In my last column, I rushed us through my take on 15 years of cleantech venture capital history. Because if we're going to look at the path forward, we need to understand how we got here in the first place. I would also refer everyone to Matthew Nordan's great four-part take on the state of cleantech venture capital from a little while back, particularly Part 2, where he argues that cleantech has performed at par with the overall venture capital category.
To which I would say: nuts to that.
It's not that I in any way wish to slight Matthew's smart analysis; it's a must-read. But if the conclusion is that cleantech has been at par with other sectors simply because on average it has returned capital? We can do better than that. As an asset category, venture capital is supposed to be out at the end of the risk-reward curve, and thus should generate outsized IRRs. But just how to do that in cleantech -- that's the as-yet-unanswered question.
So what will generate big returns for any venture capital investment? Growth, obviously. And profitability. And a high earnings or revenues multiple at time of exit. And a timely exit at that. Pretty simple, right? Buy cheap, grow quickly, sell high. Except all of us investors have seen plenty of good business ideas that don't fit this profile. And we've also all invested in businesses that we thought would produce this, and didn't.
Looking at the history of venture capital and when it has made exceptional returns, I will overgeneralize and argue that those periods saw investments in companies and products that had the following "success conditions":
1. Low customer acquisition cost.
2. Each new customer makes the overall offering even more valuable -- the so-called "virtuous cycle."
3. High margins.
These are all connected, and are tied to other aspects as well: big markets; solving customer pain points; customer economic value propositions; etc. But at the end of the day, it boils down to investing in companies that will grow quickly and be very profitable (at least on a gross-margin basis). This is what acquirers, including public equities shareholders (i.e., via IPO), will pay through the nose for.
Otherwise, the ball never gets rolling downhill. The technology being offered is one of many such options and doesn't stand out in any way. And thus customers have a lot of choices and won't buy quickly. Such customers also won't pay a lot for what you're offering. And an acquirer will have lots of choices and also won't be willing to pay up. It's not a recipe for venture success.
So what kind of strategies can create the right type of situation? I can count at least six ways. There may be more, but here are the categories I've seen.
1. Sustainable cost/performance advantage through proprietary IP, plus subsequent scale-driven cost economies
This is clearly where most cleantech venture dollars have been deployed to date. It's basically the First Solar model of cleantech venture capital. Unfortunately, these types of situations appear to be quite rare. They require such a significant IP advantage, plus a fast-growing market that no one else was clued into in time, that you get a significant (two-year?) time window in which to establish a scale advantage and really press it home. It's clearly possible, but it's infrequently successful. More often, even if the technology does catch on as quickly as hoped, commoditization and margin compression happens more rapidly than expected. Thus, you get the current patterns we're seeing in upstream bets in biofuels, solar, LEDs, lithium ion batteries, etc. And VCs keep placing more such bets in these and other subsectors. Personally, I'm starting to despair of seeing venture-type returns anytime soon from the "next big patent" investment strategy in this sector. There would need to be many earlier and more lucrative exits for these companies for it to be successful. And, somewhat unfortunately, these efforts tend to be pretty capital-intensive even before it's clear whether the company truly does have a differentiated technology. Succeeding here will require a management team that is technically brilliant, and great at building hype and raising capital.
2. Info centralization
This is the idea that, by getting out into a marketplace early (perhaps as a media play, or via a SaaS-based model or some other way of controlling data flow), a company can become a central repository for market data (costs, customer patterns, etc.) and then the value will flow from there. One problem is that it requires grabbing market share very quickly. This means basically giving away value for free, unless there are other compelling reasons for customers to adopt the service or product ahead of it becoming that dominant info repository. And the problem with giving away value for free early on is that it's pretty much an Underpants Gnomes business strategy. It's tough to later convert the original offering into value that customers will pay more for, since they're used to getting it for free, and the other sources of value from the gathered information are promising but only hoped-for (in the web sector, they've basically settled on ad revenue as the answer). This is certainly one possible business model to create the previously cited success conditions, even if we haven't seen too many examples yet of it producing outsized returns in cleantech (until Greentech Media IPOs, that is!). And because it requires building out a loss-leader offering before getting into the value-harvesting opportunities from the gathered information, this can also be a somewhat capital-intensive play, albeit much less so than proprietary hardware technology development efforts, of course.
3. Becoming a standard
This is also where a lot of cleantech venture dollars have gone. And it's been a successful strategy for hardware investments in the history of venture capital. The idea is that if you create a widget, component, product, etc., that becomes an industry standard within a larger business ecosystem, everyone will have to use you and thus you not only grow quickly, you also become an expensive acquisition for someone. It's the idea of creating a monopoly at one segment within a larger value chain. It worked for semiconductors, it worked for medical devices, it worked in some telecom bets.
Big challenge, however: It only works if it's either mandated from a regulatory standpoint, or if the customer base is homogenous and amenable to being standardized fairly quickly. The former scenario hasn't materialized as some had hoped in energy industries; the latter is possibly true for utilities, but many other customer types in cleantech are much too fragmented, and even utilities are slow and not as homogenous as you might think. Nevertheless, this is clearly the primary hoped-for source of returns in the smart grid, as well as other efforts built around controls and M2M communications (as well as efforts like Project Better Place). And there's some early evidence it can succeed, if the management teams are exceptionally good at building solutions for a particular market niche and using that as their initial beachhead customer sector, and if the market they're selling into is primed for rapid adoption.
4. Building a valuable brand
Venture capitalists backed P.F. Chang's and Jamba Juice. You can't patent a lettuce wrap or a smoothie. Cleantech VCs would never have made those bets. But outside of the cleantech sector, investors have realized for quite some time that successfully building a well-regarded brand can result in strong investment returns, simply because of the power of the brand itself to drive low customer acquisition costs and higher margins. But we haven't seen too many of these efforts in cleantech venture capital yet. I would argue that Tesla and Fisker are venture-backed efforts that have primarily pursued this strategy for venture returns (mixed in with some technology angles as well, of course, but still). Nevertheless, it remains a relatively untapped business strategy in cleantech markets.
5. Marketplace externalities
I name this late in the list not because it's not a potentially valuable approach, but because it clearly builds upon a couple of the earlier strategies. But over the past two decades, it has become an obvious truth that if you can become a dominant marketplace, you can generate good returns by benefiting from the virtuous cycle of customers and vendors increasingly needing to come to you. And I would argue that, in many cleantech markets, being a "dominant" player doesn't necessarily mean anything close to >50% market share. Customers and vendors are both so scattered and diverse in many cleantech markets that even just being a standout marketplace would likely result in the virtuous cycle effect kicking in. Even still, the challenge of getting to the appropriate level of critical mass, however low it may be, has stymied every effort to create new cleantech marketplaces that I've seen.
Even more challenging for "marketplace" efforts in cleantech, in my mind, is that we lack the necessary standard ways of relaying product performance in ways customers can use. Have you tried to buy an LED bulb on Amazon? It's a horrible experience. And looking at more commercial and industrial markets for LED lighting, I've now seen how many lighting fixture vendors really play around with (i.e., lie about) their product performance specs to a level where the average customer would find spec sheet comparisons, etc., to be a bewildering exercise, and thus something of a non-starter. We will see successful physical and/or ecommerce marketplaces established for cleantech markets. But to get there, we'll need to see someone standardize product performance info.
6. Customer access/building a new channel
As mentioned, these can be very fragmented markets. And the (often 100-year-old) channels in these markets, to put it bluntly, suck. They don't know how to sell the new innovations, nor are they incented to. The lack of good VARs in cleantech is something I've talked about before, and it remains a screaming unmet need in many cleantech markets, especially given the vendor disinformation factor I allude to above. The opportunity to build a new channel model in residential energy efficiency is one major reason we invested in Next Step Living a few years back, just to name one example. When they're now in thousands of homes each year as a trusted energy advisor, that opens up all sorts of opportunities to help bring these customers new innovative products and services. And at that company we're now seeing the proof of how valuable that access is, and how quickly it can scale. So without going so far as to be a marketplace, simply having access to a large number of customers has a lot of value in these markets where channel disruption is so badly needed.
But a separate version of the same "capture the customer" dynamic is often being attempted in more hardcore B2B markets like biochemicals, where upstream tech innovators selling into concentrated customer clusters will attempt to lock them up early on, via JVs and the like. I didn't want to break this out as a separate item, because it's kind of a different flavor of both customer access and becoming a standard, but the theory is that if a startup vendor can gain early entry into several key members of an oligopsony (and fortunately, there are a few of these in cleantech markets), they can box out followers. Again, however, we haven't seen too much evidence of this eventually turning into venture returns in cleantech, unfortunately. But you can see the potential for it to happen -- just not very often.
There are other ways to generate returns, of course, and these are not mutually exclusive categories, but these six approaches are the ones I see attempted by cleantech VCs that are clearly aimed at venture-type IRRs (versus lower-risk/lower-reward investment strategies). All of these six or so strategies are designed to build rapidly scalable businesses with valuable exits, and all are being tried in cleantech, to varying degrees. Unfortunately, what I see is that the strategies least likely to meet the three success conditions described above are also the ones being attempted most often. And despite scant evidence of high success rates in these strategies (such as the "next big patent" approach), cleantech VCs keep looking for those types of plays, and pouring huge amounts of dollars into them. All of these are valid approaches. However, it seems like the balance is out of whack. To date, it seems like the only real attempt at innovation by cleantech VCs in terms of their investment strategies has been to keep doing the same thing, just later and bigger.
I think the industry is ripe for some significant change. In the next column, I'll mention a couple of specific managers I see out there who are attempting some different approaches.