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How Big Cleantech VCs Can Suffer From Negative Selection Bias

Rob Day: April 13, 2011, 10:01 PM

One of the challenges for cleantech VCs, and for VCs in general right now, is the potential negative selection bias that comes from being a large fund. This particularly applies to the large, big-name firms that adopt a "go big or go home" perspective when it comes to their investments.

Many such large funds have minimum ownership targets -- they want to own at least 20% of the company they invest in, so that if it's a big success, they end up with a big return, which makes sense, right?  This is rarely a hard-and-fast rule, although it's often presented as such.  But whether it's a hard floor or not, big firms don't want to own only a small piece of the companies they invest in, unless it's a really obvious high flier like a Facebook or such.

What this means in practice, however, is that when they're coming in as an outside lead in a Series B round, they need to either have it be a pretty low valuation, or they need to put a lot of money at work, especially as insiders will also want to exercise their pro rata rights. For instance, let's run through some really basic math to illustrate this point.

If the pre-money is $25M, the math works for "Big Name Fund X" (BNFX, let's call them) if they put in $10M of a $25M round, or $8M of a $15M round.

But what if the company deserves a higher valuation than that?  The math starts to stack up pretty quick.  If the right pre-money is really $50M, that means that $16M of a $30M round will be necessary, for example.  

Here's the problem -- many of these companies don't need to take in that much capital at that stage. They may need only $10M for their Series B, not $15M or $25M, and certainly not $30M.

But should they take a lower pre-money valuation just because BNFX needs to get to a certain ownership target and they don't want to raise more than $10M?  So if the insiders' pro rata is, say, 40%, that leaves only $6M for the new investor BNFX.  To get to 20% with that means a pre-money of only $20M.  This might be a flat, or even down round for the company.

This has several important implications.

First, it results in an institutional bias that applies to the BNFXs of the world, one that tends to steer them toward investing in companies that are raising big rounds -- capital efficiency be damned.

Second, it means that well-performing companies are pushed to take larger rounds than they need.  This is healthy neither for the now-overcapitalized company, nor for returns.

Third, it means some of the best companies will turn down nice offers from even the biggest-name venture firms out there -- simply because the math doesn't work. In our example, BNFX (assuming they now believe in the overall market opportunity) must now hunt around for a lesser company in the same sector and either take advantage of their lesser standing to drive a lower valuation or convince this second company to overcapitalize themselves when BNFX's first choice wouldn't. Maybe BNFX can successfully take this B-grade company and leapfrog them over the one they preferred -- but maybe not.

This exemplifies the negative selection bias I'm talking about. It doesn't happen every time, of course -- there are lots of cleantech startups backed by the biggest name venture firms that truly are best in class, and these big firms obviously have a lot of other factors working in their favor. But because it does happen sometimes, that means that when you see BNFX invest in a company, don't assume that means that company is in their eyes the best company in that market. It just means that that was the company they could work out the math with. (Note to journalists: Do your homework before you start trolling BNFX's portfolio as a shortcut for your "best of" lists. It's a good starting point, but only that.)

There's an easy solution to this, of course, which is for BNFX to invest in the best companies at the Series A stage, and get their ownership (typically at an even higher level) starting point while the valuation is low enough for the math to be easy. Many such big firms take just this tack.  But in cleantech, they've been learning that it's tough to be an early-stage investor and choose bets with confidence. This helps to explain why we've seen the significant shift away from early-stage investing.  This in turns serves only to further exacerbate this negative selection bias, at both sectoral (favoring capital intensive plays) and company-specific (per the math above) levels.

And it's all because the big-name firm needs to have a significant stake of the company to make it worth their while.  

Sometimes venture capital is a seriously screwy industry.

What You Need to Know About the Q1 Cleantech Venture Numbers

Rob Day: April 5, 2011, 6:15 PM

Hardly surprising to see that the major headlines coming out of the release today of the Cleantech Group's Q1 numbers focused on the top-line dollar count -- $2.57B!

But here's what you need to read in that:

1. Yes, deal dollars were up, but deal counts were way down.

As we've talked about for a while now, cleantech VCs are continuing to shift to later-stage companies. In fact, 93% of dollars in the quarter went into follow-on rounds. That bears repeating: Only 7% of cleantech venture dollars tracked in the first quarter were for first rounds.

This is not a sign of health for the sector. It's not a sign that VCs are actively putting money into the sector. Rather, it's a sign that VCs are predominantly putting money into existing portfolio companies. Their own, and maybe each others' --  maybe. Which brings us to point number two.

2. No one -- the Cleantech Group or otherwise -- is tracking "new" money into cleantech companies.

Because it's pretty much impossible to do so, no one is able to tally up how many of these announced deals represent re-ups from existing investors supporting existing portfolio companies, and how much is coming from new investors making an affirmative investment into a company they hadn't invested in before.

This is an important distinction. When a VC makes a new investment, they typically reserve follow-on funds for investing in that same company later. If the company crashes and burns, they won't do so. But if the company goes sideways, they may still opt to put more money into it, in hopes that it can turn the corner. It's a lower bar. Comparatively, in the case of a new investment, the VC will put a higher bar on a decision to invest -- especially now.

That's not to say that insider-only or insider-heavy deals are necessarily a sign that a company isn't going well. I have seen situations where a company is doing so well that insiders don't want to give up any ownership to outsiders, all things being equal, so this isn't necessarily a bad thing. 

But my sense (and again, there are no real numbers to support this, but it's just my sense) is that many of these follow-on rounds have been insider-only or deals where the insiders set the terms. And that's a sign that valuations offered by new outside investors remain low, which in turn is a sign of a continued imbalance between supply and demand of investment opportunities -- investors with money for new deals have lots of these opportunities, so why pay up for anything? And then insiders, who may not be doing new deals at the tail end of their fund but do have reserves for follow-ons into portfolio companies, decide just to fund it themselves and save the headache.

This is further bolstered by the sectoral breakdown, which doesn't show much evidence of any shift in how investors are spending money sector-to-sector. That's a sign of follow-on activity, not new thinking.

This means that mark-to-market in cleantech VC portfolios is even more suspect than usual, by the way.  

It means that new cleantech entrepreneurs don't have many choices when it comes to finding investors.

And this tells me there will be a reckoning sometime soon, when insiders start running out of reserves, and before new investment activity picks up.

All of which means, despite the headline dollar total, this is a very tough time for cleantech entrepreneurs to raise money, unless they're already backed by deep-pocketed investors.

3. Corporate investors are getting more and more involved in the sector.

In the specific deals that have been announced, there's a lot of evidence (and I see it echoed anecdotally) to suggest that large corporate players are, contrary to VC pullback, getting more active in the sector.

This is a good thing. Corporate investment into follow-on rounds, even those that are insider-led, can help address the need for new capital and can also -- when the relationships work out as hoped -- give startups a leg up in getting into the marketplace.

There's some worry that corporations getting involved in venture capital has typically been a lagging indicator. But generally, I believe cleantech startups, since the channels in their markets aren't equipped to handle new products and services very well, might get more value out of such corporate venture activity than we might see in other venture sectors. Also, since so many of these follow-on stage cleantech startups are in capital-intensive plays, corporate balance sheets can be a critical way to get around the lack of project financing.

In the past, we've seen that this is a lot easier said than done. I know of several cleantech startups that have been disappointed by the lack of promised value from corporate investors that actually gets delivered, thanks to organizational inertia, mismatched expectations, NIH syndrome, etc.

Generally speaking, however, seeing corporations get more involved in funding cleantech startups feels like a very good thing. It's validation of the market opportunity. It's vital capital and market expertise. And it may be the first step toward a wave of acquisitions.

The Cleantech Revolution Will Not Be Televised

Rob Day: April 2, 2011, 3:06 PM

Among VCs (and their LP backers), cleantech is on the outs right now.  So says this pretty good article from the past week, anyway. It reflects what we've been saying here in this column for a while -- there's a shakeout underway in the cleantech venture sector, with many generalists abandoning deal-making in cleantech to head for "easier" returns in social media, and many sectoral specialists having a hard time raising new funds.

But there's a revolution underway in cleantech, and it's being led by the entrepreneurs.  

In my recent "Cleantech Venture Capital in 2015" presentation, I talked about the need for a new truly capital-light style of company-building in the sector (which I whimsically called "Cleantech.VC"), but I've seen very little evidence of VCs in the sector truly getting this yet.  One intriguingly different effort is Sunil Paul's "CleanWeb" approach, but for the most part, when cleantech VCs say they're into "capital efficiency," they're still focusing on the same old approach that delivered mediocre results during the past decade -- backing proprietary technology, major new product development, chasing commodity price curves, not rethinking service delivery models in the sector, etc.  In other words, a recipe for spending significant capital to develop great new products, but with slow market adoption.

As I described in the presentation, there will continue to be an important role for this approach to cleantech venture capital, but it will need to be more sectorally focused so VCs can more effectively open up channel partnerships and pathways to the market, and it simply can't be the only way we build cleantech startups.  Meanwhile, Cleantech.VC-style investing doesn't require a big fund to be effective, so in a time when LPs are generally down on putting money into cleantech venture capital, it might be the way we see the next wave of cleantech venture firms arise. Maybe.

Just spend some time with the startups in Boston's Innovation District and Greentown Labs, however, and it starts to become clearer how the next wave of cleantech startups are being launched, even ahead of any Cleantech.VC venture model catching on. Some of this next wave of startups will be hardware, but many will be software and/or services. Many will be bootstrapped or at least run very lean until they have actual revenue. "Lean Startup" approaches will be adopted, formally or informally. Business model innovation will often be stressed over technological innovation. They will sometimes marry energy-related market opportunities with Web 2.0 and social media business models and platforms. Most strikingly, they will be led by young, underpaid entrepreneurs, bringing a heck of a lot of fresh energy and a strong sense of mission to the sector. And they'll therefore be able to make a relatively small amount of angel and grant money, and low-rent space, go a long way. I was invited to speak to a group of these entrepreneurs this past week; there was some free grub and beer for the entrepreneurs, and a few words by me on the current political climate. The crowd made me feel old -- which was awesome and invigorating.

I've backed my share of well-staffed cleantech startups with nice headquarters, and I will continue to do so. I'm certainly not saying that all of cleantech will switch over to this lean cleantech startup model. But I'm excited to see it start to emerge. It won't get much attention from business journalists at first, because these startups won't be taking in big venture rounds, and they won't have big P.R. and press outreach budgets. But the revolution is happening. Go spend some time in your local cleantech incubator, and with your local university's energy club. You'll see what I mean.