A while back, I wrote about the role “impact investors” could play in funding the next wave of cleantech startups. This week I had the opportunity to sit in on a conversation between several such investors from the family office community and some of the smartest generalist VCs still investing in the sector. It was a fascinating and educational afternoon.
The gist of the conversation revolved around one basic idea: how impact investors and VCs can work together to drive more successes in the sector. Because such successes (“we need ten Teslas, not just a couple”) would bring a lot more mainstream investors and entrepreneurs into the sector and feed a new wave of cleantech commercialization. It's a great conversation to have.
Let’s take a step back and look at the “traditional” role of family offices and other similar types as investors in the startups backed by mainstream VCs. To understand the relationship, it’s important to understand how many such family offices are organized. Theytypically don’t have large staffs -- the investment decisions are made by a very small team, which often includes a member of the family itself. They typically cover a very broad range of investment asset categories, too: One day it’s evaluating hedge fund managers, another day it’s considering a set of publicly traded equities, and a couple of times a year there may be consideration of a “venture capital” round. I’m overgeneralizing here (after all, the old joke is “if you know one family office, you know one family office,” and certainly our own firm is a clear exception to this broad characterization, as are many others). But it’s a good enough model to use for this discussion.
With a family office like this, even very smart investors at such groups don’t have the bandwidth to do significant research into every investment opportunity, to do full diligence, or to learn the ins and outs of how various asset categories behave. So the idea of such groups being “lead investors” in a select few venture capital investments is difficult to fit with the above model. There’s certainly some of that that goes on. But by and large, such groups end up being followers more often than leaders.
So unsurprisingly, the relationship between VCs and such family offices has been one where the VCs fund the early rounds, and then FOs and other non-VC investors (corporates, hedge funds, bigger financial investors, PE firms) come in for larger, later rounds. Many of the most famous (and infamous) startups over the past decade of cleantech venture capital ended up with such FOs quietly investing in later-round deals because of this dynamic.
The dynamic relies upon trust and reputation, as well as a hunger for particular theses. Trust is important in the sense that the investors should be confident that what’s being offered really does have a good chance (at least at that late stage) of being a big winner, justifying what is typically a significant “up-round” valuation which very clearly benefits the existing VC investor. Reputation is important in that the venture firms introducing the opportunity have to be worthy of that trust. And certainly, there has to be a hunger for a particular investment sector, which is why the FO is stepping into what is relatively unfamiliar territory.
Right now, cleantech doesn’t possess many of these features, unfortunately. So such follow-up capital has dried up. And the fear expressed by some in the meeting this week was that, lacking follow-up capital, some very promising companies have withered on the vine during this sectoral capital depression.
I also share that fear.
To be clear, I do believe part of the problem is the capital-intensive models of many of the companies that have gotten themselves in the most trouble. Because such “cheap follow-on capital” used to be more readily available, it led some entrepreneurs and their VC backers to put the pedal to the metal and push hard to drive to a big exit. And when the exit didn’t happen as quickly as expected, the company was hemorrhaging cash, and follow-on capital was sought out to rescue it (albeit presented with great optimism, of course). That’s not a story likely to have a happy ending.
But another part of the problem is companies that didn’t let themselves fall into that trap, aren’t burning so much cash in their current form, and yet still need additional capital to take a next step, whether that step is to open up a new commercial-scale plant, to establish their first pool of distributed-asset financing, to expand into a new territory, or something else. And this capital depression is real and impacting even very well-performing companies. I see it in our own portfolio all the time: companies that are growing revenues at really impressive rates still have to work very hard to find follow-on capital, even when successful exits are likely in the near future. These types of stories would be attractive companies for FOs to invest in, especially at this point in time.
The problem from the FO perspective (whether or not “impact investment” is a focus) is differentiating between the two previous stories. This is especially true for an out-of-favor sector, where a rising tide isn’t there to raise all boats. Yet ironically, that’s exactly when smart FO investors could reap the most reward for stepping into the right deals -- if they could tell which ones were the right deals, of course.
What I think many VCs don’t realize is the extent to which many FOs (and other similar types of investors) worry about negative selection bias in terms of the deals they’re being presented. In other words, many tend to wonder, “Why am I getting a chance to invest in this deal?”
As I told the room this week, “Here’s how the family office investor looks at it. 'I’m not going to be smarter than any Sand Hill Road investors on the technology or the market. I’m not going to be smarter than mainstream project finance companies at project finance. I’m not going to be an active hands-on investor with a lot of value to add to the management team. So why am I being approached about this deal? Did other smarter investors already pass on it, or wanted to do it at a lower price, in which case, why should I do this deal at this price? Why me?'” And there’s evidence to support this fear in plenty of examples I’ve seen over the past decade, where FOs are approached sometimes weeks after I’ve seen the exact same deals pitched at VCs, who apparently must have passed before the marketing outreach got to the FOs and such.
At my firm, we looked at the above dynamic and chose to zig while others zag, to do different types of deals in different types of ways, and to figure out how to be active investors who strive for value-add. (You’ll have to ask our entrepreneur partners if we’re pulling that off, but at least we make the effort!) As such, we hope to avoid this negative selection bias trap. But our approach isn’t a fit for many kinds of family offices; we are admittedly rather different.
To get the broader FO community more actively engaged, I believe one key is to figure out what family offices bring to the table that is truly unique and valuable. And with some specific exceptions, for the most part, that asset is flexibility. FOs can invest in a venture capital structure, but don’t have to. Which means that as the startup reaches a point where it could use different types of capital other than very expensive venture capital (such as early project finance, or debt), FOs can play a unique role to make sure that the startup's corporate equity stack doesn’t get too high, and that appropriately priced capital is deployed optimally. And that directly answers the “Why me?” question.
Another key is to have investors who are knowledgeable about these alternative structures lead these follow-on rounds. FOs that are comfortable in that role are pretty rare, but they do exist. Also, an institutional investor with project finance expertise (for example) could help structure that side of the transaction, and FOs could be asked to put money into both the corporate side and the project side. Corporate venture groups are often used as a validation point (although they may validate the technology, but their ability to validate the business model or deal structure is often overrated).
All that said, as cleantech comes back into favor, we’ll continue to see lots of examples of FOs and high net worth investors putting money into follow-on rounds as passive investors. It’s the way it’s worked in the past, and it’s easy to hear it when talking with many such investors who say things like, “Well, if I was going to start investing in the sector, it would certainly be by following [brand-name VC firm], since they’re the ones who know what they’re doing.”
Yes, they do. And they know how beneficial it is to their own returns to find passive investors willing to pay up to support their existing investments. I believe that solving this moral hazard along the lines I’ve described here would help even the most well-meaning VCs, because the knowledge that it exists leaves a lot of FOs sitting on the sidelines. So I was also excited to hear other ideas discussed to resolve this trust barrier as well, from deal structure changes to simply “more transparency.”
If VCs would approach FOs with a clearer idea of why that FO is being approached as a follow-on investor, or if the moral hazard/negative selection bias dilemma could be resolved, it would unlock a lot more activity. And that would do a world of good for helping bring more cleantech innovations successfully to market. It’s the right conversation to have, so I’m glad to have had the opportunity to be part of it, at least for one afternoon. I’m looking forward to seeing how it progresses.