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In 2020: When China Rules the Clean Energy World

Rob Day: May 20, 2010, 9:07 PM

I've been most recently reading When China Rules the World.  A fascinating treatise on what happens to the world economy when, over the coming decades, China's economy becomes paramount in the world economic system.  China and cleantech is something I've been thinking about and investigating for some time now.

Timely then to see the report from New Energy Finance (note: opens pdf) that in Q1, China was the biggest recipient of clean energy project finance, nearly double that of the amount invested in clean energy project finance in the U.S., nearly two-thirds again more than that invested in Europe.

I think it's safe to say that China will be a major driver of clean energy and water technology adoption over the coming decades.  Not only because their economy is growing so quickly.  Not only because China has only 1/5th the water per capital, as well as much less domestic energy supply and arable land, than the U.S., thus necessitating wiser use of natural resources earlier in their economic development cycle.  But also because now they've visibly committed themselves to becoming leaders in the sector and, as one regional GP told me today, "they don't want to lose face by not meeting that target."

So China will be a major mover in cleantech markets.  But what does that mean?

I believe that the developments will impact cleantech investors in three phases:

1. The rapid-growth market phase

At first, the major impact on the cleantech economy will be China as outsourced manufacturer, and China as fast-adopter market.  We are already seeing this happening.  With such strong economic growth comes strong resource needs, and many cleantech startups I speak with are already in discussions in China about potential early rollouts of technology.  Using local distribution or other types of partners, they are looking to build early projects and find early customers there.  

This requires establishing such local partnerships, however, as it's a lot easier said than done to sell cleantech goods and services into this market.  So I know many entrepreneurs and investors who are racking up lots of frequent flier miles getting back and forth.  And spending a lot of time establishing strong partnerships there as a stepping stone to actual sales.

Furthermore, as cleantech hardware markets shift toward a fabless model using contract manufacturers for their device businesses, China will naturally increasingly become the actual manufacturer of cleantech hardware systems and components, just like has happened in the IT and telecom industries.

2. The homegrown innovation phase

China is awash in liquidity.  There is a lot of external capital chasing the opportunities presented by the market, but there is a lot of internal capital as well, looking for good domestic investment opportunities in China.  Plus, there is the national commitment to establish more homegrown technology leadership in this sector.

In the next few years we will see the emergence of more homegrown Chinese clean technology startups that are developing proprietary IP.  It is already beginning in sectors (such as large-scale wind turbines) where the technology is readily adaptable from technology developed elsewhere.  But with a steady source of strong technical expertise and domestic markets available, Chinese cleantech entrepreneurs will increasingly be among those developing first-to-commercialize solutions across a number of cleantech sectors and subsectors.

For cleantech investors, finding out how to access these entrepreneurs, and develop winning deals from such relationships, is the still-unanswered question.

3.  The China-sets-the-standards phase

As the Chinese market becomes the most important global market, and especially as homegrown producers become more independent producers of technology themselves, China will hold increasing sway over the development of entire industries like smart grid communications, smart buildings, distributed generation power management, M2M communications, and other subsectors of cleantech where standards-setting will be important.  

In smart buildings, languages like Bacnet are important standards that have been brought to market by European and U.S. technology developers to date.  But in the future, what the Chinese market settles on a standard will often be what the world settles on.  

And thus China will shift from being an attractive market for western cleantech entrepreneurs to think about servicing, to a critical must-address market that will be addressed by both domestic and foreign innovators alike.


All of the above will happen a lot more rapidly than many might expect.

By 2020: Green Homes

Rob Day: May 11, 2010, 7:54 PM

Why on earth would anyone care about new homes right now? Isn't that a dead market?

Yes, in the U.S. the new home construction market is down 75% from its 2005 bubble levels.  The industry is badly hurting and won't go back to bubble levels.  But that still represents around 400,000 new home starts per year.  This is still a huge market.

During the last decade the way to make money in U.S. home construction was obvious:  Just throw up some homes and let people buy them.  It was a seller's market.  But now in the "new normal" where existing home sales are down and new home sales are way down, this puts pressure on builders and developers to think more creatively as market power shifts more to the buyers who are going to discriminate not only on price, but on value.

Meanwhile, we are seeing the early signs of backlash against commuting in this country.  The decades-long trend of suburbanization and exurbinization appears to be somewhat reversing itself.  It took the downturn to reveal this, but available market data indicates that the biggest price and default hits have taken place in the exurbs, and urban and near suburbs have been the most insulated from such effects.  Basically, as the real estate market has gotten softer, overall people have preferred to take advantage of availability closer to the downtown areas to migrate inward (or at least abandon the further out properties).

As people expect energy prices to continue to rise, this trend will continue.  So-called "smart growth" and "urban infill" are going to become more widely-heard buzzwords.

But energy prices don't only hit on the commute, they hit on the home itself.  Homeowners are going to increasingly care about the energy usage of their home... and they're going to be caring about other attributes (eg: indoor air quality, overall use of "sustainable" materials, etc.) as well.

All of this is on the margin.  I mentioned that the new home construction market in 2009 was around 400k units -- compare that with around 5M overall existing home sales per year.  And 72M in total owner-occupied homes in the U.S.  Any analysis of green homes in the U.S. needs to account for the fact that change is hampered by the deep installed base of existing inefficient homes.

Nevertheless, I think we can expect to see some significant changes over the next ten years.  

On the existing homes side, as energy prices do indeed rise (or at least become more volatile), we will see new residential construction further emphasizing efficiency and dense growth.  Oil price future are indicating long-term price expectations above $80/barrel.  Natural gas price futures indicate expectations of price rises of at least 50% over the next couple of years (and this will also drive marginal electricity prices).  Potential homeowners -- and even renters -- will start caring more about the energy efficiency of their homes.  And not just because of the energy costs themselves, but because of that as an indicator of construction quality overall.

There's a limit to how much premium potential homeowners and renters will be willing to pay for energy efficiency, but bear in mind two other factors: 1) as "smart growth" drives shorter commutes, that will free up more wallet-space for home "green-ness"; and more importantly 2) green attributes will be increasingly important to the developers themselves as it will help accelerate necessary approvals.

It's this latter point that's often forgotten, but all real estate markets are incredibly local, and any developer will tell you that construction is actually relatively easy to manage -- it's siting and getting necessary approvals that are the huge determinant of their profits.  The time it takes to get a development started and the costs along the way.  And the fact that evidence suggests "green buildings" have lower vacancy rates than other buildings. So even in the absence of a "green premium," developers have strong incentives to adopt green building attributes.

Not to mention new laws in many places like California that are often requiring zero energy homes and other similar mandates by 2020.  I expect that such deadlines will get pushed back.  But they still are important market signals.

Meanwhile, in the existing homes market, energy efficiency can be retrofitted, with compelling paybacks.  In a low energy cost market this type of activity has lapsed, but it is clearly coming back strong.  Again, it's on the margins, but even if only 1% of homes got energy efficiency audits and basic retrofits (air sealing, insulation, etc.) it would make a huge difference overall -- and certainly would be rewarding for that 1%.  And new government incentive programs designed to encourage such efforts are only now starting to have an impact and will not go away quickly even if the programs are not re-upped.  

So what does this all mean?

Well first of all, we can expect significant activity in the green homes market.  But it won't be geared around "sustainability", it will be focused on location and energy efficiency.  "Sustainability" implies environmentally-sensitive materials (ie: bamboo, or certified wood) and above-standard environmental performance (ie: water re-use, etc.) that appeals to a certain small high-end niche of the market, but most homeowners won't be willing to pay for (because of long payback periods, if any paybacks are even applicable at all).  But many more homeowners will care about the energy efficiency of a home because of aforementioned cost and quality indications.  And, barring a long-term drift downward in gasoline prices, on the margins new homeowners will increasingly care about shorter commutes as well, driving increased interest in denser, closer-in neighborhoods.  Mid-range "green homes" are a relatively untapped niche, but with strong latent demand.

Therefore, developers who can address energy efficient new home construction in a cost-advantaged way will be rewarded.  And developers who can do this in a dense-housing format will be doubly rewarded.  This is a tiny part of the market now, but I wouldn't be surprised to see a quarter of new residential construction in the U.S. (mostly on the coasts, but also in places like Chicago and Dallas) qualify under such concepts by 2020.  This will create an entirely new industry in new home construction done to tighter tolerances, using new processes and designs to improve energy efficiency, and with intelligence and automation built into the home from Day 1.

But this will add up to only a small dent in the installed base of homes.  But we can also expect a significant chunk of existing homes to start to adopt such technologies as well.  It will be hard to retrofit core designs to be more energy efficient.  But air sealing and insulation is easy.  And HVAC will be increasingly intelligent, able to incorporate retrofitted, very small (and cheap) sensors to more efficiently meet required comfort levels.  Home automation will be flirted with, but really boils down to HVAC controls from an energy perspective, and it would make sense that it would eventually be integrated into central HVAC rather than be a standalone add-on application.

All of this will be only a "niche" even by 2020.  But with such a huge overall market, even as a niche it will be measured in the billions of dollars by then.  And it will be growing quickly.


By 2020: Plug-in vehicles

Rob Day: May 6, 2010, 8:25 AM

Back in my consulting days, at one point I was part of a major project with a regional investor-owned utility, helping them do an overall strategic and operational review of the entire business.  It was a great learning experience to see what such utilities think about and have to deal with from the inside perspective.  One thing that always stuck with me was when we looked at revenue-growth opportunities for them.  The answer was that there was really little that the IOU could do to significantly grow revenues within their regulated gas and electric utility business, other than to generally work to promote economic growth in their region -- not a lot of top-line high-CAGR possibility there...

But things have changed.  Among other reasons, the past decade has seen the emergence of a new significant growth opportunity for such IOUs:  Plug-in vehicles.  By transitioning energy demand away from gas stations and into plugs in garages, utilities could boost their revenue growth significantly.

Right now what I'm mostly hearing about are the fears from T&D (transmission and distribution) engineers at utilities about such a prospect.  They argue that putting a car on the grid is tantamount to putting a new house on the grid.  And they worry that clusters of early adopters creating hotspots of demand that would create local distribution problems.

This is a natural part of the utility adoption cycle.  Utilities are paid to provide electricity, but since in the U.S. electricity is seen as a god-given right of every citizen, utilities are heavily incented to avoid disruption first and foremost.  And T&D engineers are the ones most tasked with keeping the lights on.  So whenever there's any new concept available for adoption by a utility, it usually gets pushed over to the T&D engineering group for evaluation.

These engineers are often very smart.  But they have no incentive to go out on a limb, their pension rests on their ability to keep the lights on, and in my work with the utility I found that financial considerations like revenue growth were something they could nod their heads at but never truly embrace.  So the first reaction from these T&D engineers is always to highlight the potential downside scenarios, no matter how minor.

This is where we're at with utilities and plug-in vehicles, here in 2010.  Really, utilities can't handle adding more pseudo-houses to the grid?  Isn't that what happens with a new subdivision development in any case?  And especially because recharging a commuter's plug-in vehicle can be managed to occur mostly during the off-peak hours in any case.  These are the concerns of someone who's paid to think up concerns.  And they will be addressed and will pass.

Because soon, CEOs of investor-owned utilities will realize that adding new pseudo-homes to the grid in the form of plug-in vehicles is a really good way to grow revenue in a regulated business where other growth opportunities are few and far between.

I think we'll start seeing this shift happen over the next couple of years as all the moderately-priced plug-in vehicles start to enter the marketplace.  Right now when the vehicles aren't available to consumers in any case, it's easy for the conversation to be dominated by downside scenarios.  But once consumers start adopting plug-in vehicles -- even in small amounts -- the upside potential will start to get the attention of utility CEOs.

As always, it takes a few years for such mindsets to change.  But by 2020 I believe we'll be seeing this in earnest. 

  • Forward-thinking IOUs will be embracing plug-in vehicles and encouraging -- even providing incentives for -- their customers to purchase such vehicles.
  • This shift will be most rapid in states where retail-level deregulation allows homeowners to determine their electricity provider. Incentives for plug-in vehicles will become another point of marketing differentiation for the various electricity retailers vying to grab customers.
  • A couple of more advanced utilities will partner with a provider of recharging stations (maybe a startup like a Coulomb, but more likely over time it will be one of the larger, already-established T&D equipment vendors) to come up with a low-cost solution they can push on their customers that will also have very simple timing rules so as to make sure and push the recharging into off-peak hours.
  • We'll see the emergence of startups vying to establish recharging stations at major corporate HQs and other major commuter destinations, where consumers can plug in their vehicle and swipe a card and the recharging station will be intelligent enough to have the charge show up on their residential electricity bill.  But most consumers will still do most of their charging at home -- so you'll be seeing these stations over at the far corner of the parking lot, not at every single space.  The alternative vision is that of battery swapping stations -- this may happen more rapidly overseas but I don't see it having much momentum in the United States quite yet.
  • Utilities, who to date have largely taken a live-and-let-live approach to dealing with the oil giants when it comes to legislative efforts, will start to more heavily promote gasoline taxes and other disincentives for the consumption of imported oil.  As major IOUs like Duke Energy, et al, start to see their future growth being in part impeded by the presence of low gasoline prices, they'll start trying to adjust the playing field so that they can more effectively cannibalize that market.  This will mean further efforts to differentiate natural gas (which the utilities will be increasingly relying upon) from oil (which they'll be trying to steal market share from) in the overall regulatory scheme.
  • Electric vehicles and PHEVs will see adoption happen more rapidly than pundits currently expect, toward the latter half of the decade, driven by all of the above dynamics.  More vehicle volumes will help drive down up-front costs, particularly in the battery packs.  And utilities will be helping to defray, either directly or indirectly, the upfront infrastructure costs of purchasing and installing recharging stations.
  • Adoption will be slower in areas where the utility is a muni or otherwise not profit-incented, as the fears of grid disruption aren't trumped by desires for revenue growth.  And also because such utilities are often found in rural areas where commuter cars are less prevalent in any case.  But as the successful examples of IOU programs demonstrate the viability of integrating these kinds of systems into the grid, such utilities will slowly start to accommodate customers who want to go in this direction.

By 2020, I believe a significant minority of the new-sale U.S. commuter car market will be plug-in vehicle.  And investor-owned utilities will be leading the charge.


This is how it happens

Rob Day: May 1, 2010, 5:57 PM

Pretty timely re: my last post on water, this afternoon they declared a major water emergency in the Boston area, thanks to a huge water main break.  One million people, including everyone in my town, are under a "boil water" order.  I got a call from my local water district, a recorded message telling everyone not to use any water at all, not even lawn sprinklers, until they have it fixed.  Since the water main break is dumping 8 million gallons of water per hour into the Charles River, doesn't sound like it'll be fixed very soon.

I make sure and keep backup water supplies at the house just for such eventualities, but I was curious, so about an hour after the emergency was declared I went over to the nearest grocery store, one of those that's so large you can get lost.  And almost their entire supply of water was already gone.  Empty shelves, almost everything grabbed, and people were milling around the aisle in front of the empty shelves looking around as if more water was going to be found.  No panic or anything, people were nice enough, but wow nonetheless...

The phone message said something about the emergency taking only a "couple of hours", and people can boil water to drink, and yet this was still the immediate reaction.  Can't imagine what would happen if something actually serious were to happen to the water supply.

Yep, water's "free".


How water will play out in the U.S.

Rob Day: April 19, 2010, 4:32 PM

I've been thinking a bit about water lately.  So much media attention and investor and entrepreneurial interest are expended on looming energy shortages, but water shortages are perhaps even more acute.  A recent article in Fortune gave a good brief overview of water from a global standpoint.  If you're looking for water statistics and updates, the website of XPV Capital (a water tech specialist) has some good info.

There are clear looming issues with water use in the U.S.  And there are lots of uncoordinated actions going on in various parts of the country, and some hand-waving in general, but I haven't seen anyone really start to play out what's going to happen.

But it's clear to me that water is going to get more expensive over time.  It likely won't be because of any proactive water price increases by the governing bodies.  Indeed, local governing bodies appear to be just as allergic as ever to doing any kind of forward strategic planning around water.  And historically, in the U.S. people view water (for drinking, agriculture, or industrial purposes) as some kind of god-given right that shouldn't really need to be paid for.  So I think water pricing will only be affected by local and regional shortages and crises, not by any overarching strategic approach.

But such local and regional shortages and crises are happening.  In parts of the American southeast and southwest water shortages are already acute.  Here where I am this week in Texas, The Aransas Project has sued the governing state bodies for failing to manage water properly and thus endangering the whooping crane.  Take a step back and think about this one -- this is a group of Texans from all political persuasions, filing a lawsuit under the Endangered Species Act.  Water issues break across political lines, in other words, but they're also very local.  It's a really good illustration of what's likely to start happening lots of other places around the country where water withdrawals are starting to exceed water supplies.  (And an effort I've supported, btw)

And what will happen in the Southwest when the upstream states on the Colorado River start demanding access to their existing water rights?  In fact, California, Arizona, Nevada, etc. are all only able to access the water they need, thanks to upstream states like Wyoming and Colorado not fully using their own rights.  But that can't happen for long.  And even if it could, the water usage is already at unsustainable levels as it is.  We've built out some pretty major population centers in the Southwest that are dependent upon unsustainable levels of water demand. 

So I don't expect to see any forward-looking strategic policy shift at the national level that would result in any significant shift in the pricing of water.  But I do expect local water shortages (and the resulting legal, economic, etc. challenges) to rise up over the next couple of decades, and thus de facto raise the cost of water where they occur.

What does this all mean?

1. Water will be a sub-regional issue.  Which means that future water price rises will happen in isolated fashion, on a watershed basis in many cases, but certainly by region.  It will be a lot cheaper to access water in some places (like New England, for instance) than in other places (like the Southwest, for instance).

2. As such price disparities arise, it will start to affect the location of manufacturing operations.  Water-intensive manufacturers will have to trade off locating close to cheap water and energy supplies (mostly: far away from cities) with transportation costs to deliver to demand (generally: cities).  Easily transportable end products that are water-intensive, like pharmaceuticals, will relocate where water remains cheap.  

3. As water gets to be more of a strategic issue, corporations will lead the way in terms of adoption of new water treatment technology and water "microgrids" with significant re-use of water.  It'll be easier for corporations to adopt to the "new normal" in such situations than the local politically-driven processes affecting municipal drinking water, etc.  So selling new water tech to corporations will continue to be a key entry point for innovations.

4. Water efficiency will be increasingly important for agricultural use.  Water efficiency will be increasingly important for energy generation.  Both are very large consumers of water, but startups that can address either or both issues in a scalable and low-cost way will see entry points.

5. During the NEXT economic downturn, water infrastructure may be given the same government subsidies as energy infrastructure saw during this economic downturn.  Ditch-digging and pipe repair are good jobs creators, they just didn't get the necessary attention this time, but when people in swing states start being told they can't water their lawns because of infrastructure issues...

6. Local water districts will be pressured to encourage more intelligence at the end of the pipe -- the water analogy of demand response in energy.  So far the local government response has been necessarily binary: When there's a shortage, no one gets to water their lawn, etc.  But faced with more such instances, I expect we'll see more startups start focusing on "smart use" of water, and then they'll start pressuring local cities to grant exceptions for consumers who implement such solutions.

These are just some shallow thoughts around water, but it's interesting to think about how water shortages will specifically play out.  And that will affect entrepreneurs and investors in the water space as well.


Small is beautiful

Rob Day: April 15, 2010, 9:30 AM

Happy tax day, everyone. 

Silicon Valley Bank put out a must-read study yesterday, examining returns from more than 850 VC funds in the U.S., looking specifically at returns by fund size.  And what they found out was that smaller funds do better than larger (>$250M) funds.

This won't be a surprise to some limited partners out there that I speak with, in my current dual role as both an LP and direct investor.  These LPs see smaller funds as being more focused and hungry.  As the SVB report states:

"Managers of [small] funds often have industry-specific expertise and focus on particular strategies or sectors compared to those of larger funds which usually target multiple stages and sectors.  Small funds tend to have a strong general partner commitment, which heightens the alignment of interests with limited partners and potentially increases investment discipline."

Smaller funds also are less susceptible to the kind of minimum check size restriction I described in my last post, with its implications for capital efficient investments.  I caught a little bit of grief from some colleagues at smaller funds after that post, because they thought I was talking about ALL venture capital firms getting caught up in check size inflation, but really I was only talking about the larger funds and their need to shovel dollars out the door.  Indeed, this SVB report adds further support to what I was talking about -- with smaller VC funds, you can put less dollars at work in a single investment and still get the kind of outsized return that can "make the fund".

So if smaller funds are so great, why don't they get more favored by LPs?

First of all, their performance is probably more volatile.  The SVB report focuses on the portion of funds that returned high multiples.  They state that smaller funds (those under $250M) were seven times more likely to provide a 3x return or better to LPs, than larger funds.  But that's 22% vs. 3% of each population, respectively, so the comparison leaves out a lot of lesser performances.  In their study, more than a third of smaller funds returned less than 1x, meaning they lost money for LPs.  Of course, in the pool of larger funds, more than HALF lost money!  But it's unclear from their report how many of each category lost a LOT of money versus losing a little bit.  LPs may be more willing to back a larger fund that has a more limited downside, than a smaller fund that could end up with more volatile results.

And what's also true is that smaller funds tend to have less experienced managers.  Most first-time funds will be under $250M, naturally.  And LPs are often leery of first-time managers.  I've spoken with some accomplished LPs who take an opposite approach, but generally speaking LPs have a difficult time determining the caliber of a first-time fund's managers, lacking a track record to refer to.  This obviously is related to the volatility/ downside point from above as well.

And furthermore, someone did the limited partner community a great disservice at one point by doing a study showing that top quartile performers among venture managers tend to stay top quartile performers over multiple funds.  I'm sure the study was totally valid and accurate, albeit backward-looking.  But what that study did was provide all the air cover any LP manager ever needed to simply pile capital into any big-name venture firm's latest huge fund.  It'll be interesting to me when that study is eventually revisited, to see if the effect remained valid over time, because I believe it provided fundraising momentum to larger funds that encouraged them to get unsustainably big and drift in their investment strategy, in some cases.  In the fund size retrenchment SVB identifies, I believe we're seeing the results of this.  But that having been said, there are certainly some large funds that have figured out how to make money at that scale -- as the SVB report shows, less than 10% of large venture funds returned 2x or better, but in that small group I bet there's some repeat performances by the same very few fund managers.

Finally, many LPs are of such a size that they really can't engage with small fund managers.  If you are managing a multibillion dollar pension fund with hundreds of millions of dollars allocated to private equity, can you really afford the time to identify, evaluate, and manage a $5M or $10M commitment to a small, specialist venture fund?  Some can, but many don't have the bandwidth to do so.  It's the LP analogy to the venture fund size dilemma I mentioned in the last post...

So smaller funds are, according to this SVB study, a better bet for LPs.  But LPs still find it hard to effectively engage with smaller funds, as a rule.

What does all of the above mean in cleantech in particular? 

It helps explain why cleantech-interested LPs have been drawn to larger cleantech funds, and large generalist funds who are getting active in cleantech.  This has exacerbated the shift over time toward more growth stage cleantech investing, and away from early stage cleantech investing (although there are some signs this shift has mitigated recently). 

The study suggests, however, that investing in smaller cleantech specialist funds may be a winning strategy for LPs -- if they have a rigorous way to effectively identify, evaluate, select and oversee those venture managers.  We'll have to wait and see if LPs actually do this more often.  But I believe they should.

And kudos to the team at SVB that did this study.

The other capital gap:  Truly capital-efficient growth businesses

Rob Day: April 6, 2010, 9:00 AM

"My job is to look for entrepreneurs who want to change the world," one young cleantech VC told me in an engaging twitter conversation last night, "and build bigger companies."

Very true words!  But how do we define "bigger companies"?

I've seen someone mention that only two percent of startups get their financing from venture capital.  I don't know the accuracy of that number, but it does ring directionally true.  That doesn't mean 98% of startups are bad businesses, however.

Let me describe two basic types of startups:

1. The big game-changing startup that is going to be manufacturing or otherwise producing something very new.  They're going to need some significant level of capital in order to accomplish this, because R&D and commercialization efforts and then production capacity don't come cheap, but they do come before revenues. 

2. The small local startup that is going to be a nice personal business, perhaps growing over time into something a bit bigger.  These tend more to be service or retail companies going after an established market, perhaps with a new twist.  These can be really compelling businesses for the entrepreneur, and if pursued in a lean way they won't require millions of dollars to get started.

The first type of company is the purview of VCs like the one I cited above.  The latter type of startup is the one that is classically self-funded by the entrepreneur (and their credit cards), as well as friends and family, and perhaps a community bank.

But what about the companies in the middle?

Let's better define the upper end of the problem...  What many entrepreneurs often don't realize is that large VC firms typically have a pretty significant minimum check size they'll write -- quite often the bar is set at $2M or $5M, depending upon the firm.  Even funds that will do smaller seed stage checks need to see enough capital intensity in the model that they'll have the opportunity to put significant money into the company over time.


Simple math.  The larger the venture firm, the more pressure to put significant dollars at work.  And the single most limited resource for that company is the time of the partners in the firm.  Each company in the portfolio requires time to manage, whether they hold a Board seat or not.  And there are often companies in the portfolio from previous funds that haven't exited as well.  They can't have a 100 company portfolio and claim to be "value add" with a straight face.  So these larger funds are pressured to invest only when they see the opportunity to put significant dollars in either up front, or over time.

In other words, IRRs are not enough.  If you have a $400M fund, and you put only $1M into a company, even if that returns 10x it's nice but not going to move the needle in terms of aggregate fund returns (not to mention the chances for glory for the GP who did the deal, btw, which is no small consideration for some).

You can't just add more partners because GP salaries and support staff have to be paid out of the management fees, typically 2%.  So this is why most large VCs I speak with -- even early stage and seed stage ones -- tell me they need to see the potential to put something like $10M into a company over time, at a minimum.  

That's a long way of explaining why VCs need to see some level of capital intensity in a startup before they can get involved.  And yet, if a company is going to need $1-3M of capital over time, that's probably too much for credit cards and friends and family to support. 

Where does this all hit in cleantech?  In Web2.0, people are already used to capital efficient businesses, so they've had to invent efforts like Y Combinator to compliment the bigger check-writers in the space who won't touch certain sized deals.  But in cleantech the gap remains.  If you are trying to develop something like a new solar cell, or a smart-grid network, or a new LED chip or fixture, that will require some significant capital before you get to cashflow breakeven.  But what if you're just developing something purely software-based?  Or a scalable service model?  If managed well, often these won't require such large amounts of capital.  And yet they can grow to be decently-sized businesses, even if they probably won't be the "Google of cleantech".

For outside observers tracking cleantech VC dollars, to a certain extent the reason they tend to declare that ALL of cleantech is capital-intensive is because they see all the VCs flocking to capital-intensive businesses because of the above dynamics.  Even in areas like energy efficiency and smart grid, where VCs now say they're interested because it's less capital-intensive, they typically are backing businesses that will "only" require tens of millions before an exit, instead of the hundreds of millions that have been required for some of the bigger named startups that were the focus a couple of years ago.

But there are indeed truly capital-efficient businesses in cleantech.  I get contacted by entrepreneurs all the time who are only looking for $1-3M or so to get started.  They're entrepreneurs, and they read about certain high-profile VCs who are interested in cleantech, so they reach out to those investors to raise their funding.  They have a business that, with a little bit of money, might turn into a $20-50M company, resulting (they believe) in very nice IRRs for the investor with such a light capitalization.  In many cases, they may already have significant revenues, and they just need a little bit of capital to hire up some more sales and implementation teams, or to shore up the balance sheet.

And then they're surprised they can't get any big name VCs interested.

In some cases, these entrepreneurs are simply underestimating the amount of capital they'll really need -- I'll write about that sometime soon as well (short version: take more money than you think you need, especially in the current fundraising environment).  But there are a lot of solid service, software, web-based, etc. cleantech businesses out there, that are having real trouble raising the capital they need.

It's a serious capital gap, if you care about more than just innovation in cleantech -- if you care about actual near-term implementation.  Because these businesses are the ones positioned to make an impact today.  To go back to the initial quote, these are companies that are poised to change the world... even if they're not poised to become a "big company" of the massive scale that young VC thinks he needs to see.

If you are one of these entrepreneurs, however, there are some underexplored options you should focus on instead.  Don't waste your time with the big-name firms who structurally won't be able to engage with you.  Instead, look to regional, smaller VCs -- such as the network of Village Ventures firms.  Reach out to local angel groups, and local smaller family offices.  And if you are indeed already at a revenue stage, local commercial bankers may be able to do a venture loan alongside any equity you might be able to bring in.  In other words, don't waste your time flogging your plan up and down Sand Hill Rd., spend your time networking locally to find the investors in the right check size range.

My point isn't to knock the perspective of the VC I quoted at the beginning of this overly-long column.  He's looking for a certain profile of investment that is right for his firm's size and strategy.  And I'm certainly not saying there aren't big-dollar VCs who won't write smaller checks.

But as this same VC wrote elsewhere in the conversation, "VCs want to be involved if the entrepreneur wants to build to a big outcome.  If you are happy selling [your business] for $20M, surely go to angels."  A snarky comment, but I would say it's completely valid at the $50M exit level and below, not $20M.

When the average venture-backed M&A event is well under $100M, a $20-50M exit can be considered a real win for the vast majority of startups.  Entrepreneurs need to acknowledge to themselves when their business is most likely going to be a <$50M exit down the road -- if it even exits at all, it may instead become a cashflow producer for the entrepreneur and angel investors.  That's NOT a bad business.  It can be a phenomenal business that makes the entrepreneur and angel quite wealthy, and makes a significant impact on their community. 

But it does mean you have to be smart about what types of funders you approach when you need startup and growth capital.