Rob Day | March 11, 2008 at 3:47 PM 1 Comment

Cleantech is in a “virtuous cycle”

It’s business plan contest season, and many of us cleantech VCs have been enlisted as judges for the various events.  I’ve had the pleasure of being a judge for numerous contests over several years now, and so these events become an interesting yardstick for measuring developments in the industry at the company formation level.

Certainly, we already know that VCs are getting more active in cleantech.  And large companies as well.  What’s very encouraging is that, if these contests and other anecdotal evidence are any indication, entrepreneurs are also increasingly drawn to the sector.

There’s a virtuous cycle that appears to happen in any venture capital investment sector when that sector starts to get hot.  A few successes encourage investors to begin targeting a sector.  Then as the money starts to flow in, the press jumps on board the bandwagon.  All of which focuses entrepreneurs’ attention on that sector.  You might think that the money just follows where the entrepreneurs go, but it can actually be the opposite, and certainly the two drivers actively feed off each other.

Cleantech is now in the midst of this kind of virtuous cycle.

What we’re seeing in these business plan contests is an impressive level of entrepreneurial activity.  At the MIT Clean Energy Entrepreneurship Prize contest, for example, there were over 90 entries this year.

What’s also impressive is the quality of these entrepreneurial efforts, in relation to those of years past.  There are a lot of credible cleantech startups being launched right now.  I’ve been a part of cleantech business plan contests in the past where there were a couple of decent ideas hidden in the midst of a lot of chaff.  But at the CEEP contest, we semi-final round judges had a very difficult time eliminating entries from dozens of good ideas just to get down to 20 semifinalists.

Don’t get me wrong.  I’m not saying there were 20 sure-thing successful startup ideas in this contest, all of the ideas we reviewed faced some daunting challenges.  I’m just pointing out that the ideas held more promise, and were more scrubbed and realistic, in relation to similar sets of ideas I’ve seen in similar events in the past.  Stronger management teams, better thought-out IP, stronger business models, more credible go-to-market strategies, etc.

This helps explain why, when I speak with my cleantech VC colleagues, many of us are busier than we’ve ever been.  While the number of investors coming in has grown, the number of entrepreneurs getting in has grown even more rapidly, so that many of us are chasing down (or just as often, being referred to) an almost overwhelming number of qualified investments these days.  These are a different set of opportunities than those in these business plan contests, sure, but it’s all indicative of an overall trend.

Of course, with all of this entrepreneurial interest in the sector, the natural question is – are we running out of the GOOD ideas?  Certainly, as entrepreneurial activity grows, a lot of “me-tooâ€? ideas and bandwagon efforts are often a result.  And the usual (low) ratio of venture-backable to non-venture-backable ideas seems to be holding fairly steady.  But that in itself is encouraging, since the overall level of entrepreneurial activity is up, so holding the ratio steady means the absolute number of venture-backable ideas is up.  Essentially, as with all emerging market sectors, the growth of early sub-sectors encourages the growth of other new niches.

(Bear with me here…)  To use an analogy from ecology, in any emergent investment sector you might start with a base market that might resemble a clearing after a forest fire.  Thin soil without much nutrients, relatively little biodiversity, little biomass.  But as the first-colonizing fast-growth plants move in, they start to change the clearing, contributing more diversity and nutrients, establishing a healthier habitat for next-stage plants.  And then those plants further create new ecological niches and build biomass for other creatures to utilize.  Over time, from such slim beginnings you grow back a rich, diverse climax forest with mature plants, and an amazing array of habitats and niches for a variety of food chains to exploit.

In other words, as the early technology sectors grow, they provide a platform for the next technology sector to emerge.  Good ideas beget even more good ideas.  And this appears to be what is happening in cleantech.  It ain’t just solar and biofuels and a couple of other lesser sub-sectors.

Ironically, as the diversity of high-growth investment opportunities increases, it may make the market even more challenging for some investors.  As dealflow goes up, so do the knowledge requirements.  Many enthusiastic entrepreneurs jumping into the hot market often know little (at first) about their newly-adopted industry, and thus will be drawn to learning about the higher-profile sectors, rather than having the time, knowledge and resources necessary to dig into the full range of possibilities and find more out-of-the-box ideas.

Generalist investors, meanwhile, who do some investing in cleantech but don’t focus on it exclusively may have a hard time developing the breadth of domain knowledge necessary to be able to sort out the wheat from the chaff across the full set of possible investment sectors by themselves.  After all, a solar cell looks nothing like a fuel cell, and neither of them look anything like a D-cell or a desalination unit.  But despite the learning curve challenges, LPs are telling their generalists to invest in cleantech, so they may assign someone to get look into it, gravitating naturally toward the high-profile subsectors first.

When these generalist entrepreneurs and these generalist investors find each other, you might start to see momentum investing in some subsectors (er, solar, anyone?).  Within these subsectors, the startups become harder and harder to differentiate, and the valuations get driven up as VCs compete to put their dollars to work in already crowded subsectors.

Generalists, being experienced and smart, recognize this challenge.  So one approach increasingly used by many generalist VCs is to co-invest with the specialists—often at the prompting of entrepreneurs looking for a well-balanced set of investors.  And thus we’re also seeing increasing efforts by specialists to syndicate with smart, collaborative generalists.  Because this kind of collaboration can often work very well: It takes advantage of the new entrepreneurial energy and technical and market knowledge that can be borrowed from other investment sectors (biotech, IT, etc.), but also takes advantage of informed vetting by the cleantech specialist firms during diligence, and eventually the domain expertise value-add by the specialist firms around the boardroom table.  Such multi-dimensional collaborations remain more the exception than the rule, of course, and simply bringing these ingredients together around the same table doesn’t assure disciplined and informed investing – otherwise you wouldn’t see such momentum investing in certain sectors.  But when they are done right, these collaborations can be powerful.

Meanwhile, at the edges of all that, but in sufficient numbers to be drive significant dealflow, we’re also seeing entrepreneurs with the intellectual curiosity and energy to dig into the next thing, not just me-too ideas.

…And specialist investors with the breadth of knowledge and networks to recognize when some of these ideas hold promise, even when they’re not in a sector with a lot of existing momentum.

…And the multiplier effect of success begetting success, creating rich opportunity for growth in subsectors where once such prospects seemed dim, or in brand new market niches altogether.

…All of which continue to drive the virtuous cycle forward.

Other news and notes:  John Doerr wants more government-sponsored energy research...  Finally, we need a version of this contest for cleantech ideas.