Last week I went for a sweaty hike in the mountains near Los Angeles. I was with a consultant in the cleantech / energy space, and in the stifling 90 degree heat, he told me how his industry works.
He got me thinking about cleantech a lot more carefully. And I’ve been pulling on that thread for the last few weeks.
(What’s cleantech? Cleantech is anything that helps people use resources more efficiently. It covers everything from solar power to electric cars, batteries and software.)
Today I want to write about cleantech investing. Who’s backing these technologies? Who’s buying them? And who’s making money?
I found an interesting paper on the topic: Venture Capital and Cleantech: The Wrong Model for Clean Energy Innovation.
The paper says that venture capital (VC) hasn’t worked for cleantech companies (venture capital is about giving a risky new business cash in exchange for a share of the company). Here’s how I described VC in a previous email:
VCs are the technology industry’s money men. They back talented entrepreneurs with millions of dollars in exchange for a stake in the future of their companies.
(Think Dragons’ Den, except with Mark Zuckerberg pitching Facebook instead of a guy pitching edible birthday cards for dogs.)
Here’s how venture capital works: the entrepreneur pitches his startup idea to a VC to get “seed capital”. This is the first round of funding, and it usually comes before the company has made a penny.
When his product gets some traction (and he needs more money) he goes back to the VC for more funding. This is the “A round”. All going well, he’ll come back later for a “B round”. And so on. Each time, the entrepreneur gives up a slice of his company for cash.
The authors of this paper – Dr Benjamin Gaddy, Dr Varun Sivaram, and Dr Francis O’Sullivan – looked at cleantech companies which got their “A round” funding between 2006 and 2011. And they found that most VCs made a terrible return on their cleantech investments!
VCs normally invest in internet startups and software companies. Those types of companies are easier to invest in – they grow quickly and then succeed or fail quickly.
Cleantech companies are different. They work in different markets. And they make very different products to software companies.
The authors of the paper say that VCs failed in cleantech for four reasons. The first is that clean tech companies are illiquid. In other words, they tie up investors money for longer than other technology startups. Investors in cleantech might have to wait three to five years to see any return on their money. VCs don’t like waiting.
The second is that cleantech companies can be expensive to scale. For example, to scale a solar cell company you’ve to build a new factory. By comparison, scaling a software business just means renting more server space. Building physical objects and infrastructure is much more expensive than building software.
The third problem is that there’s no margin for error in lots of cleantech markets. That’s because cleantech companies are often trying to sell into markets – such as electricity or solar panels – which are already competitive. The profit margins in the solar panel market, for example, are razor thin. So a startup solar panel company basically has to get it right the first time. It doesn’t have the luxury of figuring things out on the hoof.
The last problem is that the types of business which might be expected to acquire cleantech startups, like big power companies, are slow to open their wallets. In the software business, a bigger company might be willing to buy a small startup which is growing quickly. But utilities are old, highly regulated, and risk-averse. They don’t have a growth mindset. So they’re slow to pay for an exciting, fast-growing cleantech startup.
I have some problems with the authors’ methodology – for example, their entire study is based on one period between 2006 and 2011, which wasn’t a good time for cleantech companies. But it’s a good read all the same. Cleantech was a red hot investment trend back in the mid 2000s, and it’s interesting to dissect that investment boom, ten years on.
The main lesson I’d take from it, which is applicable more broadly to small company investing, is to be sure you understand how much capital a business is going to require in the future. It’s no good investing in a great technology, and a great team, if it’s going to take years and millions of shareholder capital to see it through.