Rob Day 06 19 09, 10:36 AM

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Defenestrate your assumptions

If one is to go by what cleantech VCs are saying these days, it seems like we're at a time where some of the core assumptions and current patterns in cleantech venture capital might be about to see some changes.

This is all within the context of VCs generally agreeing that cleantech is going to see continued interest and investments going forward (note: pdf), of course.  But the colleagues I speak with will often refer to some key challenges facing the sector's status quo:

1.  The venture model is (kinda) broken, across all sectors.  Lots of people say this phrase, but they all tend to mean different things by it.  In general, however, there's a growing recognition that in the overall venture capital industry the big funds are getting too big, the returns have been too low, the valuations have risen as too much money floods in, and true company-building skills have fallen away in favor of attempts to simply harvest already well-established opportunities. 

2.  We're still waiting on the big exits in cleantech.  To be clear, there have definitely been some big cleantech success stories and there has been an increasing pattern of exits overall, but we have yet to see the big "make the fund" type of exit that would justify the kind of dollars that have been thrown at certain opportunities (ahem, solar, ahem).  There are plenty of good excuses for this, including the lack of an IPO window, the overall economy, and the fact that the major investment activity has only taken place over the last few years.  But lacking success stories, VCs lack good examples of what works in the sector.  And so many of the most ardently-felt and -stated opinions about investment models (ones that become conventional wisdom and accepted at face value by journalists and others) remain very untested.

3.  There are too many VC firms in general, and too many inexperienced teams throwing themselves at cleantech in particular.  That sounds more disparaging than I mean it to be -- I've met with many first-time teams that have very smart ideas and good backgrounds outside of cleantech venture capital.  Some will end up being the engines of the new creative thinking that we might be about to see in the sector.  But the fact remains that there are well over 100 venture capital firms that are focused only on cleantech venture capital, and then another couple of hundred that want to put money into the sector along with other venture sectors.  They can't all thrive, and in fact many won't survive their initial fundraising efforts.  But the number of these firms running around meeting with companies, with LPs, etc. is dizzying.  And yet at the same time, actual experience (much less track records) in cleantech venture capital remains tough to find.

4.  It's become conventional wisdom that the sector should focus on "growth stage" investments (although different investors have different ideas about what exactly that means).  On paper, at least, it appears to be the stage where the risk/rewards and the timeframe to exit fit best with the returns hopes of these investors.  However, as per point #2 above, it's completely uncertain that the exit multiples in industries like energy and water (where the market prices are often affected by the availability of multiple alternative solutions to what is essentially the production of basic commodities like kwh and drinking water) will be as healthy as these investors expect, since we haven't seen many such exits yet.  And the sheer volumes of capital being directed into this stage means that, in order to win these deals, many of these investors will likely end up overpaying for the opportunity.  It may seem less risky on paper, but the capital supply and demand dynamics in growth stage cleantech venture capital means that the efficacy of that kind of a stage focus is very much an open question.  Yet in general, according to the NVCA survey linked above, many more VCs expect to be shifting later rather than earlier over time.

5.  There remain some pretty major underserved "gaps" in the marketplace.  A) There's a gap at the seed stage, in subsectors within cleantech where the gestation period of an innovation is going to take longer to bring to market than typically meets the timeframes of even "early stage" cleantech investors.  B) There's a gap in "first of a kind" and "second of a kind", etc., project finance -- financing the build-out of a CIGS solar manufacturing facility, for instance.  VCs have done some of this, but it costs a lot and they're reticent to keep paying for steel in the ground.  Government dollars are helping to address this, but it remains (as always) a slow and uncertain source of such capital.  C) There's a gap in all of the non-proprietary-technology parts of clean energy and water markets.  Much of the business opportunity from any "clean energy revolution" (as some have termed it) will actually be captured by service players like specialized installers, consultants, outsourced service providers, etc.  But these types of businesses really don't fit the typical venture model, because it's tough to see huge exit multiples and tough to see how they scale quickly enough to provide 10x returns for VCs.  Yet they will make money as businesses, even if they won't do it in the specific model that VCs will look for.

What's the answer to all of the above?  To be determined, stay tuned.  But these are the kinds of challenges that I hear about from my fellow investors in the space, and these investors are often talking about this being a time to be innovative about investment models, investment structures, and the like. 

Of course, VCs are infamous for not really putting their money where their mouths are when it comes to changing the traditional VC model.  So we'll have to see if anything actually happens.  But if there's ever to be innovative new approaches that could change the way our industry does things, now would be the time.