At Canaccord Genuity's very good sustainability dinner in Boston this week, I had an enjoyable conversation with CG's Marc Marano, a leader on their cleantech team.  He told me about some pretty interesting data they'd pulled together on the solar industry.

We're all familiar already with what a down year 2009 was for financings, but perhaps no sector was harder hit than solar panel manufacturers.  Marc's team had pulled together a list of all the financings in the solar sector for the five quarters Q1 2009 through Q1 2010.  And looking over their tally, I see 18 follow-on rounds during that period to solar panel manufacturers or their suppliers.

Twelve of those rounds were insider rounds, often bridge financings.  And two of the remaining ones were led by a corporate investor not an institutional investor.

Basically, during those five quarters almost no VCs were writing big new checks to follow-on rounds.  They were backing their existing solar panel plays, and making small Series A investments.  Marc notes that things have been better since then (including a couple of deals his group helped), but still... 

It's a wonder we haven't seen even more of a shakeout than is already going on in that sector.  I suspect we'll soon start being able to tell eventual winners from losers with a little more clarity... 

As an active investor in the cleantech market I'm definitely hoping we can start to see some successful exits.  I, like others, am pining for a few successful IPOs with stellar returns that can be good beacons of hope for the rest of the sector's bets.  When there were practically zero venture-backed IPOs across all sectors, you knew there was a backlog of cleantech companies that were lining up to IPO and couldn't.  And of course now that the IPO window is re-opened slightly, it's not surprising to see venture-backed cleantech startups jumping in and filing to go public.

But why are THESE the ones that are doing so?  A123, Codexis, Tesla, Amyris, PetroAlgae, Gevo... Several with no or little revenue, really looking to 2012 or beyond for their significant revenue growth. Not all bad companies, that's certainly not my point, some on this list may end up being very successful.  But certainly not the exact same short list one would have come up with a year ago when guessing which companies would be READY (note: not WANTING) to IPO as soon as the IPO window reopened.  And certainly a couple of stories with some real hair on them.

So why these companies?  I'm increasingly believing that these companies aren't IPOing as a result of the same reasons dotcom startups were IPOing in 1999.  It's not that there's overexuberance, and investors and management are eager to put companies out into the market too early simply because they know they can get great returns from an overly optimistic stock market eager to get a piece of the Next Big Thing.  

No, these companies are IPOing because they pretty much have to.  The current investors are fatigued, new venture funders are hard to find, the companies are burning cash very quickly, and with the IPO window open getting another venture financing round from the stock market seems the best solution.  Even if the IPO isn't primed to "pop" and be a great IPO story.  And in some cases, when you dive into the details of the S-1, you see that the existing funders have put the company in a position where it's IPO or else...

These companies are also seeing their competitors file for IPOs, and they know that as a result these competitors are about to have good access to capital to go out and start the inevitable consolidation trend as the shakeouts continue in these sectors... So they want to also be among the acquirers, but are too low on cash, and so need to be able to tap into the public markets.

Plus, these companies are still struggling with that same old classic cleantech problem:  The first commercial-scale project.  For many biofuels, solar, battery and vehicle companies (ie: where VCs have mostly been placing their cleantech bets), no matter how capital-efficiently (or not) they try to get the company to be ready for commercialization, at some point they need to build out a large production plant, and project financiers won't do it for an unproven technology.  So these VCs have turned to (in order, as the options have dried up over time) other VCs, then hedge funds and "special" funds, then the government, then corporate JV partners, and now to public shareholders to supply the tens if not hundreds of millions of dollars necessary to build these first-time production plants.

So to paraphrase Obi-Wan, "These are not the IPOs you're looking for"... This crop of cleantech IPOs doesn't represent the upside of the sector.  I don't believe that the VCs are expecting that after taking into account this market and their 6-month lockup, an IPO today is their way to a massive IPO exit story.  

Unfortunately, this wave of such IPOs hides the fact that there are many other cleantech startups that are now generating revenue, are profitable or within sight of it, and are seeing good signs of rapid market adoption.  These are the companies that will eventually be the ones with the great IPO stories... but they're taking the "let's wait until we're clearly ready and the market's clearly ready" approach.  

It's almost a perverse selection bias -- many of the best IPO candidates are waiting for better market conditions so they get the best exit, leaving companies that are worried about falling behind or falling out to slip out the IPO window while they can...

I just hope in the meantime, these early IPO stories don't muddy the water too much for the sector.

[Note: While I don't have any direct exposure to any of the aforementioned companies, it's worth noting that I have indirect exposure to some of them]

One thing that non-VCs typically don't have a good understanding of is how different venture investors view the risk versus reward tradeoff when it comes to managing portfolio companies.

How do VCs get compensated, besides salary?  "Carry", a/k/a profit-sharing.  And except in very few cases, carry on an entire fund, not on a per-deal basis.  Everyone in the industry is familiar with the studies that have shown that fund performance is typically determined, at least on the upside, by a handful of deals across an entire portfolio.  In other words, 1 or more really big wins drive all the performance.  And, by the way, 1 or more really big wins really drive a VC's career as well, because of the visibility they bring.  

It all sets up a dynamic where individual VCs, and overall partnerships, are motivated not to try to produce steady returns across an entire portfolio, but instead to try to maximize the slim chance that each deal becomes a blockbuster.

Let's put some really oversimplified math to it:  

$100M fund, 10 portfolio companies, each with $10M committed.  If each one creates a 2x outcome, that's $100M in return.  But if just one company creates a 10x outcome, then you could only break even with all the others and still come close to creating the same return ($90M).  If you get two 10x outcomes, or one ten-bagger and one 5-bagger, then the VC fund is sitting pretty almost regardless of what anything else in the portfolio does.  

This has a lot of implications for how VCs typically manage their portfolios.  To overgeneralize a bit:

First of all, it explains why VCs would so often pass on investment opportunities with good chances to double or triple their money.  Not that any one as an individual would pass up on the opportunity to double or triple their own money all things being equal, but if you're more motivated to find the 5-10x opportunities you'll pass up on attractive but smaller ones.  I interact with entrepreneurs all the time who have good solid businesses with good growth prospects, and yet they're frustrated at their inability to get VC interest.  Basically, this is one major reason why that happens.

Secondly, it means VCs will spend more time on their portfolio companies that are doing well, versus the companies that aren't doing well.  If they can help turn a 3x outcome into a 10x outcome, that's worth a lot more to them than working hard to turn a 0.3x outcome into a 1x outcome.  Many VCs I know have a hard time sticking to this rule, because at the end of the day as individuals with personal relationships and a sense of obligation they want to help out all their companies as much as possible, but the more hardnosed VCs will admit that this is how they try to spend their limited available time in portfolio management.  I've even heard of some big-name VCs who simply stop showing up for board meetings once the company gets off-track.  

Thirdly, it means that around the boardroom, many VCs will tend to push their companies into riskier situations when it means a better likelihood of an upside outcome.  Let me illustrate:

If the VC starts out with each company having a 30% chance of a 0x, a 30% chance of a 1x, a 30% chance of a 2x, and a 10% chance of a 10x, then if they can shift that to be 50% chance of a 0x, 15% chance of a 1x, 15% chance of a 2x, and 20% chance of a 10x, that can end up being a better odds-weighted return.

But note that, to the entrepreneur, that just became a much riskier scenario.  

How does this play out in reality?  Well, the other day someone was telling me about one cleantech company with two big-name generalist VC firms as investors.  And they were describing how, around the boardroom, there had been major disagreement between the two VC firms -- one wanted the company to be burning several hundred thousand in cash per month, the other wanted the company to be burning more than a million in cash per month.  With the real disagreement being around how quickly to push the company to bring a commercial product to market.  This is a natural outcome of all of the motivations described above, along with an expectation that one way or another these brand-name VCs could attract additional follow-on capital into the company if and when it ran out of cash.

On the other hand, I know that many of the "original cleantech crew" of sectoral specialist VCs, and some other specialist and generalist VCs with lower-risk approaches, tend to want the companies to get to cashflow breakeven as quickly as possible.  And thus they want to keep the company expenses lean.

I typically favor that last approach (albeit on a case by case basis).  I just think in slow-moving cleantech markets, rushing a product to market doesn't have the same likelihood of creating customer uptake and first-mover advantage as is often seen in other technology sectors.  So you can easily put a company in a high cash burn situation to successfully bring a product to market, and still fail.  Venture capital is risky enough, without adding further risk into a company... 

But no one knows which approach is truly best for producing investment returns.  In the boardroom anecdote above, those investors were deeply experienced and VC-savvy (certainly more so than me), and not dumb about cleantech either.  And until we see a wave of exits, no one in this industry will have proven that they know how to consistently make money.  So the right risk/reward tradeoff approach to cleantech venture investing remains a very open question.

However, to those out there urging that major amounts of government dollars be simply handed over to VCs to invest as they see fit... Make sure you really understand and are comfortable with all of the above dynamic, and what its implications would be for the successful commercialization of a broad range of clean energy and other technologies.  I am absolutely a strong proponent of government support for commercialization of clean technologies.  But not as a carte blanche to VCs... 

Happy tax day, everyone. 

Silicon Valley Bank put out a must-read study yesterday, examining returns from more than 850 VC funds in the U.S., looking specifically at returns by fund size.  And what they found out was that smaller funds do better than larger (>$250M) funds.

This won't be a surprise to some limited partners out there that I speak with, in my current dual role as both an LP and direct investor.  These LPs see smaller funds as being more focused and hungry.  As the SVB report states:

"Managers of [small] funds often have industry-specific expertise and focus on particular strategies or sectors compared to those of larger funds which usually target multiple stages and sectors.  Small funds tend to have a strong general partner commitment, which heightens the alignment of interests with limited partners and potentially increases investment discipline."

Smaller funds also are less susceptible to the kind of minimum check size restriction I described in my last post, with its implications for capital efficient investments.  I caught a little bit of grief from some colleagues at smaller funds after that post, because they thought I was talking about ALL venture capital firms getting caught up in check size inflation, but really I was only talking about the larger funds and their need to shovel dollars out the door.  Indeed, this SVB report adds further support to what I was talking about -- with smaller VC funds, you can put less dollars at work in a single investment and still get the kind of outsized return that can "make the fund".

So if smaller funds are so great, why don't they get more favored by LPs?

First of all, their performance is probably more volatile.  The SVB report focuses on the portion of funds that returned high multiples.  They state that smaller funds (those under $250M) were seven times more likely to provide a 3x return or better to LPs, than larger funds.  But that's 22% vs. 3% of each population, respectively, so the comparison leaves out a lot of lesser performances.  In their study, more than a third of smaller funds returned less than 1x, meaning they lost money for LPs.  Of course, in the pool of larger funds, more than HALF lost money!  But it's unclear from their report how many of each category lost a LOT of money versus losing a little bit.  LPs may be more willing to back a larger fund that has a more limited downside, than a smaller fund that could end up with more volatile results.

And what's also true is that smaller funds tend to have less experienced managers.  Most first-time funds will be under $250M, naturally.  And LPs are often leery of first-time managers.  I've spoken with some accomplished LPs who take an opposite approach, but generally speaking LPs have a difficult time determining the caliber of a first-time fund's managers, lacking a track record to refer to.  This obviously is related to the volatility/ downside point from above as well.

And furthermore, someone did the limited partner community a great disservice at one point by doing a study showing that top quartile performers among venture managers tend to stay top quartile performers over multiple funds.  I'm sure the study was totally valid and accurate, albeit backward-looking.  But what that study did was provide all the air cover any LP manager ever needed to simply pile capital into any big-name venture firm's latest huge fund.  It'll be interesting to me when that study is eventually revisited, to see if the effect remained valid over time, because I believe it provided fundraising momentum to larger funds that encouraged them to get unsustainably big and drift in their investment strategy, in some cases.  In the fund size retrenchment SVB identifies, I believe we're seeing the results of this.  But that having been said, there are certainly some large funds that have figured out how to make money at that scale -- as the SVB report shows, less than 10% of large venture funds returned 2x or better, but in that small group I bet there's some repeat performances by the same very few fund managers.

Finally, many LPs are of such a size that they really can't engage with small fund managers.  If you are managing a multibillion dollar pension fund with hundreds of millions of dollars allocated to private equity, can you really afford the time to identify, evaluate, and manage a $5M or $10M commitment to a small, specialist venture fund?  Some can, but many don't have the bandwidth to do so.  It's the LP analogy to the venture fund size dilemma I mentioned in the last post...

So smaller funds are, according to this SVB study, a better bet for LPs.  But LPs still find it hard to effectively engage with smaller funds, as a rule.

What does all of the above mean in cleantech in particular? 

It helps explain why cleantech-interested LPs have been drawn to larger cleantech funds, and large generalist funds who are getting active in cleantech.  This has exacerbated the shift over time toward more growth stage cleantech investing, and away from early stage cleantech investing (although there are some signs this shift has mitigated recently). 

The study suggests, however, that investing in smaller cleantech specialist funds may be a winning strategy for LPs -- if they have a rigorous way to effectively identify, evaluate, select and oversee those venture managers.  We'll have to wait and see if LPs actually do this more often.  But I believe they should.

And kudos to the team at SVB that did this study.

"My job is to look for entrepreneurs who want to change the world," one young cleantech VC told me in an engaging twitter conversation last night, "and build bigger companies."

Very true words!  But how do we define "bigger companies"?

I've seen someone mention that only two percent of startups get their financing from venture capital.  I don't know the accuracy of that number, but it does ring directionally true.  That doesn't mean 98% of startups are bad businesses, however.

Let me describe two basic types of startups:

1. The big game-changing startup that is going to be manufacturing or otherwise producing something very new.  They're going to need some significant level of capital in order to accomplish this, because R&D and commercialization efforts and then production capacity don't come cheap, but they do come before revenues. 

2. The small local startup that is going to be a nice personal business, perhaps growing over time into something a bit bigger.  These tend more to be service or retail companies going after an established market, perhaps with a new twist.  These can be really compelling businesses for the entrepreneur, and if pursued in a lean way they won't require millions of dollars to get started.

The first type of company is the purview of VCs like the one I cited above.  The latter type of startup is the one that is classically self-funded by the entrepreneur (and their credit cards), as well as friends and family, and perhaps a community bank.

But what about the companies in the middle?

Let's better define the upper end of the problem...  What many entrepreneurs often don't realize is that large VC firms typically have a pretty significant minimum check size they'll write -- quite often the bar is set at $2M or $5M, depending upon the firm.  Even funds that will do smaller seed stage checks need to see enough capital intensity in the model that they'll have the opportunity to put significant money into the company over time.

Why?

Simple math.  The larger the venture firm, the more pressure to put significant dollars at work.  And the single most limited resource for that company is the time of the partners in the firm.  Each company in the portfolio requires time to manage, whether they hold a Board seat or not.  And there are often companies in the portfolio from previous funds that haven't exited as well.  They can't have a 100 company portfolio and claim to be "value add" with a straight face.  So these larger funds are pressured to invest only when they see the opportunity to put significant dollars in either up front, or over time.

In other words, IRRs are not enough.  If you have a $400M fund, and you put only $1M into a company, even if that returns 10x it's nice but not going to move the needle in terms of aggregate fund returns (not to mention the chances for glory for the GP who did the deal, btw, which is no small consideration for some).

You can't just add more partners because GP salaries and support staff have to be paid out of the management fees, typically 2%.  So this is why most large VCs I speak with -- even early stage and seed stage ones -- tell me they need to see the potential to put something like $10M into a company over time, at a minimum.  

That's a long way of explaining why VCs need to see some level of capital intensity in a startup before they can get involved.  And yet, if a company is going to need $1-3M of capital over time, that's probably too much for credit cards and friends and family to support. 

Where does this all hit in cleantech?  In Web2.0, people are already used to capital efficient businesses, so they've had to invent efforts like Y Combinator to compliment the bigger check-writers in the space who won't touch certain sized deals.  But in cleantech the gap remains.  If you are trying to develop something like a new solar cell, or a smart-grid network, or a new LED chip or fixture, that will require some significant capital before you get to cashflow breakeven.  But what if you're just developing something purely software-based?  Or a scalable service model?  If managed well, often these won't require such large amounts of capital.  And yet they can grow to be decently-sized businesses, even if they probably won't be the "Google of cleantech".

For outside observers tracking cleantech VC dollars, to a certain extent the reason they tend to declare that ALL of cleantech is capital-intensive is because they see all the VCs flocking to capital-intensive businesses because of the above dynamics.  Even in areas like energy efficiency and smart grid, where VCs now say they're interested because it's less capital-intensive, they typically are backing businesses that will "only" require tens of millions before an exit, instead of the hundreds of millions that have been required for some of the bigger named startups that were the focus a couple of years ago.

But there are indeed truly capital-efficient businesses in cleantech.  I get contacted by entrepreneurs all the time who are only looking for $1-3M or so to get started.  They're entrepreneurs, and they read about certain high-profile VCs who are interested in cleantech, so they reach out to those investors to raise their funding.  They have a business that, with a little bit of money, might turn into a $20-50M company, resulting (they believe) in very nice IRRs for the investor with such a light capitalization.  In many cases, they may already have significant revenues, and they just need a little bit of capital to hire up some more sales and implementation teams, or to shore up the balance sheet.

And then they're surprised they can't get any big name VCs interested.

In some cases, these entrepreneurs are simply underestimating the amount of capital they'll really need -- I'll write about that sometime soon as well (short version: take more money than you think you need, especially in the current fundraising environment).  But there are a lot of solid service, software, web-based, etc. cleantech businesses out there, that are having real trouble raising the capital they need.

It's a serious capital gap, if you care about more than just innovation in cleantech -- if you care about actual near-term implementation.  Because these businesses are the ones positioned to make an impact today.  To go back to the initial quote, these are companies that are poised to change the world... even if they're not poised to become a "big company" of the massive scale that young VC thinks he needs to see.

If you are one of these entrepreneurs, however, there are some underexplored options you should focus on instead.  Don't waste your time with the big-name firms who structurally won't be able to engage with you.  Instead, look to regional, smaller VCs -- such as the network of Village Ventures firms.  Reach out to local angel groups, and local smaller family offices.  And if you are indeed already at a revenue stage, local commercial bankers may be able to do a venture loan alongside any equity you might be able to bring in.  In other words, don't waste your time flogging your plan up and down Sand Hill Rd., spend your time networking locally to find the investors in the right check size range.

My point isn't to knock the perspective of the VC I quoted at the beginning of this overly-long column.  He's looking for a certain profile of investment that is right for his firm's size and strategy.  And I'm certainly not saying there aren't big-dollar VCs who won't write smaller checks.

But as this same VC wrote elsewhere in the conversation, "VCs want to be involved if the entrepreneur wants to build to a big outcome.  If you are happy selling [your business] for $20M, surely go to angels."  A snarky comment, but I would say it's completely valid at the $50M exit level and below, not $20M.

When the average venture-backed M&A event is well under $100M, a $20-50M exit can be considered a real win for the vast majority of startups.  Entrepreneurs need to acknowledge to themselves when their business is most likely going to be a <$50M exit down the road -- if it even exits at all, it may instead become a cashflow producer for the entrepreneur and angel investors.  That's NOT a bad business.  It can be a phenomenal business that makes the entrepreneur and angel quite wealthy, and makes a significant impact on their community. 

But it does mean you have to be smart about what types of funders you approach when you need startup and growth capital.

We're going to look back upon 2010 as a time of major change in the cleantech venture industry.

I haven't heard yet of many established specialized cleantech venture firms scaling back, but it will happen, starting this year.  Certainly there have been a few of the more fledgling efforts to create new specialist firms that have floundered due to the bad fundraising environment over the past 18 months.  And now we're seeing scale-backs at generalist firms (such as Atlas Venture, and Polaris which PE Hub is reporting is raising $500M for their sixth fund, versus $1B for their last one).  As generalists shrink their funds, some are doing more cleantech, but many are going "back to their core" in IT, etc. 

In the Boston area alone, I know of at least a half-dozen VCs who were doing cleantech when I moved out here, who are now either not doing new cleantech deals, or had to change firms, or are not even in the venture capital business at all anymore.  There have been a couple of additions to the community in the meantime, but not enough to make up for the exodus.

This means there are potential gaps in the marketplace (early stage cleantech venture capital in New England is starting to seem especially scarce, for example), but in this fundraising environment, not many new efforts are able to launch to fill in the gaps.

Meanwhile, as we've talked about here for a while now, lots of investors are continuing to re-evaluate the way the venture capital model has been applied to cleantech overall.  Some of this will result in new thinking and new approaches.  Some of which will work and some of which won't.

But overall, it just feels like a time of serious transition.

I'm at the Clean Tech Investor Summit on the west coast this week.  It'll be interesting to see how much my Boston-based perspective is reflected in the cleantech venture community out here...  If I can, I'll try to tweet a bit from the proceedings.

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And speaking of cleantech investors, here's a good interview with Chuck McDermott, one of my favorite guys in the business.

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And speaking of venture capital [total data wonk alert here, read on at severe risk of additional boredom], I saw an interesting article on PE Hub talking about one investor's study purporting to show that venture capitalists with less than 10 years' experience do better -- the implication being that there's a level of experience VCs may get to where they actually become WORSE investors. 

The article says that they examined nearly a thousand VCs' track records, and then looked at the 35 who had produced a "good track record".  Of those 35, the VC who did the study says, "more than half of them have been in the industry for 10 years or fewer".  I love numbers, so this caught my eye.

So first of all, if you look over the track records of 945 VCs and find only 35 with "good" track records... talk about an indictment of the industry. 

Secondly, what proportion of those 945 VCs had been in the industry less than 10 years?  If it's anything close to or more than 50%... have we really learned anything?

And finally, what about the fact that in the beginning of the last decade, a lot of VCs' track records followed the industry's overall collapse in IRRs?  Point being, there may be some underlying factors here having nothing to do with age or experience.

I'd love to see the actual study, obviously it looks interesting but I also have a lot of questions...

2010 may be looking up economically (although I'm personally feeling like we're headed for a double-dip, but let's stay optimistic), and yet 2010 may not be as happy a fundraising environment for cleantech startups as many would hope.

Why?  Because there's a lag between when venture firms raise their capital and when they can deploy it.  And 2009 was the worst year for VC fundraising since 1993, according to the NVCA (note: link opens pdf).

Only about half as many funds successfully raised money as we've seen in other years of the past decade.  And the dollar amounts dropped similarly.

VC funds are typically raised in a fairly consistent two to three year cycle.  So when you see a drop-off like this, it means a lot of firms pushed off fundraising until things picked up.  Which means there are a lot of firms that were due to raise funds in 2009 that instead decided to wait.

These firms will have to go out and raise new funds soon.  The cycle can only be pushed so far out for many funds, before their internal dynamics get squeezed.  Fund fees typically decline over time, meaning that the operating budget for the firm goes DOWN if they don't raise a new fund.  So unless they're going to start shedding staff, either the delaying firms will need to raise new funds in 2010, or the GPs will have to take pay cuts.  Probably a mix of all of the above...

The easing denominator effect for LPs and other LP dynamics probably means that GP fundraising will indeed be easier in 2010 than in 2009.  But even if all goes well (and I'm not saying it will), it'll still mean a lag time before those new funds get up and running.  Meanwhile, all these firms are running out the string on their last fund, and many are thus out of dry powder and unable to do many, if any, new deals (most will be reserving capital for follow-ons with existing portfolio companies, fortunately).

So what does this mean for entrepreneurs?  The trickle-down effect doesn't look good right now.  At least for the first part of the year, it will mean it's still very tough to raise outside capital.  Expect to see yet more insider rounds and bridges.  And expect to have to take a lot more meetings (the GPs will need to be seen as still being "in the game" so they'll still take meetings) before you land a funder.  Follow the money, and watch who's actually doing NEW deals (not just follow-ons into their existing portfolio companies), they'll be the best targets.