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A123: A deeper look

Rob Day: September 27, 2009, 9:38 PM

Many cleantech investors were cheered by the successful IPO of A123 this past week

I noted a very interesting column on PE Hub (sub req'd), by Lawrence Aragon, one of the finer private equity journalists out there.

(We need to caveat all this by acknowledging that it's unlikely much of the VCs' returns have been realized yet, there's typically a lock-up period.  So here's hoping the market valuation holds up.  Still, Lawrence's approach of using current valuations is still quite useful for our illustrative purposes...)

Lawrence takes a look at estimated investment totals and returns for major VCs in the company, and concludes that these investors didn't produce "a huge return", because the major holders only got like 4x or 5x.  But let's look at that a little deeper.  One thing that really struck me about Lawrence's column is that his assumption seems to be that these were all venture investments, and that therefore if you don't get a 10x you didn't get a "high voltage charge" for "venture investors". 

I would argue that much of the pre-IPO capital that was put into A123 wasn't "venture capital", at least in the sense Lawrence seems to mean it.  Let me illustrate what I mean:  If you have the chance to make 2x on an investment over 1 year, would you do it?  Sure, 100% IRRs are pretty sweet.  2x over 2 years, 3x over 3 years are all pretty attractive returns as well, on an IRR basis.  So when Lawrence points to 4x type returns to "venture investors", he seems to be assuming that these were long-term holders, but many weren't.  The Series D was in 2007, for example, and was at an approximate pre-money of $300M. Right now, that return looks pretty good on an IRR basis, even after an extra year's delay past the originally intended IPO date.  North Bridge, for example, was looking at a much higher multiple on their investment before they had to pump in an extra $10M as part of a May 2009 Series F, and while that very late round yielded a much smaller multiple, it was over just a few months, and probably looks great right now on an IRR basis.

So I don't think Lawrence crystalized the point he was trying to make.  However, I think the A123 experience illustrates a couple of important principles at work in cleantech investing today:

1.  I continue to have a hard time thinking about pre-IPO equity investments at pre-money valuations in the hundreds of millions as being "venture capital".  At very least, we need a new sub-category to describe this type of investing.  We have early stage investing, the Series As and Series Bs that are what most outsiders think of when they think of "venture capital" (if at all), typically aiming (read: "hoping") for a 10x return over 5-7 years.  Then you have "growth stage" venture capital, which is later-stage VC investing, aiming for a 5x in 3-5 years.  But as I noted back in that August 2008 post, much of the Series E (June '08, ~$100M raise, approx. $1B pre-money) appears to have been provided by first-time investors.  These investors weren't brought into the raise as "venture capitalists," I guarantee you.  Instead, it's probably best to think about that type of investment as a "mezz equity round".  In other words, the expectations were probably for a 2x in 1-2 years.  That's not necessarily better or worse investing than "venture capital" as Lawrence is referring to.  But it's certainly different.  It means a simple analysis of returns based on multiples is useless if all these types of investors are bundled together.

2.  Growth and even "equity mezz" financing isn't as low-risk as it's made out to be.  It's worth noting that those Series E investors are the ones who didn't make out so well.  Right now it's looking good as A123 trades almost 50% above its IPO price, so if that holds up through their holding periods they may still make out with a 1.5x return.  But the initial offering price appears to have been at just about the same post-money (around $1.1B) valuation of the Series E.  So a zero return at that price. And since my write-up last August after the Series E, apparently investors needed to pony up an additional $99M Series F round according to the updated S-1... and that was at a significant down round valuation (something like $9.20/sh vs. the Series E's $16/sh).

A lot of non-VC investors such as family offices and hedge funds have been brought into these kinds of mezz equity rounds in the past.  The pitch to those investors is, "hey, this company is going to IPO, and you're going to double your money over a year or so -- you can't lose!"  What we've learned about these kinds of rounds in thin-film solar, and now with A123, is that even at that late stage there's still plenty of risk of an exit not happening in the timeframe anticipated, or at a lower than hoped for valuation, or perhaps not at all. 

There's this theory out there that being a very late investor into cleantech is the way to go because the risk has been taken out of the equation.  Do the later investors into thin-film solar companies still feel that the risk of a timely and high-valuation exit was low?  Do the Series E investors in A123 feel like the risk was low in retrospect, after a year of holding their breath amid high cash burn and a down round and no exit window in sight? It worked out for A123.  But so far, for most of the large late-round investors in cleantech, the exits still haven't appeared. We all know early stage cleantech venture capital is risky.  But when I see it said/written/implied that we somehow can conclude with confidence that early stage cleantech VC doesn't make sense because it's "too risky, too long" whereas growth stage is the "smart way to do cleantech", I just shake my head.  And when anyone tells me I "can't lose" on a later-stage investment, I run away as fast as I can, because there's no such thing.

So basically, I look at the A123 IPO and am cheered.  I see it as being a sign of more good exits to come, in a sector that really needs them.  And I believe it shows us something about the shape of cleantech venture investing right now.



A grab bag of news-ish stuff

Rob Day: September 23, 2009, 4:15 PM

Been remiss in updating this column recently, it's been a busy time on the investment front.  But I also took time to have a residential home energy audit and "Step 1" retrofit done by Next Step Living, a local Boston-based firm.  If you're in the New England region, I definitely recommend it, especially if you're a gas heat customer.  They sent two smart guys out for 3 hours, brought their air blower door and infrared camera to identify the problem areas, showed me a bunch of things I could do with good economic paybacks, did a fair amount of air-sealing while they were there, and took care of all the rebates, etc., so it really didn't end up costing me that much, more than worthwhile versus the savings.  A good example of how smart approaches to service plays in cleantech might be one of the missing links in growing energy tech markets and jobs -- all the technological innovations are great and all, but someone's got to actually install and implement these solutions in a customer-friendly way.

Anyways, on with the deals and news grab bag:

  • Serious Materials has raised a $60M Series C.  Mesirow Financial led the round, which included new investors Enertech Capital, Cheyenne, and Saints Capital. Previous investors including New Enterprise Associates (NEA), Foundation Capital, Rustic Canyon Partners, Navitas Capital, and Staenberg also participated.
  • Swedish LED startup GLO AB raised a SEK82M Series B, including new investors Hafslund Venture AS and Agder Energi Venture AS, as well as existing investors Provider Venture Partners, Teknoinvest, Nano Future Invest, LU Innovation, and LUAB, along with the founders and employees of GLO.
  • Energy and environmental software vendor Hara has raised a $14M Series B led by JAFCO Ventures alongside Nth Power and existing investor Kleiner Perkins.

Other randomness: 

  • Will 2010 finally be the year we see production from the big-named CIGS players?  Looks like both Nanosolar and Miasole have finally got manufacturing facilities up and ready to go...
  • Is Silicon Valley finally figuring out how much cleantech innovation is happening outside of Silicon Valley?  Note the subsequently panicky tone of the headline of this article...
  • Congrats to Whitney Rockley on joining Emerald -- and congrats to Emerald on snagging her!
  • Definition of a crowded market:  Here's a list (a "sampling", actually) of 11 algal biofuel efforts located in Southern California alone.
  • Renaissance Man:  I've been enjoying Excessive Entanglement, a novel by author Nick D'Arbeloff.  Those readers in the Boston area may also recognize Nick as the Executive Director of the New England Clean Energy Council.

Finally, it has basically nothing to do with cleantech, but this press release has to be the clear front-runner for most incomprehensible headline of 2009.  Enjoy!

Fingers crossed for A123

Rob Day: September 11, 2009, 2:21 PM

Cleantech could really use some venture-backed exits to help both further validate the sector as an investment area, and generally boost investor spirits in this tough time.  Plus, it would be great to see some big IPOs out of subsectors other than solar.  Thus, here's hoping A123's IPO happens smoothly and successfully.

Of course, it's not their first attempt, as their timing back in 2008 was bad once the economy started crushing everyone.  For a blast from the past (and additional proof that yours truly can be pretty wrong at times), see this post I wrote back then about the company and their investors.  Also, here's Kanellos' take and Wesoff's take on the data from the S-1.

Fingers crossed!


It’s going to get worse before it gets better

Rob Day: September 9, 2009, 4:50 PM

I'm at the Cleantech Forum in Boston this week.  As always, a great networking event, they've really honed the model here at the 23rd edition of the series.  For those of you into such things, you can follow various tweets on the conference, including far too many from yours truly, with the #cleantechforum hashtag...

It's notable, however, how few west coast investors are attending this event.  Now, bay area VCs are always pretty loathe to travel outside of the 650 area code, but still, it's clear that even fewer made this trip than would have this time last year.  Why?  Perhaps some travel budgets are smaller, especially for the smaller shops, but really this is instead an indicator that most VCs are just really inactive on new deals and fundraising right now.  If an investor is actively seeking deals and/or LPs, they'll use a conference as an excuse to travel somewhere for networking purposes.  Which means that conference attendance by VCs is a bit of a leading indicator.

It's an important indicator, because cleantech venture capital doesn't seem to have been too badly hit yet.  Not to say things are easy for cleantech entrepreneurs right now, by any stretch.  But still, according to the Cleantech Group's numbers described at the conference today, in Q3 cleantech became the #1 venture capital category, above IT and biotech, etc. (details to follow on that once I get them).  And while there have been some companies that have gone under over the past 12 months or so, most continue to chug along one way or another.

But for the most part, most VC-backed cleantech startups remain net negative on cashflow.  Which means they're going to need either a rapid market pick-up translating into very near-term revenues, or else they're going to need to raise more capital.

My strong sense, watching the reported deals from the past few months, is that a significant portion of those deals that are taking place (and thus are captured in those Cleantech Group numbers) are insider-only rounds.  I wouldn't at all be surprised to see about half of the deals being such.  This means that most of the rounds taking place are not being priced by the market, it's instead just existing investors putting more money into their portfolio investments, likely at flat valuations or unpriced bridge financings.  Anecdotally, I can tell you that most investors are still refusing to take down valuations on their own portfolios, and yet only looking at follow-on deals that are at down valuations. 

These insider rounds, including many more that probably haven't been announced, are what have been allowing cash-burning cleantech startups to survive, in other words. 

And they can't continue indefinitely.  VCs don't have unlimited funds, and many at this point are starting to feel out of dry powder.  They'll only have so much patience and so much capital they can devote to any one portfolio company.  And with VC fundraising on hold, we shouldn't expect to see VCs be refreshed with capital anytime soon.

I'm not trying to sound too doom-and-gloom, we're not talking about some kind of mass extinction event.  Certainly, government support is going to help some companies survive.  And for those companies and investors willing to take a down valuation, there are still some investors out there willing to step in and carry the torch. Even a slight recovery of the credit markets could also help some startups raise non-dilutive growth financing.

But my point is that, while we haven't seen a massive wave of cleantech startups crashing yet, the factors underlying that are drying up.  And so I expect to see many more unfortunate stories over the next 12 months, even if the economy appears to be slowing getting better.  And if the economy twitches back downward... batten down the hatches.


Proving clean technology works

Rob Day: September 2, 2009, 10:43 AM

The headline-grabbing news this week is Khosla Venture's recent fund closings, of their $275M seed fund and $800M "main fund".  It's good to see more seed capital available in the sector -- as we've talked about here before, things have probably shifted too heavily toward late stage deals over the past few quarters, leaving a critical funding gap at the seed stage for cleantech startups.  And it's also good, I think, to see such seed efforts split out into a separate fund from later-stage efforts.  In many of the larger recent cleantech funds, seed and growth stage have been conflated within the same fund, which sets up some internal management challenges and also from an LP's perspective makes it tough to find specialized early stage focus.

In the NYT article about the closings, however, I was a bit surprised to see the suggestion that a few million dollars' worth of investment is all it takes for a cleantech startup to prove their technology to the point of being able to secure project financing.  Now note, I'm not going to pick on Vinod for that quote, because I would bet there were nuances to it that didn't pass through the journalist-editor translation.  But it brings up an important point to discuss, nonetheless.

There is in fact a huge capital gap for cleantech startups around early project finance.  In most cleantech startups that will actually be producing anything (as opposed to software-based cleantech startups), building out production or manufacturing capacity is capital-intensive by definition.  To build out a commercial-scale solar fab could require tens or even hundreds of millions of dollars.  Ditto for biofuel plants, for utility-scale solar generation facilities, and for battery manufacturing lines. 

The problem is, project finance is traditionally very risk-averse, and very intolerant of any new technology.  Project finance firms are very good at structuring deals to enable the build-out of large generation or manufacturing projects, as long as they're not taking any technology risk and as long as the construction timeframe and future revenues and costs are very well understood.  That's why project finance will take a much lower expected rate of return than venture capital, because it's correspondingly lower risk.

So what we've seen this decade in cleantech has been the inability of cleantech startups to raise project finance or high levels of leverage for their first or even second commercial-scale facilities.  Even after having "proven" the technology at a pilot plant scale, it's still too early for project financiers to feel they have a good understanding of the construction timeframes and costs for a first of a kind ("FOAK") commercial scale plant.  Also, in many cases the market acceptance is still not locked in, and furthermore the technology will likely not be proven out to nearly the level of confidence that the project financiers would want to see.  So they just don't touch such things.

Thus, for the past few years we've seen venture capitalists stepping in to fund the FOAKs out of necessity.  When you see a $100M+ solar round, for example, there's some working capital and growth equity in there, but the majority of it is going to fill the gap that project finance is unwilling to fund.  It's not really venture capital.  It's quasi- project finance. 

I'm not against this type of activity per se, it can still provide some attractive risk-adjusted returns when it's done creatively.  But it's tough to see how that type of activity can be expected to generate the kinds of absolute returns that VCs are telling their LPs they're targeting, unless there's an opportunity to push a very, very attractive near-term exit afterwords (and there are few such exits right now).  And so when it gets done out of the same venture fund, it's just important to note that it's a bit of a stretch on the definition of "venture capital" as traditionally used.  So be it, rules are made to be broken.

However, what we've seen very clearly over the past 12 months is that such financing will greatly dry up at times.  And a number of high-flying startups have been left high and dry by the pull-back of VCs from FOAK funding.  So it's strange to get the impression from the NYT article that it's fine for VCs to invest in early stage capital-intensive opportunities, because it won't take much capital for the henceforth "proven" technology to bring in project finance to support full-scale commercialization.  FOAKs remain a big gap, one that has already killed a number of promising cleantech startups that had taken in tens of millions of dollars just to get to that point.  What I'm guessing the quote was really intended to say was that non-traditional players like corporate partners, large family offices and government financing can help solve the FOAK challenge, and to an extent that's true.  But it's far from the slam-dunk prospect that comes across in the article.

With $275M to put to work, at around $2M per first-time check, that "seed" Khosla fund must be planning on doing some significant follow-ons (tough to see how they would be able to manage upwards of 100 investments).  And then with the additional $800M in the "main" fund, it's probably a safe bet that KV will have to put some money into FOAKs just like many other VCs have.  Investors may have been advocating for smaller funds focused on capital efficient opportunities.  But there's little evidence such advocacy has really taken hold in Silicon Valley.

Deals from the past week or so:

  • Think Global AS has emerged from bankruptcy and has taken in a capital infusion of around $47M, from investors including several strategics.  Ener1 has put in $18M as part of the financing, in exchange for getting exclusive rights to supply Think with lithium ion batteries, and along with converting $3M in debt is now the biggest shareholder in the company at 31%.
  • Membrane-based separation startup BPT has taken in a $12M Series B, co-led by US Venture Partners and Pitango Venture Capital, and including existing investors Aurum Ventures and Elron Electric Industries.

Other news and notes:  Another nobel laureate has come out as a pessimist on fuel cells -- at least "present" ones...  Here's a good list of the recipients of the recently-announced ARRA battery and EV awards...  Finally, if you're going to be in Boston on October 27th, check out the cleantech networking session being organized by PE Hub, featuring five insightful panelists (oh, and yours truly as well).