thing for the entrepreneurs as well -- it avoids further dilution for additional option refreshes later, and also in some cases the bigger option pool might end up being used for additional incentives for the existing management team as well. Thirdly, the use of the term "promote" is pretty confusing, since it means a totally different thing in other financial investment areas (such as real estate), so another term might be more useful, perhaps "effective premoney"?
But it brings up another point about valuation as well, one that I've seen happen in cleantech perhaps more often than in other sectors. Since many (note: by no means ALL) cleantech investments can be capital-intensive, the capital needs even in earlier rounds can be higher than for other sectors. Even a few years ago a $20m deal wasn't unusual for solar Series A rounds, for example. And so in cleantech moreso than in some other sectors, for instance, we see valuation pressure forced by round sizes.
This is one of the backwards facts of venture capital -- valuation is often heavily influenced by round size. It comes about because of a confluence of factors. One, the management team is naturally sensitive to giving up too much ownership to investors, with a particular sticking point around 50% ownership in early rounds. Two, in some areas like solar panel manufacturing and other capital intensive areas, the capital needs for necessary equipment can be large, and thus the round size could be double digits even for a Series A. Three, in a sector with such huge potential upside as cleantech, and as the funds targeting cleantech (either as specialists or because big generalists have gotten in) have gotten bigger and bigger, some VCs have been willing to pay a higher valuation if it means being able to put more money at work in an exciting opportunity.
So what this then naturally leads to are some deals with overly high valuations. Not as a rule to be applied across the entire sector (as some journalists have seemed to want to do), but certainly in some high-profile examples.
Which is a great thing for those entrepreneurs, right? After all, they get more capital up front, without giving up more than 50% of the company, so it's a clear "win" for the founders, right? No, in my opinion. From the entrepreneur's perspective, a higher valuation is generally a good thing, certainly. But when you start seeing real nosebleed valuations, it very much affects the ability of the management team to get real upside from that.
Here's why: I sat down a few years back with an entrepreneur who had just taken in a Series A round with a very high valuation (tens of millions of dollars). He was quite pleased. But after congratulating him, I was compelled to warn him that now he was marching across no-man's land with a bayonet at his back. No stumbles allowed. For a company that was still a few years from initial revenue to carry a valuation like that at the Series A stage really demonstrated that the expectation of their investors was that this was going to have to be a "big win" investment. If the revenue was a while off, therefore the exit was a while off, and thus to get the high IRRs that VCs expect would take an exit valuation (likely an IPO) of a billion dollars or more, within the VC's investment timeframe.
That's possible, sure, but pretty improbable. It would require everything going really well, pretty much a faultless execution according to plan. And as anyone who's been involved in an early stage venture can tell you, things never go according to plan. In which case who was going to get the axe? The management team, of course.
Here's the other problem: If you look at the (relatively short) list of cleantech "success stories" out there, what most of them have in common is that at some point in their history they hit a major hiccup or two. When that happens to a startup, more capital is going to be required to see the company through an unanticipated delay and/or tough times. But that's tough when the valuation from the last round of financing is high. It would require a significant "down round" to entice new capital. When that's even possible, it often ends up washing out much of the founding team's ownership along the way, because of some of the structural advantages of the institutional investors which allow them to protect some of their ownership. Since even the successes often stumbled like this, it seems likely that to put a big valuation on an early stage company increases the chances that a slight operational disruption could require a pretty disruptive round of financing down the road.
High valuations mean less dilution but higher risk for the entrepreneurs.
So while I quibble with a few details in Jeff's column, I would want to endorse his overall message to entrepreneurs, and take it a bit further: Worry about the pre-money valuation of a round, sure. But don't think it's the single most important factor to consider in selecting an investor. In fact, it will often fall short to other more important factors. For as much as it's a real economic issue, it's also a window into what kind of investor the entrepreneur will be partnering with, and an overly high valuation isn't a good sign in that regard. As first priority, select investors who will be good business partners. THEN worry about valuation.
Here are recently-announced deals (I'm sure they were all done at very mutually-reasonable valuations):
Other news and notes: PE/VC fundraising terms are unsurprisingly shifting to become friendlier to LPs... What I found most fascinating from this survey is that almost 50% of VCs surveyed expect to do 2 or fewer (note: the article had it wrong) deals over the next 12 months... India's renewable energy industry took in $527M in PE/VC investments over the past four years... Cleantech remains a relative bright spot in the otherwise moribund venture capital market... And finally, aaaachooo!!!
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
2. Market
3. People
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...
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:
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?
... 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...
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:
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.
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:
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???
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!
Rob Day is a Boston-based cleantech venture capital investor and entrepreneur, and is also the President of the Renewable Energy Business Network (REBN). The views expressed on this blog are those of Rob and his friends and colleagues, not necessarily the views of REBN or Greentech Media or any other group. Contact Rob Day at: (JavaScript must be enabled to view this email address)