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How cleantech VCs are reacting to the broken venture model

Rob Day: November 30, 2010, 10:34 AM

In many of my recent conversations with colleagues, there's a recurring theme: As a group, these investors are increasingly convinced that the traditional venture capital investment model as applied to cleantech hasn't been working.

In part, this is because there's increasing conviction among VCs and LPs across sectors that the venture capital model overall is broken and needs re-invention.  And in part, this is because the exit window has been so tough to hit for so many venture-backed startups across all sectors, over the past decade. So it's not just a cleantech thing.

But even so, with some exceptions the overall body of cleantech VCs I speak with do recognize that there are differences in energy, water and materials markets that mean the mid-2000s Silicon Valley approach to cleantech venture capital doesn't work.  To recap some of these which we've previously discussed on this site:

1. The investment models have been too focused on and accepting of capital intensity, without already knowing where the capacity-buildout / project finance capital would come from.

2. There's been too many investments done at valuations that reflect unrealistic growth expectations, unrealistic visions of the endgame being some "winner take all" scenario, and unrealistic hopes for huge IPOs instead of the more likely M&A exit.

3. Too much of a focus on proprietary IP, when so much of that IP is just defending one particular way of producing a commodity.

4. Too much of a focus on the technology, and not enough on the management team's ability to out-execute other teams.

5. Too much focus on just a handful of subsectors (solar, biofuels, transportation, building energy efficiency), when cleantech is really more an overarching investment thesis about looming natural resource scarcity, and thus more broadly applicable to a wider variety of subsectors.

6. Too much capital put in too early in the lifecycle of the company.  Putting in a ton of capital after the science risk is removed, under the expectation that now it's off to the races... but then finding that the path of successful productization, scale manufacturing, and commercialization will take longer than expected, which can be deadly when the company has been put into a high cashburn situation.

For all of these reasons, VCs who have invested into the cleantech sector are now talking to me and to each other about hard lessons learned from the past 5 years of investing.

What's interesting right now, however, is to see how differently many of these investors are reacting to these lessons.  If you think about it, there are really four basic ways to react to the realization that the traditional venture model as applied to cleantech isn't working.

- You can continue to beat your head against the wall anyway.  And there are certainly numerous investors out there doing just that.  They may talk about doing things differently, but at the end of the day their investments in 2011 will look much like their investments in 2007.

- You can narrow down your view of cleantech so that you're only investing in the sectors that look very much like other sectors you're more used to.  For example, narrowing down to only investing in internet and electronics-based sectors within cleantech.  And there are many investors, predominantly among the generalist VCs who had dabbled in cleantech, who are doing exactly this.  They don't want to say they're abandoning cleantech, but they do say they're really focusing on familiar-looking areas. Which helps partially explain the current high level of interest in "energy efficiency" as a category, because so much of that is IT-based.  This makes a lot of sense, but is kind of where most of the herd is headed right now, and also it's a bit unclear still how a "Netscape Moment" can emerge out of these investment categories.

- You can run screaming for the hills and abandon the category altogether.  And this is definitely happening across the generalist venture landscape as well.  Rarely is it being done overtly, but in many cases it's been a quiet retreat as cleantech teams get purged from big-named generalist venture firms.  And it's happening to a lesser extent among LPs, although it's tough to tell how much of this is just due to a general pullback of LPs from venture capital altogether.  But the net result is the same -- fewer specialist firms able to raise their next fund, and fewer cleantech specialists within generalist funds, so fewer cleantech venture investors overall.

- Or you can try to invent new approaches to venture-stage investing that would better apply to various categories and stages of cleantech investments.  This is where family offices and angels have the advantage of flexibility over institutional VCs and corporate VCs who have specific mandates and pre-approved investment strategies.  But even among these latter categories I'm hearing some interesting thinking from some of my cleantech investor colleagues out there.

All of the last three reactions have their merits, and I'm sure the first reaction has its defenders as well.  Nevertheless, I think there is a continuing shakeout happening among cleantech venture investors that will continue for some time forward.  And I think there will be a community of investors who redefine how they engage with cleantech so that it's really more about the core, familiar technology than about the market opportunity.

But I'm also excited to see what this fourth category, the re-inventors, will be coming up with and introducing over the next couple of years.  I've seen a few new ideas brought to my attention, but not one that I would say has obviously got it figured out yet, including my own nascent ideas for new approaches.  But I continue to be impressed with the level of thinking I see being applied to this challenge, and think we'll see some intriguingly different approaches being tried over the next year or so.  Some won't fly at all.  But some will.  And we'll look back on this 2009-2011 period as having been very formative for the next wave of cleantech "venture capital".

Cleantech venture capital isn’t baseball

Rob Day: November 10, 2010, 10:09 AM

It's rugby.

Sorry, this is a bit of a stretch but I wanted to illustrate a basic learning many cleantech VCs have had to go through over the past few years (myself very much included).

I hear some investors say all the time that they're looking to "hit 'em where they ain't."  That quote comes from "Wee Willie" Keeler, a professional baseball player from a century ago, and when used by VCs, they're typically meaning that they're going to be looking for investment opportunities in sectors and market segments where other investors aren't also placing bets.  The theory being that therefore you can get out ahead of the crowd and establish investments in early leaders in a fast-emerging sector.

It's a fine theory, but it's getting hard to spot any real gaps in the outfield these days.  When I started out doing cleantech venture capital six years ago it was still relatively easy to find sectors and markets that had been pretty unaddressed by other VCs, but these days where there's a capital gap it's usually not about a technology or market, but more about the limitations of applying the venture capital model to certain markets and business opportunities in the first place.

So hitting 'em where they ain't is getting harder, and it's unclear that the remaining gaps don't exist for very good reasons.

The metaphor also belies a core but increasingly tenuous assumption many VCs have, that simply being into a market early is sufficient to gain a key advantage on the rest of the VC herd.  Hit a ball into the gap, and just start rounding the bases!

But the right way to think about it isn't baseball, but rugby.  As with baseball, in rugby there are times where a player will want to kick the ball where defenders aren't, to gain a key advantage.  But the big difference is, in rugby you have to run like heck to go cover that kick -- to go where you kicked the ball, and grab it and try to make something out of that momentary advantage.  It's not sufficient to just have kicked it where no one is standing.

Okay, it's a bit of a stretched analogy.  But the serious fact is that it's a lot easier said than done to successfully invest in a technology or market niche where VCs haven't previously invested.  

1. There will be unforeseen challenges in developing, productizing, and commercializing the technology, and the Board and oftentimes the management team will likely be unprepared for the serious delays versus plan when they encounter these challenges. 

2. It will be difficult to find entrepreneurs, either already in the company or that can be recruited in, who will be both knowledgeable about the sector AND about how VCs work.  I've already had plenty of experiences backing industry-knowledgeable entrepreneurs who've never been part of a venture-backed enterprise before, and I've learned there can be serious expectations and knowledge gaps that can end up really fouling things up.  Especially when it comes to subsequent fundraising rounds, if the entrepreneurs don't understand how to raise that Series B, and/or they don't know why their Board is pushing them to take on more dilution, it can result in missed growth opportunities through a critical lack of capital (not that I'm a fan of overcapitalizing companies either, it's a fine line).  Venture capital is a bit of a black box, if not a black art, and it's tough for even very smart entrepreneurs to understand how it works until they've gone through it before.  And on the flip side, we've all already seen plenty of examples of serial entrepreneurs being brought into companies in sectors they're not already familiar with, and making critical mistakes by not understanding the market, the technology development challenges, etc.  So the inability to readily find entrepreneurs/ managers who ALREADY have both venture capital knowledge and domain expertise is one of the critical challenges of making investments in unaddressed sectors.

3. A lot of costly and time-intensive customer education and proselytism will be required, if your company is one of the first to offer a new product in an unaddressed market.  Customers may in fact NEED to see multiple vendors before an entire category of product or service offerings have enough validity for them to do any serious adoption.

4. And it can be almost as dangerous when and if the rest of the VC herd catches onto the sector and jump in.  The second wave of investors jump in and, attempting to catch up, throw a bunch of capital at accelerating commercialization of their own bets.  Which increases the pressure on the early movers to also pour capital into an attempt to stay ahead of the pack.  Next thing you know, those early Series A investors who initially colonized the sector are being sucked into larger and larger rounds of financing in markets that initially looked unpopulated but increasingly look crowded.  

Okay, far too many mixed metaphors in one column, apologies.  But I wanted to get across the point that simply being an early investor in a market doesn't ensure success.  And in fact, there are plenty of examples in venture capital's history where the first wave of investors did mediocre and the second wave of investors were the ones that reaped the benefits.  After all, Google wasn't the first search engine.  So rather than applaud VCs who talk simply about putting the ball "where they ain't", pay attention to what skillsets and unique attributes they're going to be able to bring to the above challenges.  In other words, how they're going to cover the kick and what they plan to do with the ball once they get there.

And by the way, rugby is much more of a contact sport than baseball anyway. 

Smart grid: Lessons from networking?

Rob Day: November 8, 2010, 10:37 AM

In my last post, I mentioned the smart grid / energy intelligence "panel" at the Future Forward event last week.  It ended up being a great informal conversation between the panelists and attendees, so I thought I would share a bit of what I heard that I thought was interesting.

The participants included:

Eric Emmons, of Siemens Venture Capital, and one of the smartest guys I know on all things cleantech-related.

Martin Flusberg, CEO of Powerhouse Dynamics, a networking and energy software serial entrepreneur.  Powerhouse Dynamics has developed a home energy monitoring system.

Tom Pincince, President and CEO of Digital Lumens, a former networking hardware entrepreneur and analyst.  Digital Lumens has developed a cost-saving lighting controls system (to date, integrated into their proprietary LED fixtures) which among numerous features also includes a strong energy intelligence / data gathering aspect.  [Self-promotion alert: DL is a portfolio investment of my firm]

Here are some takeaways that I found interesting (all obviously very paraphrased by me):

1. Smart grid and energy intelligence are coming, albeit slower than some may have expected.  And it's a bit like we're building out the lower layers of the "stack" right now -- there will be opportunities for a lot of applications to eventually ride over the intelligent energy networks being put in place now.  Automation, device management, dynamic real time pricing interactions, even social networking and gaming are possibilities.  That having been said, the long-held vision of a "third pipe into the home" serviced by electric utilities seems to be (pardon the pun) just a pipe dream.  This energy data is quite often utilizing small-bytes networking capabilities to connect to the main utility grid.  But energy-intelligent devices inside the meter are coming, slowly but surely.

2. Standards will need to be developed to allow energy-intelligent devices to more readily connect into and function on these emerging energy networks.  It's too difficult to think about your refrigerator manufacturer negotiating with a home energy monitoring system manufacturing negotiating with a smart meter vendor negotiating with a utility to make them all work seamlessly.  But if some basic information-exchange and controls standards can be decided upon (by which link in that chain, I'm not yet certain) it would unlock more plug-and-play capabilities.

3. The sector needs more experienced networking execs to get involved.  However, the experienced execs involved in this conversation also had some very cautionary notes to share.  First of all, there are some big differences between telecom companies and utilities, and those are mostly negative differences.  Second, public utility commissions are much more of an obstacle to smart grid technology for utilities than they were to new telecom equipment for ILECs and CLECs.  Third, in this sector it's easy for startups to fool themselves into falsely thinking they're not selling to utilities but only to end consumers and thus protected from the difficulties of selling to utilities; even "inside the meter" energy intelligence will somehow (via rebates, standards setting, etc.) involve utilities as critical stakeholders, and thus present a real rate-of-adoption challenge.  And fourth, the channels stink for these technologies.  How do you get intelligent devices sold to end customers? Hopefully you're not planning on early sales/installations through utilities.  And hopefully you're not counting upon fragmented efforts through broader retail channels like Home Depots and online direct sales.  Finding channel partners who are already inside the homes / businesses and selling through them is key.  Net-net, the panelists acknowledged that selling into these markets is more difficult than selling into networking equipment markets, even though there are some very analogous lessons to be drawn.

4. There's an emerging schism in the richness of data inside versus outside the meter.  Inside the meter the trend is toward richer customer data, more data points, more detailed use of the data for a variety of purposes.  Outside the meter (on the grid side) the trend seems to be toward getting the data as pared down as possible, to only what's really necessary for the utility and associated purposes.  Unclear what impacts this schism will have, but it's an interesting trend.

5. A big positive difference between networking and smart grid is that, with both being concerned at a very basic level with managing network capacity, only on the energy side can you create "negawatts" and free up capacity by curtailing usage.  Tough to free up telecom capacity by curtailing video-on-demand, etc.  And as with telecom you can shift demand out time-wise to accommodate peak traffic.  However, with the electric grid it always has to be in balance, unlike with the telecom grid.  So there are different motivators and value creation opportunities from one sector to the other.

My thanks again to those panelists, in the end we and the handful of audience members just pulled our chairs into a circle and ended up having a pretty good conversation amongst ourselves.


On a completely other topic, I also was struck by a couple of things said during an earlier angel / seed investor panel at Future Forward. Granted, I didn't hear any mention of cleantech on that panel, but even still (or perhaps BECAUSE of that) a couple of lessons struck me.  

One panelist mentioned how Boston-area angel investors typically invest in sectors they know, and in people they know, and so most angels are previously successful businesspeople investing into the next wave of their industry.  For cleantech, we really haven't had that first wave.  So it helps explain why, despite lots of overt interest in cleantech, I'm finding that actually active angel cleantech investors here in this region are few and far between.

And partly in response to that above observation, another panelist urged entrepreneurs to go out there and make their own angel investors.  In other words, rather than just trying to find existing angel investors who are probably pretty inundated with investment opportunities anyway, find the former colleagues who used to sit around the corner in the same office; and businesspeople who have recently gotten lucrative returns from their own related business efforts.  Even if they haven't been angel investors in the past, if it's a personal and professional connection they may be convinced to get involved.

I see a lot of seed-stage cleantech startups these days scrambling for funding and many ask me for help in identifying angel investors, so I thought I would pass along the above advice in case it's helpful.

A tale of two communities

Rob Day: November 6, 2010, 9:14 PM

I was asked to moderate a panel at the Future Forward executive retreat, a long-running event in the IT community in Boston.  Pretty impressive group of around 150 C-level IT execs in attendance, good smart speakers.  Made sense that the cleantech panel to be held as one of the breakout sessions would be about smart grid and customer energy information, since that is a sector that has strong overlap with IT.

Nevertheless, whereas the panel on cloud computing had something like 80 people, the panel on smart grid / energy data had 8.  The IT execs at the event clearly had very little interest.

Frankly, I can understand why.  These IT execs don't know any peers who've made it rich in cleantech.  They see the overall federal government trends as being pretty much anti-cleantech, after last tuesday.  Why should they pay attention to smart grid or energy efficiency when technologies like cloud computing are closer to them and more proven?

This is happening across the entrepreneurial and tech spaces to some degree: Investors and operating-side people who could be applying all that great knowledge about how to build successful tech businesses, but aren't.  Not necessarily a wrong decision for them, but a missed opportunity for the cleantech sector.  The lack of interest at the IT event is just one indicator of how cleantech still has a long way to go to gain true acceptance within the broader tech community.    

But then that same evening I went to the New England Clean Energy Council's annual Green Tie Gala.  A phenomenal event, perhaps the best Boston cleantech networking event of the year, 400 attendees from across the local community. Investors from some of the biggest name venture firms in the area, tons of entrepreneurs, various high-level state officials, etc.  Demonstrated a huge amount of positive energy about the sector, particularly here in Massachusetts where a governor who's been very supportive of clean energy and energy efficiency got re-elected.

So it's not as if there isn't a lot of entrepreneurial energy and general excitement around cleantech.  It's just that the strong IT community here in Boston, and the vibrant cleantech community here in Boston, don't talk to each other very much.  And that's bad.

Cleantech needs more entrepreneurial talent.  It needs more senior business leadership.  It needs the IT community.  And, based upon the number of IT industry refugees I do see entering the sector, it does seem that there could be a lot of interesting ways for IT execs to tackle big problems and big business opportunities in cleantech.  If the two communities would just talk more, maybe it would happen more often.

I'm not sure how much of what I saw that day is really reflective of a community schism just here in Boston.  I have the impression there's more crosspollination between the cleantech and IT sectors in California, but I would welcome comments from folks there and in other regions as to whether they're seeing the same thing or not.

Q3: Behind the ugly numbers

Rob Day: November 1, 2010, 1:52 PM

The kind folks at Ernst & Young sent over their Q3 cleantech venture deal data this morning.  You've probably already seen the headlines, but suffice to say they've confirmed what many have been saying, that Q3 was a pretty big pullback quarter.  They tallied a 55% decline in deal dollars versus Q3 2009, and not only were deals getting smaller on average, but the total number of deals was also down 22%.

Can't say this was a surprise.  As we've been talking about for a while, it's seemed that the deal and dollar totals this year and last have been somewhat propped up by insider rounds.  And also, VCs are themselves running out of money, and it's a brutal time to be fundraising from LPs.  If the VCs don't have money, they have to pull back their check writing.  Plus, it could always be just a temporary thing -- Q1 and Q2 2009 were even lower quarters than this last one, in the E&Y data, and the sector bounced back from that.

But by and large, pretty ugly numbers.  

Thought I'd do a quick dive into the actual data and see what might be of particular interest underneath all that.

By far my biggest takeaway is that this was an across-the-board pullback.  It wasn't due to one stage of deal, or one subcategory, falling off the table.  

There are degrees of emphasis,of course -- First Round and Second Round deal counts have declined this year while Seed Round and Later Stage deals have kept pretty steady.  But across all stages, average deal sizes are slightly down this year versus where they've been in previous years.

More than just the one quarter's bad news, what's interesting to me is that I see evidence of an ever-increasing shift by investors toward later-stage deals and away from first round investments.  But that's not what drove an overall down Q3, of course, since later stage rounds are typically bigger than earlier stage rounds.  If anything, the longer term trend toward later stage investing probably buffered even worse sector-wide dynamics.

But also in the sectoral breakdown there wasn't any huge shift either.  No big anti-solar movement is evidenced (yet), nor any anti-biofuels shift.  In fact, the area that saw any decline of significance so far this year is "power and efficiency management services".  And that's only because Q4 2009 was such a crowded quarter for such deals (17, versus 10 in the latest quarter).

To me, this is pretty suspicious.  Not in that it undermines the E&Y data in any way.  But that it tells me a lot of investments are still being directed toward existing portfolio companies and not new rounds.  After all, it's pretty clear anecdotally that investors are shifting their sectoral interests, away from solar and biofuels and transportation, and toward energy efficiency and batteries.  If the deal counts aren't showing evidence of this, my educated guess is that it's because true new deals are few and far between, and the deal counts continue to be dominated by insider rounds and other insider-heavy rounds.  This fits with the "first round" decline illustrated above.  Either that, or everyone is blatantly lying about what they're interested in right now.  But my guess is that investors are hunkered down, helping their existing companies, and hoping for some exits so they can go out and tell LPs they've figured this sector out.

The cleantech venture sector is basically still just digesting the deals that were done in 2007-2008.  That, and the fact that the economy continues to be stagnant and VCs continue to be low on dry powder, means unfortunately that things will probably continue to be pretty moribund in US cleantech venture capital going forward... In this environment, bringing new investors into a company (whether for the first round, or for later rounds) should be considered a pretty big victory.

PS: If you've read this far, you might enjoy looking back at what CI readers predicted would happen during the first three quarters of 2010.  By and large, readers were spot-on.  At least as a group... Thanks again to everyone who participated in that survey.