VC Investor Lessons From the Past 12 Years: Exits

It's been a while since I've last had the chance to do so, but I always look to try to draw out lessons learned from successes and failures that I've witnessed firsthand in this sector over now something like 12 years of being a cleantech investor. In particular, over the past year or so I've gained a lot more of these lessons, for better or for worse.

There's an elephant in the room today for cleantech entrepreneurs, and it's this: exits are hard to come by. This is a major problem.

First, let's take a step back -- why are exits even necessary? Why feel forced to sell a good company? Why not just grow a profitable cleantech startup to the point of profitability and then sit back and reap a share of the free cash flows?

The answer is, unfortunately, "Because venture capital." If you structure a company as an LLC or simply as entirely capitalized with common shares, it's not an issue. But the go-to, basic documents for Series A rounds (and beyond) are geared toward investors only really making their returns in some kind of liquidity event for them. That's just the way it's been for decades. The assumption is that the VCs, with a finite holding period on their investments, need to push the company to be sold either to a single buyer or to the public markets. So in the document templates, the dividends are usually limited to 8 percent per year (and that's not the target return for these investors, by a long shot). And redemption rights and other protective provisions in the document templates give the investors great leverage for pushing the company to exit. This is just part of the deal when an entrepreneur decides to raise venture capital in its traditional form.

All of which is fine if the shared goal for both the entrepreneurs and the investors is to build a fast-growing company and then sell it within a single-digit number of years. There are many outstanding examples of how this ends up being a win-win for all involved. But it breaks down when the attractive exits aren't available.

Many a cleantech startup board has discussed how best to position their company for an IPO. But there are very few IPOs these days. So this leaves acquisition as the primary exit path. And that has not worked out very well either for many cleantech startups. 

If you build something valuable, someone will want to buy it, right? That's been the working assumption for cleantech venture investing for two decades now, and it makes sense on the surface. However, the real question isn't whether someone wants to buy something of value. It's how much they'll pay for it, and when. And the reality to date, in far too many cleantech startups, has been that likely acquirers aren't willing to pay much for the value they would be acquiring.

For many cleantech startups, the universe of likely acquirers has been pretty narrow, and they've been of a type of acquirer that doesn't want to pay up for valuable innovations. When we're talking about energy, water and related technologies, with some exceptions, they really haven't been of interest to acquirers with deep checkbooks and a willingness to pay up for "strategic value." I'm not talking about the tech giants of Silicon Valley or the big banks. Instead, for many cleantech innovations, the expected acquirers to date have been largely industrial by nature: chemicals producers, oil companies, industrial equipment OEMs, utilities, etc. 

There have been some exceptions over the years (I'm old enough to remember when every oil patch service company was desperate to acquire their own downhole optical sensor startup at any price), but for the most part, these types of acquirers have rarely "paid up" for anything.

• They have M&A teams that are evaluated by how immediately accretive their acquisitions are, which means they greatly favor profitable companies and are used to paying according to EBITDA multiples, not growth rates or revenue multiples, certainly not according to subjective assessments of strategic opportunity value. I've witnessed well-meaning corporate M&A staff trying to massage cost-savings assumptions at a startup so that they can validate a small amount of additional acquisition valuation on a net-present-value basis, attempting to justify a barely attractive acquisition offer. Which, of course, is already a losing situation for the startup's investors.
• They move slowly. And why not? As long as all of their peers move slowly as well, they won't miss any big game-changing opportunities. I saw a startup get deep into a process with a potential acquirer, over months of diligence, burning expensive and scant venture capital all along the way. Then suddenly, there was a change of heart at the acquirer and they backed away. As a result, as the CEO had to tell his main contact at the acquirer, the company needed to shut down operations, as they had run out of cash. "What?!" was the surprised response from that corporate contact. "I thought we could just pick up the conversation again next year!" Which, of course, is not how venture-backed startups work -- at all.
• They bargain-hunt. And again, why not? It just makes sense, if you are seeing a ton of tuck-in acquisitions (and they do), you can't tackle them all. So you will prioritize big "career-making" acquisitions (but these have to be very big and already profitable, in most cases, because "career-making" can so easily become "career-risking"), and then a few very obvious bargain opportunities among mostly distressed startups, where the prices are so low that the bigwigs at the company just sort of shrug and say, "Hey, why not?"
• They're often large enough to have some engineering team inside the corporation that thinks they can duplicate the startup's offerings anyway. This may or may not be actually true, but it makes it organizationally very hard to pay a high price for outside innovation.

It may seem like I'm disparaging these acquirers, but I most definitely am not. They make acquisitions this way because it makes total sense to do so, when you are in relatively low-growth industries and have relatively low margins, and are evaluated heavily according to your quarterly earnings. Huge "swing for the fences" acquisitions for such companies rarely make sense within that context, unless they face some kind of existential threat. These are smart people making smart decisions within their current context.

Contrast this to the Googles, Apples, etc. of the world. They are more attuned to the fact that they exist within rapidly evolving industries. They know they need to buy best-of-breed talent, top-notch innovations, and access to new markets or they will wither on the vine and become irrelevant. And they have a ton of cash anyway. So you see acquisitions made (at least sometimes) according to the logic of, "We have to have this!" instead of, "Well, what's the EBITDA multiple?" This is how Nest got acquired for $3.2 billion. This is why Facebook paid so much for Oculus, even before it had a fully commercialized product. It's why eBay bought PayPal. You can't justify these prices (c'mon, let's be honest) according to hard financial modeling. It's a "strategic acquisition." And they take place both at large scale like these examples, and at a smaller scale in less publicized ways. 

In a subsequent column, I'll talk about some of the other challenges of the venture capital model as applied to the cleantech sector. But the lack of attractive exits for cleantech startups is a major obstacle for making the venture capital model apply well in this context. If you raise $50 million in venture capital, for instance, your valuation is probably $100 million or higher after all that capital infusion. But there cannot be many $100 million or higher exits when the acquirers look like the industrial ones I've described above, with their unique motivations. So pretty much even the successful startups within this system have trouble making positive returns for their investors.

This creates some horrible dynamics. It makes investors and entrepreneurs push for unsustainably high growth (because hey, at least revenue should be rewarded even if innovation isn't, right?). It means that even mid- to low-case returns are lost in translation -- I've seen cleantech startups turn into a complete zero for lack of an acquirer, only to later hear firsthand from potential acquirers that they didn't move on the company because "we thought the price would be too high." Gah. And I've seen way too many startups' boards decide to put the company into a sales process, only to see the slow-moving acquirers stretch that process out until the company is out of cash, all the while saying optimistic things but never pulling the trigger. 

This will all change. It has to. These industrial acquirers are able to take this slow, low-priced path to acquisition now because they aren't forced to do anything else. But for many of them, the world is changing under their feet. This isn't just because of sustainability pressures; it's more a fact based upon "Software Eating the World" and their traditional businesses being risked by fast-moving software- and IT-based competition. Many now do, finally, face true existential threats.

• As behind-the-meter energy solutions proliferate, the lines between equipment OEMs and utilities is blurring. See, for example, GE Current, microgrids, and distributed solar.
• As lights and other equipment become more intelligent, effectively becoming little computers, the data challenges and opportunities are blowing up the industry. See, for example, Digital Lumens, which offers intelligent lighting -- but whose customers find the real value from such intelligence to often be much more than just lighting efficiency.
• As remote equipment becomes both more automated and more connected, traditional centralized plant equipment OEMs find their business increasingly cannibalized by upstarts offering the same services at lower cost, such as with Cambrian Innovation. 

As these traditional corporations find their core business models threatened by more rapid innovation cycles driven by IT, and in general by the massive market shifts underway in the energy, food, water, transportation, buildings, etc. markets, they're going to have to get more "strategic" and bold in their acquisition strategies. Or as illustrated in the case of Nest, they're going to see their businesses heavily impacted by the IT world.

What does Nest's acquisition by Google mean for Honeywell's building controls business, after all? So the "low and slow" acquisition market for cleantech startups is going to have to change. Thus, for example, the likely acquirer for a Digital Lumens, in my humble opinion, isn't a lighting company. It's a company that wants to do something much bigger with all that juicy data. But then where does that leave the current lighting OEMs, just selling commodity fixtures while IT vendors grab all the economic value off of that powerful network? Either they have to make the big change, or the big change will be forced upon them.

But when will it change? That's the key question for cleantech entrepreneurs today.