Why cleantech venture investments fail

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

• The technology being developed by a startup may just plain not work.  However, this happens a lot less frequently than journalists' coverage of the sector would have you believe.  VCs are typically smart enough to want to see technical proof of concept before making an investment.  So they won't invest before, at least in the lab, the bugs make the fuel, or the device makes some power, etc.  So while there are undoubtedly some examples to be found of venture-backed innovations that simply failed to work at a conceptual level, none come to mind.

• The technology works in the lab, but takes too long to scale up to a point where the economics work.  This happens a lot more frequently.  The bugs make the fuel, but even after a lot of effort they can't make the fuel in sufficient volume to achieve a low-cost position versus incumbent fuels.  The solar cells produce power, but not at a high enough efficiency, or low enough production cost, to achieve a cost competitive result.  This is tougher for a VC to diligence, and is somewhat un-knowable from the beginning anyway.  There have even been companies that have gone public in the past who have subsequently fallen short because of this factor.  Certainly in solar and biofuels and a couple of other sectors, there are examples where VCs ended up seeing their investments go toward technology maturation efforts that haven't panned out.  Some of these efforts have been significant, in terms of dollars and time.  However, the VCs I speak with are getting much more cautious about this.  Once bitten, twice shy.  This kind of failure is one of the major differences between cleantech and other venture sectors, and being able to identify promising lab-scale or even beta-stage techs that won't be able to "graduate" to commercial scale very easily has quickly become a very specialize skillset among investors, and a vital one.  

• The technology works, but something better comes along.  This is another factor that really hasn't been seen as much to date.  The market needs are so intense, and so much that's gone on remains pre-commercial, that even when a technology is on a "dead end path" many of the companies developing them have been able to transition to a new approach, or target their innovation to a better-suited (albeit smaller) market opportunity, so we haven't seen too many examples yet of venture-backed technology efforts that have become completely obviated by new innovations.  However, this will start to happen more and more often, as the markets continue to mature and commercialization leaves some efforts by the wayside.

2.  Market

• The dogs won't eat the dog food.  Cleantech is typically an engineering-led sector, where innovators come up with a new solution that would appear to provide superior economics (price and/or performance) versus incumbent technologies.  But what VCs have been quickly learning is that many of the purchasing decisions in the sector are not overtly driven by economics.  A superior building efficiency solution, for instance, may not gain purchase in the market when the target buildings are owned by one party but occupied by another.  In many markets, even if the new solution provides a cost advantage over the status quo, the purchasers may have bigger things to worry about and thus may be unwilling to let bigger issues be risked by a more minor cost-saving opportunity -- this can happen, for example, in industrial markets, where the facility manager would rather continue to pay a higher cost for energy, rather than take a risk that a newer "low cost" energy solution could disrupt their factory's production.  Or it may simply come down to lack of awareness.  Homeowners may rather pay for expensive bottled drinking water than to adopt a new in-home drinking water treatment technology that would achieve the same results.  For example.  All of which are examples of markets where "better" innovations see much slower adoption than VCs and entrepreneurs have expected at times in the past.  However, this is another factor where investors are starting to get more cautious when selecting investments.

• Existing solutions may be "sticky" because of existing infrastructure.  This is a very important factor across a number of energy, water and materials markets.  The innovation that a VC backs may make good sense from a technology and economics perspective assuming an agnostic infrastructure, but that's rarely the case.  A fuel cell car needs to find an H2 refueling station.  Ethanol infrastructure doesn't co-exist perfectly with incumbent gasoline infrastructure. Biomass-gasification efforts require a new waste processing infrastructure that may not exist in many cases.  Net metering has been an issue for solar PV installations in some places.  Etc. Cleantech investors are learning just how important it is to consider the entire value chain before making a bet in one segment of it.

• The hoped-for market never materializes within the investment timeframe. This has tripped up more than a few overly optimistic entrepreneurs and investors, as the hype around a new market (for example, electric vehicles in the US) gets out ahead of the actual market development.  The technological innovation may be superior, the market need may be clear, the economics may be favorable... and yet it still just doesn't happen very quickly.  So the investors find themselves backing a company going after a small market niche instead of being the "next Google" of some anticipated market revolution.

3.  People

• Gaps in the management team skillset.  It's rare that a startup will have a fully-baked management team in place as of the time of a venture investment.  And it's even rarer that such a management team will have the right skillset to see a startup through from inception to exit.  So VCs are used to working with founders and management teams to insert new managers at all stages of a company's development.  However, it's still not a skill that most VCs are good at (and yes, my house is made of glass as well).  So I have seen numerous examples where an early stage CEO didn't step aside at the right time, and the delay in finding the eventual right next CEO ends up being hurtful to the company's commercialization efforts.  Even worse, some CEOs have seriously over-promised and then under-delivered, seriously hurting the company in the eyes of prospective customers, business partners, and follow-on investors.  Or below the CEO level, the failure to bring in the right manufacturing and operations expertise, or especially the failure to bring in strong sales management at the right time, can mean commercialization delays and slower than anticipated sales growth.  And with a venture investment, the pace of growth is critical, for cashflow reasons described below.  Note that even though I am describing this as a failure of management, the blame lies with the VCs, who ostensibly have the skills and pattern recognition to identify and address such gaps before they become a problem.  Nevertheless, I still see it becoming a problem quite often.

• Management teams that don't know how to use their Board.  Venture capital is a pretty unique and opaque industry, so many first-time venture-backed entrepreneurs don't really know how to use their Board for maximum benefit.  They may view their investors and their Board as an unnecessary group, or worse as some "dumb money" parasite that's only along for the ride.  This is especially true when the management team are serial entrepreneurs but first-time venture capital recipients -- they know how to grow a startup, but don't really recognize the demands and capabilities that come along with a VC investment.  Which can be a problem, because it can affect growth path, ability to raise more funds, etc.  Venture capital is very expensive capital.  It only makes sense to take in venture dollars (as opposed to angel or other early stage funding) if the amount of capital needed isn't available elsewhere, or if the benefits the VCs can bring make the costs worthwhile.  Thus, VCs pitch themselves as being "value-added investors", and most do mean it, bringing pattern recognition, networks for customers and for hiring, PR, access to expertise, etc.  When it works, it's truly a partnership, not just a financing arrangement.  Nevertheless, I have seen a few management teams who have taken in venture dollars but then attempted to keep their Board at arm's length, and it never ends well.  Alternatively, the management team may overly buy the "value-add" pitch from their new investors, and expect the VCs to deliver customers and business relationships on a silver platter, but it's never that easy.  Such mismatches in terms of expectations between management and investors can really mess things up.  It's perhaps more of an issue with cleantech, since so many of the innovations and entrepreneurs are found outside of the typical VC-heavy regions, so you get a higher proportion of experienced entrepreneurs who haven't dealt with VCs before, so both sides walk in with entrenched and yet divergent expectations.

• Investors who push for a more capital-intensive growth path.  Many VCs only make an investment if they see huge returns potential to the opportunity.  This means that, when they make an investment, they expect the company to achieve very big, very fast growth.  And for some, the solution has been to throw more money at the situation.  If higher cashburn can lead to bigger engineering teams and more salespeople, the theory goes, then the company can get to market and grow faster than the competition, so go ahead and raise a big round and then spend that money.  But of course, for all of the reasons described above, there's often at least one additional limiting factor that more money cannot solve.  It may be a slow-adopting market, it may be a tricky technical issue going from the pilot line to full scale production, etc.  But no matter what the immediate cause is, the fact remains that in cleantech, higher spending often doesn't speed up development and growth.  But now the company is locked into burning significant capital.  Which not only means they run out of money ahead of necessary milestones, it also makes it tougher to raise new money.  The larger round the last time around probably meant a higher post-money valuation, which means valuation expectations for the next round are high.  But new prospective investors are asked to put money into a company that is burning cash quickly, with missed milestones, at a high valuation.  It may be the entrepreneurs who pushed for a high cash burn model, but in many cases the investors are really the ones driving that kind of model.  And it's been a very important failure factor for many unsuccessful cleantech venture investments.

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...