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Year end thoughts: Why good technologies don’t get funded

Rob Day: December 31, 2005, 6:55 AM
As with the previous year-end thoughts column, this post will depart from the usual relayed news updates to provide one man's conjecture, and thus should be read with a lot of caveats attached...

One common complaint from entrepreneurs is that their compelling technology isn't getting the attention it deserves from the venture community. They have an advantaged technology, a strong management team, and huge market potential -- so why is it proving difficult to raise VC funding?

Amidst all of the increasing capital flowing into cleantech, and talk of finding the "next Google," it's easy to forget that there are some significant differences between many clean technologies and traditional VC-backed tech areas. Some of the differences are gaps that are quickly narrowing, if not already bridged: Strong entrepreneurial leadership, significant M&A activity, etc. Cleantech already has developed, or is rapidly developing, these and other key success factors.

One feature that is unlikely to change, however, is the industrial-equipment and project-based nature of many clean technologies. In contrast to technologies such as software, Internet services, biotech, etc., many clean technologies are material-intensive mechanical devices (or their components). Successfully introducing such devices requires significant inventories, right-sized manufacturing capacity, and appropriate sales models. Even in comparison to other similarly manufacturing-intensive VC-backed tech areas such as hardware, telecom equipment, medical devices and semiconductors, the heavy industrial nature of clean technologies such as water treatment equipment, electricity generation and transmission equipment, etc... is distinctive.

Furthermore, unlike those other manufacturing-focused traditionally-VC-backed industries, in many cleantech markets the major buyers of the technologies haven't yet demonstrated rapid adoption when presented with an innovation that is "evolutionary, not revolutionary." So that investors can't be assured of very fast penetration of a winning new technology throughout the target market, even if eventual market adoption appears likely.

This is, of course, an over-generalization. There are plenty of clean technologies that are not capital intensive, there are plenty of rapidly-adopting customers of clean technologies, and certainly there are innovations in cleantech that all would agree are revolutionary, not evolutionary. But as a generalization, these two factors (capital equipment, and less rapid adoption) help explain a few key unique challenges for both cleantech startups and cleantech investors.

There is a lot of venture-backable dealflow in cleantech, and it appears to be increasing over time, just witness the statistics that show the capital is flowing in. However, what I want to address is why I have also seen compelling clean technologies that have had trouble attracting venture capital investments.

First of all, venture capital and capital equipment manufacturing, regardless of industry, are often a difficult fit. Venture equity is very expensive. Thus, VCs need "scalable" investments -- ie, if a VC is looking to achieve targeted returns from their investment, they need to see a company that is poised for stratospheric growth. For software, once the code is written, every incremental sale comes at a low marginal cost. So the scalability is limited only by the company's ability to sell and implement product. Additionally, recurring revenue is a standard part of the industry's business model, through annual fees. So the very expensive VC capital can go primarily into R&D and sales and marketing, and (if the company and their product are successful) drive strong growth. Even for a hardware company, if the industry is one where rapid adoption of new innovations is commonplace, then the anticipated growth may warrant using venture capital for other purposes as well.

Contrast this with a company that has developed a new water filtration technology and is looking for capital to sell equipment to slower-adopting end users. Assume it is a clearly advantaged new technology, targeting a very large market, with good exit potential, strong management team, etc., so management feels they present a strong investment opportunity. They are planning on deploying some of the capital toward the classically "scalable" sales and marketing and R&D efforts. But some will go to parts and other inventories so as to be in a position to supply increasing demand for the equipment. And if the company is looking to develop a recurring revenue stream from their equipment, by for example leasing the equipment to customers instead of a one-time sale, then they'll need even more working capital to build up and carry a fleet of assets as well.

In a few cases the growth potential will be strong enough to warrant venture equity financing of all of the above. But for many cleantech innovations, even if they are compelling technologies with strong value propositions, VC may not be the right fit for 100% of financing needs. Thus, it's important to remember that there are other forms of capital potentially available as well (emphasis on "potentially").
  • Depending upon the stage of the company and technology, angel and/or strategic partner funding may be attractive.
  • Venture debt (sometimes called "technology lending") may be available.
  • For proven technologies going into large projects, project financing can be tapped.
  • Customers may be willing in some cases to supply financing or pay up-front fees.
  • Also, and increasingly used, it may be possible to do a go-public move through a reverse merger with a shell company that is already listed (or through a similar process). Feelings are mixed about this approach, which is a topic to be addressed in another post.
  • There are other forms of financing that can be tapped as well.
The key point is that venture capital -- specifically, equity -- is not necessarily the right fit for a lot of great innovations. Venture equity financing is perhaps the single most expensive form of capital available to companies. And yet, companies with new innovations tend to look to VCs first. And then there is frustration when there isn't a fit -- financing the effort with pure venture equity doesn't provide the requisite returns, so the company finds doors closed to them, even when there is a strong underlying technology and business.

My personal thought is that there is a need for more technology lending in cleantech. In the above example of the water filtration company, a combination of venture debt financing (convertible, and secured via assets and inventories) and venture equity financing may be a good fit, if the technology has been proven. There are a few emerging such lenders, including GE Technology Lending and Blue Hill Partners among several others. Some VCs are even starting to look at doing convertible debt financings themselves. But from my perspective, it still appears to be a bit of a gap.

The venture debt and equity bundle is not a perfect solution, and there is no one-size-fits-all. Many VCs wouldn't want to invest in any transaction involving debt, which would subordinate their own investment. The specifics of the technology and company may not lend themselves to venture debt. And in almost all cases, such a transaction would require a company which had already largely proven out its technology, it is not a "beta stage" vehicle.

So take this for what it's worth. But in an era when the pundits are lamenting the available opportunities for private equity investing, and when clean technologies are in the ascendency but remain unique in certain respects, it is not surprising and v ery welcome to see the emergence of clean technology lenders to work with clean technology equity funders. The more types of funding available to cleantech startups, the more likely there will be the right fit for each financing need.

Year-end thoughts: Solar and the long tail

Rob Day: December 26, 2005, 2:01 PM
In the next few days we'll try to provide some year-end thoughts on various cleantech investing topics. Importantly, unlike many of the other notes on this site, these are conjecture and opinion and not the usual passed-along news updates, so read them with all due skepticism.

First and foremost, we pretty much have to start with solar.

According to numbers from an AP/ Dow Jones report (with figures from the NVCA), solar VC investments reached $67.7M in the first three quarters of 2005, as compared to $31.4M for all of 2004. The AP and Dow Jones also report that solar made up more than a third of all energy VC investments so far this year. Regardless of the specifics of the numbers, solar is without a doubt the hottest cleantech investment area right now (if you'll pardon the pun).

Relative to the billions-of-dollars-per-year market that solar power is fast becoming, the amount being invested is still a small amount. But it's important to recognize that almost every investment in solar technology (with some rare exceptions) is someone making an investment in a proprietary generation technology, all from the same basic source of energy - the sun. A natural assumption would be that for any given energy-generation situation (ie: rooftop panels), there will be one single most economic technology. With some solar investors declaring that they are "looking for the next Google," it is tempting to think of solar technology as a zero-sum game, with one winning technology (perhaps already invented, perhaps not) and a lot of lesser approaches that will either be subsumed or that will outright fail.

Consider that this year there were at least 10 different solar-technology venture fundings (probably a lot more, just did a quick scan), plus other IPOs, plus the presence of well-established major players such as GE and BP Solar, etc. If solar is indeed a zero-sum game, it makes it a bit tough to understand the level of investment in solar right now. Is there going to be one "home run" and a lot of money-losers in the segment? Is there a bubble in solar?

First, let's examine the idea that solar is truly a winner-take-all market. We tend to think of solar as being a uniform market -- solar panels on rooftops, whether commercial or residential, whether new-build or retrofit. But in fact, there are a number of differentiating factors that can mean different technologies are best-suited for different niches.

For example, the standard economic measurement of efficiency for solar technologies is cost per peak watt. One would assume that the "winning" technology would simply be whatever achieves the lowest cost on that measure. But installation and application are key variables that can affect the answer, and in fact create different needs.

For a residential system, the end user often has a relatively small energy load, is usually unable to feed excess power back into the grid, and doesn't have storage. Thus, the load is the limiting factor for the size of the system, and there is often more than enough space on the rooftop for a number of different technologies to be used, including technologies that achieve low cost per peak watt, but also lower amounts of energy generated per square foot. In other words, it can sometimes be more attractive to go with a cost-efficient technology that requires a lot of square footage, because you have the space.

However, in speaking with installers who target large commercial buildings, you often hear a different story -- the limiting factor of the system isn't the load, it's the available roof space. In which case, these installers argue, it's often best to go with a higher cost-per-peak-watt system if you can squeeze more watts on a roof (this can also be affected by the specific form of any subsidies).

The real-life trade-off here, currently, is thin-film versus high-end silicon-based systems. No unconcentrated technologies beat high-end silicon in terms of watts per square foot. But many emerging thin-film technologies, because they avoid the use of silicon, can achieve significantly lower costs per peak watt. Which one will be best-suited will thus depend upon the specifics of the situation.

And so we can already see that the market environment which may seem monolithic in fact has different niches that different technologies can best address. Other similar market schisms are created by trade-offs such as:
  • Centralized grid power vs. decentralized off-grid power
  • Building-mounted versus other uses (portable systems, electronics, LED lighting, etc.)
  • Cost of system versus lifetime of system (for your rooftop system you probably want at least 20 years of warranteed lifetime, but for your solar-powered radio you can probably be happy with a more rapidly-degrading 5-year lifespan if it means lower cost)
  • Form of mounting (rooftop panels vs. concentrators vs. BIPV)
  • Power only or co-generation (ie: solar heating and/or hot water)
Investors are often focusing on specific market niches when they invest in specific technologies. They are looking at the market niche for which the technology appears best-suited, and evaluating the size of that niche, rather than seeing solar as one huge monolithic market.

Perhaps one way to think about this is to borrow the much-overused phrase from other venture investing areas, the "long tail," which is really just another reincarnation of the old 80/20 rule. The concept here is that, if one is to think about an overall market for solar, there will be some large key segments that make up the lion's share of the market (e.g., 20% of niches make up 80% of total market demand), and a multitude of much smaller niches that fill out the rest of the market (e.g., the other 80% of niches make up 20% of total market demand). True long-tail thinking says that the ratio may actually be 80/30 or 80/40 (and available market data suggests that for the solar industry it's probably pretty concentrated in the big grid-connected rooftop markets, so our original guess of 80/20 may be most appropriate), but the basic concept still holds regardless.

In other technology markets, the idea is to invest in technologies that enable efficiently tapping into the long-tail market opportunities (ie: eBay,, etc.), because the larger market niches have already been somewhat saturated, but if you can aggregate all those individually tiny niches you can add up to a pretty big market as well. The same phenomenon appears to be happening in solar, albeit at an early disaggregated stage.

Secondly, the other factor at play is the timing question: What will win today, versus what will win in ten years. Silicon-based technologies are well-understood and well-warranteed. But as silicon prices continue to rise along with demand, and emerging second- and third-generation PV technologies continue to mature, will non-silicon technologies achieve pre-eminence in the coming years? Investors are playing both sides of this question.

Finally, even within specific niches and time-to-market windows, there is always room for more than one player to potentially succeed -- in some niches it will be winner-take-all, and (more often) in other niches there will be several permanent players. The management team's ability to execute thus becomes key -- technological advantage is not enough.

This is all a long way of getting to a very basic conclusion -- that there is a lot of room for a lot of different bets in solar, it will remain a very un-concentrated market for some time. Silicon-based solar saw a wave of investments a few years ago, recently thin-film technologies have seen a lot of bets, and perhaps third-generation nanotechnology-based PV and solar concentrators will see the next wave, but the biggest conclusion is that there is room for all -- at least for now.

There are some other conclusions investors should draw as well:
  • Investors need to be aware of whether the technology they are backing is an "80%" technology or a "20%" technology. Does the technology only address specific niches in the long-tail, or in the main market? Is it a platform technology that can address multiple niches, or is it really just suited for a couple of specific applications?
  • Very soon, the market is likely to see significant consolidation. Right now, there is so much demand that everyone has as much business as they can handle, and the focus is on simple execution. But during the inevitable slower parts of the growth cycle, core competencies such as branding, distribution, etc. will drive companies to try to aggregate niches by aggregating technologies, and thus achieve economies of scope and scale. Some companies, for example Carmanah, are already targeting the long tail by aggregating different applications and market niches. Others will find the advantages of being able to "single-source" for installers a full suite of technologies addressing their different needs, and will look to acquire those technologies.
  • Given the above, we are probably passing from a period where investors will be funding startups with an IPO exit in mind, and moving into a phase where trade sale is a relatively more likely exit. This should affect valuation expectations accordingly.
  • While never unimportant, the quality of the management team and other aspects of execution are going to be increasingly important relative to the specific technology being developed.
None of the above should dampen any enthusiasm for the solar market for investors, and they are just one person's (likely mistaken) perspective. However, since it has been seeing rapid market growth and high interest from venture investors, the solar market will probably end up being a model that other clean technologies will follow as they mature and develop as well. So even for investors who are not investing in solar right now, it will be an important industry to follow and learn from.

Recent articles of interest

Rob Day: December 22, 2005, 10:56 PM
The articles of interest have built up a bit with the time away. Here are some that may be of interest to cleantech investors:
  • Bob Bellemare of Utilipoint provides a succinct overview of the various government subsidies in support of solar power installation, discusses the likelihood of their continuation and their likely evolution, and generally points to continued growth of the industry.
  • MIT Technology Review discusses the efforts Siemens is making toward a vision of ubiquitous sensing, a technology we've discussed here before that is a good example of a cleantech "enabler".
  • The LA Times discussed how the Kyoto Protocol treaty, even if not ratified by the U.S., is still having a significant impact on U.S. businesses and clean technologies. The increased role of London's AIM exchange is also mentioned...
  • Here's a terrific overview of the status and economics of fuel cell technology. Bookmark this one, if this is a topic important to you.

William McDonough joins VPVP

Rob Day: December 22, 2005, 10:48 PM
William McDonough, who for years has been a thought leader for green and clean technologies in his roles as architect and pundit, is becoming a venture capitalist. According to VantagePoint Venture Partners' website, he has joined the firm as a "Venture Partner." As someone who has been involved in green and clean technologies for many years, I can attest to McDonough's expertise and visibility in the field -- this is a strong addition to the VPVP team. To find out more about his role and outlook, see this interesting transcript.

Catching up: Agrilink, H2O Innovation, Tubel Technologies, XsunX

Rob Day: December 22, 2005, 10:16 PM
Apologies for falling behind a bit lately on the posts, as a new addition to the family has been requiring complete attention in recent days... That hasn't stopped news of various cleantech fundings, however:
  • Agrilink, an Australian developer of automated irrigation systems which optimize water use, announced an A$3M raise from British venture firm WHEB Ventures. The claimed savings reach 50% of water usage. Agrilink's approach is comparable to that of US firm Hydropoint and others.
  • H2O Innovation (TVX: HOI), which is developing clean water technologies, announced the final C$1.55M round of a series of private placements (the prior C$1M round was in November), as well as a recap. Total investment in the private placement to date appears to be around C$6M. The press release has many details about the recapitalization.
  • Tubel Technologies, whose hydrocarbon extraction optimization technologies fall squarely in a big grey area for cleantech investors (some would say it is resource efficiency, some would say it isn't), closed a second round of venture financing of an undisclosed amount. Chevron Technology Ventures' CTTV Investments arm joined existing investor Altira in the round. "Downhole" sensing technologies, part of Tubel's approach, have been seeing a lot of entrepreneurial activity in recent years.
  • XsunX (OTCBB: XSNX) announced a $5M raise of secured convertible debentures from Cornell Capital. XsunX is developing thin-film solar technology for application on windows. As previously mentioned here, the raise is part of a larger commitment by Cornell Capital.

Oxford Catalysts, Ltd. launches, and other news items

Rob Day: December 16, 2005, 7:59 AM
  • Oxford Catalysts, Ltd., announced a GBP500k funding led by IP2IPO Group plc, with additional funding from Top Technology Ventures (also affiliated with IP2IPO), as part of a spin-out from Oxford University. The company's catalyst technology has uses across several energy areas, including the production of hydrogen from waste methane.
  • Here's a good article describing the recent NREL Industry Growth Forum.

Solar still hot: Carmanah and Cyrium announce raises

Rob Day: December 14, 2005, 8:52 AM
  • Carmanah Technologies, an integrator of solar PV and LED lighting for a variety of outdoor lighting solutions, announced a $15M private placement. Carmanah is publicly-traded (on the TSX Venture exchange), and has made acquisitions in the past.
  • Cyrium Technologies, which is developing next generation solar products using nanotechnology (specifically, "quantum dots"), announced a $3M raise led by Pangaea Ventures Fund, with participation from seed funders Chrysalix and BDC.
  • On non-solar matters, for today's amusing see this article in Wired News. Best quote: "Eighty percent or more of the ideas that come directly to us violate the laws of physics..."