In defense of Vinod

During several discussions I’ve had with industry observers and fellow venture investors over the past few weeks, the topic of biofuels have come up, and those I’ve spoken with have mentioned “Vinod’s bad bet” on ethanol.  Their point being that Khosla Ventures and Vinod Khosla himself placed a number of different ethanol bets and then publicly backed that sector, which is now seen as being somewhat out of favor.

But that conclusion is probably off-base, in my opinion.

First of all, most of Khosla Ventures’ biofuels investments haven’t been first-generation (ie: corn- and sugar-based) ethanol, which is the specific subsector that is out of favor right now.  The jury is still out on cellulosic ethanol—people have strongly-held views both ways on the technology, but in the meantime most startups in the cellulosic space are still waiting to find out if they’ll have a good path to market and exit, they haven’t had to put up or shut up yet.  And many of the other biofuels bets in the Khosla Ventures portfolio, like LS9 and Gevo, are even further out in terms of tech and market development.  So it’s a bit unfair to point at just the corn-based ethanol and other first-gen bets in that portfolio and say that the verdict on their biofuels strategy is in.

And it’s also not quite clear that even the first-gen biofuels bets by Khosla Ventures haven’t been smart ones, from a strategic perspective.  Regardless of what the individual investments themselves look like, it’s important to recognize that Khosla Ventures has taken a different strategic approach to their investment thesis around biofuels than most venture firms take.  Khosla’s been happy to place multiple bets across a single sector, whereas many firms prefer to only place a couple of bets in any given sector.  Why be different?  Because of the special advantages Khosla has.  He’s writing his own checks, not having to report to an investment committee.  He has been actively leveraging his own personal brand equity and political access to bring government dollars and private sector attention to the ethanol story.

Most venture firms don’t want to end up having their portfolio companies compete against each other.  But by taking more of a concentrated approach to ethanol, Khosla Ventures appears to be betting that they can take advantage of a rising tide raising all boats, when they own half the fleet in the harbor (I overstate, but you get the point), and being able to combine those efforts when opportune.  And also betting that they can make the tide rise faster than it would have otherwise.  It’s a very specialized strategy that only works when a very quick and flexible investor with a lot of political access and brand equity can identify an investment thesis ahead of the crowd and take a strong early position in that sector.  And then, as Vinod does, speak anywhere and everywhere, and visit D.C. regularly, to make the case for the sector.  Hard work, but something many other venture investors couldn’t duplicate.

Such an investment/political/PR strategy also only works, however, if there are near-term jobs and revenues to tout.  Politicians need to see jobs creation opportunities in order to do their part of this kind of sectoral strategy.  Revenues and exits need to be seen in the near term by the press and the private sector before they’ll play their roles in the development of the sector.  So to effectively pursue this strategy, it becomes necessary to make some investments in first-gen players that are relatively close to market.  These first-gen players then become key examples to point to.  And even more importantly, perhaps, they can provide an eventual platform for the second-generation technologies that end up working the best, accelerating the paths to market for cellulosic players that would otherwise have to build capacity that would potentially be redundant to whatever first-gen players were already in the market by that time.

Long story short, you don’t need to believe in sugar- and corn-based ethanol as a long-term story in order to want to make a couple of bets on such companies, if you’re Khosla Ventures.  You just have to believe that the first-gen bets you’re making will be a good bridge for your second-gen bets.

The problem?  The market turned against first-gen ethanol much quicker than anyone expected.  A controversy about food and energy balances arising at almost the same time that oil prices drop precipitously and corn markets go out of whack.  Many people predicted some or all of these things would come to pass eventually.  I don’t know anyone who thought all that would happen in 2008.

Does that mean it was a bad strategy?  Nope.  And by the way, as per the first point above, their overall biofuels strategy may still end up making great returns anyway.  Political support and incentives for biofuels don’t seem to be going away.  And the sector continues to develop even as first-gen players fall out.

Vinod and Khosla Ventures certainly don’t need the likes of me to defend their biofuels strategy.  Plus, I’ve probably gotten it all wrong from their perspective, I haven’t discussed the above with anyone on that team, so I’m likely guilty of projecting my own views more than reflecting theirs.  But I thought this might be a useful case study to point out a few unique things about the cleantech venture sector, and put down my two cents’ worth.