Cleantech just can’t escape it’s reputation. Bradford Cross, in his rundown of AI predictions for 2017, said AI would be “cleantech 2.0”: a trendy area where VCs are likely to lose a lot of money. Bradford is an investor at DCVC and has been working in AI for decades. There’s a lot of great stuff in the post and I encourage you to read the whole thing, but here’s the section on cleantech:
“Cleantech isn’t a market, it’s a cross cutting concern. … [C]leantech for cleantech’s sake doesn’t work because it doesn’t start from the premise of a customer need. Great businesses start with customer need. Great missionary businesses start with a vision defined by customer need, and incorporate a mission that aligns to satiating the need. An organization with a societal mission but without a customer-centered vision is at best a moderately effective philanthropic organization. Great business put customer needs first, not a cross-cutting technology trend, even if it’s a missionary one.”
– Bradford Cross. Emphasis added.
Bradford is absolutely right that businesses don’t succeed unless they focus on customer needs. It’s also fair to say that some of the cleantech failures didn’t start from customer needs. In other cases, they were addressing needs that didn’t exist. Plenty of biofuels companies bet that customers would have certain needs when oil prices went to $300 a barrel.
A different cleantech 2.0
The time to buy is when there’s blood in the streets.
– attributed to Baron Rothschild
During the panel I moderated last week at the ARPA-E Summit, I asked Ira Ehrenpreis (DBL Partners) and Mike Biddle (Evok Innovations) about the bad rap Cleantech got with VCs, the subsequent flight of venture funding from the sector, and what’s different now. After all, DBL recently closed a $400m fund and Evok raised $100m to invest in early stage cleantech startups. Ira pointed out that Facebook and Google rose out of the ashes of the dot-com bust. In his view, “cleantech is a widening prism.” That is, there’s more than just solar, batteries, and biofuels. Now they’re seeing better and more diverse companies. Companies that focus on real customer needs, not just pushing innovations to an unreceptive market. Investors are practicing better discipline—no more $100m equity rounds to build factories before R&D is done. As they see it, founders and investors learned some tough lessons. In their view, Cleantech 2.0 is here and they’re betting on it.
Commercializing Energy Innovation
Last week the energy innovation community gathered outside Washington, D.C. for the eighth ARPA-E Summit. The event brings research and commercialization together in a way that few other events do. ARPA-E staff pitch their ideas for the future of energy, transportation, cities, and food. Leading scientists explain how they push the frontier of innovation in energy and materials. The technology showcase lets ARPA-E awardees highlight the progress they’ve made over the course of their 3-year grants.
But the Summit doesn’t just spout techno-optimism. The conference balances technical sessions with panel discussions, keynote speeches, and fire-side chats that offered practical advice on how to commercialize those innovations. It was fascinating to understand how these experts think about building and scaling cleantech companies.
I had the honor of moderating a panel featuring some of the smartest people in the field:
- Ira Ehrenpreis of DBL Partners, a Director on the board of Tesla and one of its first investors;
- Mike Biddle of Evok Innovations, who built one of the world’s leading advanced recycling companies and now is an early-stage investor; and
- Michael Horwitz of Greentech Capital Advisors, an expert on mergers and acquisitions in the cleantech sector.
The discussion was lively and featured plenty of tales from the trenches. The summit also featured an excellent discussion with Ajay Royan of Mithril Capital Management, which he co-founded with Peter Thiel and has $1.5B under management, and a panel on alternative capital solutions that featured Jeffrey Sirr of Munich Re, one of the world’s largest re-insurance companies.
Throughout these sessions, the conversation kept returning to the importance of Risk, Markets, and Team. Of course, startups in any sector have to think about these factors but the investors explained why the nature of energy and cleantech has a multiplying effect on these challenges. As Ajay put it: You have to focus on quality of market, then product, then founder. It doesn’t work in the reverse order. The biggest problem in commercializing hard tech is the friction cost associated with entering the market. He calls this “artificial friction” and emphasizes that this makes it more challenging.
What follows are some of the most interesting things I heard at the Summit—things I think anyone in the sector should keep in mind as they build and grow their business.
On Markets and Market Adoption
Ajay channeled Warren Buffett in his focus on the market first: If you put a brilliant team up against a tough market, the market always wins. He emphasized repeatedly that energy is so tough because it’s a commodity. It’s difficult to price a premium product. In any industry, he said, new products hit a barrier of market access. Even if it’s a great product and it works well, no one adopts it. Energy startups need to think about how they will break that wall, even on day one. How will they ease that friction? According to Ajay, the only way to do that is through product. He offered a particular challenge to energy startups: If you have a great innovation that then needs a whole support mechanism and consulting firm to work with customers to get it adopted, it’s not likely to work. This really matters because even though you can show—analytically and through pilots or demonstrations—that this product works, you end up spending all your capital on adoption friction costs. So then you need to raise another $100 million just to get the product in the customers’ hands. So what’s the result? New innovations aren’t being adopted as fast as they’re being created.
Perhaps Ajay would be interested in the solution proposed by Jeffrey Sirr of Munich Re who has been exploring new ways to insure against the risk of adopting new technologies. For instance, suppose an energy storage startup had a new flow battery technology and found a customer who was interested in the improved technology, but was unwilling to take the risk that the batteries didn’t live up to expectations. Munich Re would do their technical due diligence and underwrite the performance of the batteries. If the batteries failed, the insurance policy would pay out and make the customer whole again. This approach seems like it would assuage at least some of the fears of technology risk. Of course, insurance adds cost, but Jeffrey maintains that the insurance underwriting can also help secure less expensive debt to finance the project which may make up for the additional cost. A general overview of these types of mechanisms can be found at the Climate Policy Initiative. This is an exciting space to watch and it will be interesting to see if the model is sustainable for earlier stage smaller deployments.
Ira, Mike, and Michael acknowledged the realities of the cleantech markets, but for them this means the team is even more important. When they evaluate an investment, they ask themselves whether this team can “stare death in the face and survive.” Each shared a story where the company would have gone under but for the extreme resilience of the founding team.
For founders, the message is clear: you have to be fully committed to the business. As Ira said “This company can’t be the second or third most important thing in your life. If you want to make it, the company has to come first.” Building a business, especially in this sector, requires complete dedication and investors need to see that commitment.
On the Sector and Investment Theses
Based on his evaluation of the Market, Ajay shaped a contrary investment thesis at Mithril. “Cleantech was being talked about as religion. But most people in the world were still going to use oil and gas, and 20% of power was nuclear. This is where we started spending time.” He went on to emphasize that it is key that the underlying product is “long on technology”—meaning that as technology improves in the future, the product gets more competitive, not less. He used solar as an example—emerging technologies like thin-film solar were “short” innovation. As Chinese manufacturers glutted the market and costs came down the learning curve, the new technologies couldn’t compete. He likened this to companies in the IT sector: Cisco would be hurt by foreign innovations in router technology, while Facebook, Apple, Netflix, and Google can all take advantage of it.
On Long Technology Development Cycles
Mithril isn’t afraid of long development cycles—they have invested in nuclear fusion startup Helion Energy. When asked how they can make decisions about a company that has such a long road ahead, Ajay said you have to do all the underwriting up front. He says they treat diligence meetings as board meetings that will happen in the future. He asks the founders “What is it that you would talk about at a board meeting next week?” What challenges are you facing right now? What are the strategic decisions you need to make in the next 6 months? He emphasized that this is good for founders too, because “capital is marriage and you want to be with investors who you can talk to about the really thorny issues.”
As for the long time-horizon, Mithril has the added advantage of being structured as a 12-year fund (as opposed to the more common 10-year fund). Here, he channeled Buffett again: “Time horizon arbitrage is avail to all of us. If you can operate rationally on a five-year horizon, you are in an elite category.” It is certainly an open question whether a 12-year fund is long enough for breakthrough energy technologies that still have 5+ years of R&D before they’re commercially ready. If 12 years isn’t enough, those companies must find other ways to fund their development in the interim.
Venture capital is a high-risk, high-reward business. At the end of the long road of technology commercialization, a startup turns into a successful business selling product and delighting customers. But, for companies backed by outside investors, that reward can only be realized when the startup goes public or gets acquired. One of the biggest problems facing cleantech companies and their VC investors in the last decade was the lack of acquirers. It looks like things may be changing. According to Michael Horwitz, there has never been more activity in cleantech M&A than there is today—this is great news. The pathways to IPO, unfortunately, may not be looking any brighter. As Ajay put it “you have to be the last company that matters in your market before you can go public” and contrasted this with the go-go market in the mid-1990s: “Go read S1 filings from ’95.”
I’m very grateful to Danny Cunningham at ARPA-E for the invitation to moderate the panel and to the rest of the ARPA-E staff who made the event a success.
Software ate cleantech.
Today, my colleagues Varun Sivaram and Frank O’Sullivan and I released a report through the MIT Energy Initiative on the past, present, and future of cleantech venture capital.
As we wrote this morning in an op/ed in the Financial Times:
In 2006, Silicon Valley began to bet big on clean energy technology. Seduced by grand visions of making a fortune while saving the planet, venture capitalists invested a then-record $123m in the first round of fundraising for 16 new companies that year. In 2008, they would sink nearly $1bn in over 100 new companies.
But when these investments began to flop, the cleantech bubble abruptly popped. Since 2009, VCs have barely funded 25 new cleantech companies a year, slowing new investment to a trickle.
What went wrong? And where should cleantech go from here? To answer these questions, we compared the performance of every medical technology, software technology and cleantech company that received its first round of VC funding between 2006 and 2011. We found that betting on cleantech start-ups just did not make sense for VCs, because cleantech could not deliver the outsized returns found in other sectors.
This conclusion is alarming because new technologies are desperately needed to confront climate change. Still, guided by the lessons learnt from the cleantech VC boom and bust, new private and public funding sources may be able to better support revolutionary technologies.
Challenging the conventional wisdom: Cleantech just needs more money and more time
We hope that our findings will dispel the notion that the climate change can be solved by simply replacing VC money with patient capital. While it is true that the R&D needed to bring breakthrough innovations to market often takes decades and that building factories and manufacturing products requires substantial capital, there are further lessons to be learned from the first cleantech bubble.
What went wrong?
In short, investments in cleantech — especially those in companies commercializing breakthrough energy technologies — simply couldn’t deliver the outsized returns required by the venture capital model. We found five basic reasons that these companies failed:
- Long development cycles. Developing breakthrough materials, such as those for next generation solar panels, can take 20-30 years.
- Significant capital requirements. To reach scale, venture capital money was used to build factories, in some cases before R&D was done.
- Business model failures. Many companies faced expensive customer acquisition and long sales cycles.
- No sales premium. Energy companies were selling into established commodity markets where price (of electricity or of the solar panel itself) was the main driver.
- Few exit opportunities. Acquirers in the utility and industrial sectors were not eager to take risks or place a premium on a startup’s growth.
Software ate cleantech.
The result was an overall retrenchment of venture capital in cleantech companies. Total funding for startups in the sector fell from $5 billion in 2008 to $2 billion in 2012. More importantly, funding for new companies took an even harder hit. In 2008, nearly 120 companies received their first major round of funding. In 2009, fewer than 30 companies could say the same — a number that has remained approximately constant every year since.
What about the deals that are still getting done?
VCs all but stopped funding “deep technology” companies and shifted their focus largely towards software.
Who will fund the breakthroughs?
In order to avoid the worst effects of climate change through the year 2050 and beyond, we absolutely must both deploy as much existing technology as we can, as quickly as we can manage, and with clever new business models — but the magnitude of the problem will require new breakthroughs. There has been a substantial evolution of the ecosystem since the boom and bust, but the battle is not won yet.
First, public-sector support of energy R&D has been buoyed by ARPA-E, the Department of Energy’s advanced research projects arm. More recently, in committing to Mission Innovation at the Paris climate talks last year, President Obama pledged to double the nation’s energy R&D budget over the next several years. Other commercialization and technology transfer efforts within the Department of Energy have provided increased access to our National Laboratories and infused an entrepreneurial culture inside the Lab system. In just the past few years, DOE has launched Cyclotron Road and Chain Reaction Innovations, Small Business Vouchers, and LabCorps, and has established the new Office of Technology Transitions.
New sources of capital are also available. A number of foundations, family wealth management offices, and high net-worth individuals have begun pledging to support these breakthrough technologies. Keep in mind that these are largely not new actors: these investors were the source of capital originally deployed by the VCs in the first wave of cleantech. Now, however, some feel that by investing directly or through syndicates, they may avoid the short term horizon imposed by the typical venture structure. Last Fall, Bill Gates and 27 other billionaires announced the Breakthrough Energy Coalition, pledging to put billions of dollars to work over the long term to support emerging technologies. Meanwhile, the PRIME coalition is helping foundations and philanthropists invest directly in game-changing technology companies, often before other institutional investors would be willing to take such risks.
But capital is only part of the equation. Cleantech companies require much of the same support as other types startups: help with developing sales strategies, hiring the right key employees, marketing, and fundraising. But they also require some things a SaaS company doesn’t: lab space, manufacturing expertise, and — particularly important when selling to risk-averse adopters — opportunities to test and demonstrate their technology. In the decade since the cleantech boom started, a number of incubators and accelerators have stepped in to fill these gaps. My organization, Clean Energy Trust, invests in and works directly with startups to help them through this early scale-up process. Others, such as the Los Angeles Cleantech Incubator and Greentown Labs in Somerville, MA provide physical incubation space for new companies. Cleantech companies now have improved access to first-of-a-kind demonstration and pilot projects through programs like the Wells Fargo/NREL Innovation Incubator, the Energy Excelerator demonstration track, and CET’s Campus Cleantech Pilots. Large industrial corporations and utilities are also increasingly becoming aware of the need to work with innovative companies. For example, through our Cleantech Innovation Bridge we match startups with corporate partners in need of emerging technologies.
No Exit: Funding the slow-growth company
There is no doubt that the support structures for new emerging technology companies has gotten stronger and we hope that this will fuel increased interest in solving climate change through innovation. Before 2012, some cleantech companies were able to raise over $500 million in venture capital before turning a profit. That is simply not likely to happen again.
The model for success in the current funding environment has not yet been proven, though there are a few predictions we can make. To succeed, cleantech founders will have to run lean. First, they will have to take advantage of incubators and accelerators and will need to fund R&D through public grant funding. Later, they will need to rely on debt for projects (such as Black Coral and Generate Capital) and manufacturing (including private working capital revolving funds and public sources such as OPIC) as an alternative to equity financing. Throughout the process, cleantech founders should be in close contact with corporate and strategic partners who will not only be the likely customer for the product, but also potential acquirers of the company.
Finally, cleantech companies will need to build a business on the assumption that they will be valued based on their profits, not their growth.
Venture capital didn’t work for cleantech because there were better places to invest. That doesn’t mean it’s not a sector worth investing in. As many others have put it: climate change is the greatest challenge we have faced in a generation and the transition to a low-carbon energy system will be the single greatest economic opportunity in our lifetimes.
Will your clever cleantech business model bankrupt your company?
If you spend enough time talking to people in cleantech, you’ll often hear them talk excitedly about how new business models will be key to unlocking the low-carbon energy economy. But what if it could end up killing your company?
Let’s start with the basics: a business model is “all the parts of a strategy necessary to deliver a product to a customer and make money from it,” as Steve Blank describes it. As Blank tells it, this includes “the product itself, the customer, the distribution channel, the revenue model, how to get, keep and grow customers, resources and activities needed to build the business, and costs.”
In world of Silicon Valley-funded software startups, the subscription model where customers make recurring payments (software as a service, or SaaS) has come to dominate, even if it’s not a new idea. For software companies, this has been enabled by relatively cheap cloud computing. But other benefits such as increased customer retention (“stickiness”) have helped justify the old-fashioned magazine-and-newspaper subscription model in other industries–think razors, snacks, clothes, and even dog toys.
In cleantech, business model innovation often means a different revenue model. The first version of this was a leasing model, which gives customers the advantage of low up-front costs and gives the startup predictable cash flows. Think of a company that, instead of selling solar panels, installs the panels on a customer’s roof, maintains ownership of the panels, and simply sells electric power. There are some very inventive new revenue models that take advantage of “ancillary markets” which are in essence things a utility will pay you to do or not do. For instance, a smart battery system in your garage can communicate with the utility to help regulate the frequency—and the utility will pay you for that service. Some new startups are building businesses around these multiple revenue streams, and offering the battery hardware for free, up front, with recurring payments based on these new revenues. This is a very clever variation on a lease, and while it’s tempting to compare the leasing model to SaaS and consumer goods subscriptions because all three models yield monthly cash flows, the reality is that the differences make leasing a tough route for new startups.
Cleantech leasing models aren’t a new concept. (You could even argue that electric utilities have been operating a kind of leasing model since the 1880s.) In the early 2000s, Jigar Shah’s SunEdison LLC began developing solar projects where they provided the up-front capital for the equipment and installation, then sold electricity via Power Purchase Agreements (PPAs). This meant that a customer who was interested in solar didn’t have to worry about buying, installing, or maintaining the solar power plant, but still got to enjoy the benefits. This model meant that not only did the customer avoid worrying about the risk of the new technology (if the panels broke, the customer wasn’t on the hook to fix them) but also let them avoid the hefty up-front investment.
In 2008, SolarCity applied the model to residential rooftop solar. A homeowner could have solar panels installed on their roof with no money down, and simply pay a monthly fee. Other solar companies quickly followed suit (including Sungevity, BrightGrid, and SunRun) and the model was ported to other technologies (LEDs from Lemmis Lighting and Green Ray, fuel cells from Bloom, electric vehicle chargers from ChargePoint, batteries from Stem, as just a few examples).
Problems with the No Money Down Model
“No money down” is very appealing to customers, especially for energy efficiency technology, so it’s not surprising that so many cleantech startups raising money today pitch some sort of recurring revenue or subscription model. Of course, there are cleantech software businesses that might be a great fit for the model, but let’s focus on the companies selling tangible energy products.
There are two interrelated problems with the leasing/subscription/cleantech-as-a-service model. The first problem is one of mismatched growth expectations and the second is that these companies will run out of cash, fast.
Problem 1: Growth
When you read that a SaaS startup is valued at 10x ARR (annual recurring revenue), it’s easy to run the numbers and try to guess what that means for your company. But here’s the key difference: investors in the private and public markets place a value on subscription businesses based on their revenue and their growth. Subscription companies grow by spending huge amounts of money on sales, and they can afford to do this because their product is scalable. Once the software is written and sold to the first customer, the cost of delivering the software to the second customer is very small. Take a company like SalesForce, an industry-leading SaaS company, as an example. For every $1 of revenue, SalesForce spends about $0.50 on sales, $0.25 getting the software to the customer, $0.15 on writing the software. The sad reality is that making physical products is more expensive. For every $1 of Tesla’s revenue, $0.70 goes into making the product. (And for those who are counting: at Ford the number is $0.77).
This model works well for software startups. Acquirers are willing to pay for that future growth. Over the last decade, we’ve seen the acquirers in the cleantech space are not willing to pay that growth premium, and instead focus on profitability.
Problem 2: Cashflow
That brings us to the second problem: running out of cash.
Let’s say your company is selling solar panels. You have a bit of seed money in the bank, so you use that to manufacture your product and then go out and make a sale. You take the money your customer just paid you and plow the profits back into making more panels.
Suppose instead you adopt the leasing model. You take your seed capital, manufacture the product, and install it at the customer’s site. Instead of the customer paying you $20,000 up front, maybe they’re paying you $120/month. Maybe you can repeat this a few times, but sooner or later, even with customers and revenue, you won’t have the cash on hand to continue to grow. This isn’t just a hypothetical problem: SolarCity just ran into this issue and solved it by selling $227 million of installed systems to a bank. Unfortunately, your startup isn’t likely to get the same deal.
Making the Model Work
Given the difficulty of scaling companies that make physical products, is there a path forward for the leasing model for startups?
A handful of investors are working on solving this exact problem by separating equity finance from project finance. For mature technologies, Jigar Shah’s current venture, Generate Capital is actively providing funding for projects using reliable and proven but under-installed technology. This model is fundamentally different from venture capital, because it doesn’t assume the high risk and therefore doesn’t require the same rocket-ship growth. For those slightly less mature technologies, there is also hope: Rob Day at Black Coral Capital has structured a few deals where the equity for the startup has been separated from the debt for the projects and installations.
So what does this mean for your cleantech startup? On the one hand, high up-front costs are likely to remain a deterrent to customer adoption, and “no money down” will remain an attractive option. At the same time, banks will remain unlikely to lend to a risky startup without a balance sheet and investors are keenly aware of the pressures this model will put on the business. Investors like Generate and Black Coral who understand project finance for emerging (but not totally new) technology may be the only path forward. But beware: if your company is developing a next-generation battery AND trying to sell it using a no-money-down model, the leasing model just might kill your startup.