Cleantech Investing: A Primer on Risks

I sense that many in the cleantech world generally hold a negative view of venture investors.  Although rarely worded as such, I can almost hear the pleas:  “Why don’t you invest more in cleantech?  Why don’t you do more cleantech deals?”

Well, as a venture capitalist, I can tell you plainly that our capital is very scarce.  I wish we had a lot more money to work with.  Not rolling in dough, we have to be very picky about the deals in which we invest.

I’ve been looking at early-stage cleantech opportunities for over a dozen years now, starting well before the word “cleantech” had been coined.  Good news:  the quality of entrepreneurs and their ideas in the cleantech space has improved dramatically.

And yet, many inventors still lack a basic grasp of what makes a start-up a potentially investible prospect.  So, it is with this posting that I aim to provide a bit of guidance for those that want to create a successful cleantech company, especially if they want to get it funded by investors.

For the most part, venture capital investors are managing other people’s money.  VCs are compelled to provide good returns to their investors, or else they will be out of business when they try to raise their next fund. 

Like most money managers, VCs aim to assess the potential risks of an investment against the potential rewards.  In early-stage companies, there are many risks, so the rewards have to be quite high.

Usually, entrepreneurs have little problem in touting the upsides of their deals.  In many cases, the potential is overestimated or naively broached.  “The energy sector is a $6 trillion annual industry — all we have to do is capture 1% of it and we’ll be a $60 billion business!” 

Yes…but…securing that 1% is really damn hard, as the companies selling in the market aren’t going to roll over, and customers will be demanding and slow to change.  And, oh by the way:  your addressable market is only a small portion of that $6 trillion, unless your idea can somehow fuel any vehicle, generate electricity anywhere at all times, and also provide heat.

As naive as they can be in describing the potential rewards,  it’s on the risk side that many inventors fail to think through their business opportunity with sufficient depth and insight.  There are many elements of risk in all ventures, but several of these are especially pronounced in cleantech ventures:

Technology Risk

This is one area in which most inventors at least have a bit of a clue how to approach.  Most know that they have to show that their gizmo will actually work — even if all they’ve done so far is conceptual analysis, and have not established “proof-of-concept” with a real working prototype.  But, what so many entrepreneurs fail to appreciate is that actual operability — and also reliability — is only half the battle.  Just as important, maybe more important, is that the widget has to be manufacturable at a cost level that enables a profitable sale at a price point that will be competitive in the marketplace so that customers will actually want to buy it.

To illustrate, I spoke last week with perhaps the 100th person I’ve encountered in the past decade that’s trying to commercialize a new wind turbine design for on-site application.  When asked about the economics of the design, the leader of the team praised its advantages in manufacturability — an important enabler of cost-competitiveness, but by no means the whole story.  Then, the entrepreneur mentioned a cost level, in $/watt installed, that should be achieveable.  There followed a pause, as if this should be a compelling answer. 

However, the important pricing level for any electricity-generating device is not $/watt installed, but cents/kilowatt-hour over the life of the equipment.  No-one cares if they spend $10,000 on a wind turbine:  they want to know whether they’ll save money relative to other options available to them — specifically, in this case, power bought from the grid at maybe 15 cents/kilowatt-hour in certain locations where electricity is not cheap. 

Translating $/watt to cents/kilowatt-hour means figuring out how many kilowatt-hours the turbine will generate, and also adding the occasional maintenance and replacement costs after installation.  Doing these calculations in a back-of-the-envelope manner, we arrived at an estimated 22 cents/kilowatt-hour.  The entrepreneur was non-plussed, but I was very plussed:  22 cents/kilowatt-hour isn’t close to being competitive for the electric generating sector except in the very highest cost islands in the middle of oceans. 

At best, then, this is a niche play, although the entrepreneur had been pitching the technology as a ubiquitous world-beater.  I needed to hear a cost number that was no higher than 10 cents/kilowatt-hour — just because eager inventors are virtually always too optimistic about their technology, and will thus tend to underestimate costs — for me to retain any interest in this opportunity.

While this person’s wind turbine may well actually work, it’s commercially irrelevant if it can’t generate electricity at a cost level anywhere close to other sources of electricity generation.  It’s more likely that cost reductions will bottom out at 30 cents/kilowatt-hour than they will reach 18 cents/kilowatt-hour — much less the 12 cents/kilowatt-hour it would need to be to offer a sufficient competitive advantage to grid power to make customers in most parts of the world adopt.  So, I can’t imagine spending any more time on this one — as much as anything, because the entrepreneur did not have a well-informed view of the market requirements of his proposed product.

Competitor Risk

Of course, we live in a market-based society, and a new cleantech product will have to beat out other alternatives.  While it’s relatively easy to assess the current competitive landscape, that’s hardly all that’s important to scope out.  If you’re developing a new product, one that will take a couple of years to fully mature and introduce, you’re aiming for a moving target.  What will the competitive alternatives be at that time?  This is much, much harder to assess.

It’s especially hard to assess in a dynamic and stealthy segment of cleantech adoption.  I’m always troubled when an entrpreneur says that they have a unique solution, perhaps even patented, in a market space that has attracted lots of investment capital.  What are all those ventures doing with all the capital they’ve raised?  And, what about the companies you don’t even know about?  Is the distinctiveness of your technology all it’s really cracked up to be, given what everyone else is doing?

A side note about patents:  overrated!  First of all, anything can be patented; just because something is patented doesn’t mean it’s commercially interesting.  More importantly, I’ve heard intellectual property attorneys say that patents are only a ticket to a lawsuit, and my limited experience in this is that those lawsuits are both very expensive and hard to win.  This is doubly so when you vie against some really deep-pocketed large corporation that can easily afford to outspend a venture on legal fees by a ratio of 10-to-1 or more.  Patents may be necessary to establish a competitive advantage, but they are usually insufficient.  Best is a combination of patents and trade secrets — proprietary know-how (i.e., “secret sauce”) that is difficult to reverse engineer and that is not published, as patents are.

Adoption Risk

Just about every entrepreneur thinks they have developed a better mousetrap.  Of course; they have to.  Let’s assume they’re right and they have made a true innovation with commercial relevance.  Entrepreneurs are also prone to believing that customers will be dying to buy their baby once it’s on the market.  Not so fast, my friend.

For the most part, customers have become very accustomed to what they buy today.  Even when their current purchases aren’t fully satisfactory, customers generally believe that it’s the least of all evils, that the other alternatives in the marketplace are somehow inferior to what they currently obtain.  And, they have made accomodations in their businesses or in their lives to the less-than-optimal aspects of what they buy now.

In contrast, a new purchase entails a whole host of risks.  Will it really work as promised?  Will it really cost what is promised?  Will it really deliver the benefits that are promised?  Ultimately, these are questions of trust.  In the case of cleantech, most of the purchasing decisions are capital-intensive and have significant associated time horizons and serious consequences of failure, so the buyer is going to have to trust the product — and its supplier — for a long, long time.

Thus, it’s often safer for customers to keep with the status quo, even when presented with something that at least superficially looks better.  Between the trust issues and the hassle factor of doing/learning something new, customer inertia of “do nothing” is frequently the easiest path forward.  With the exception of perhaps the Tesla (NASDAQ: TSLA), cleantech goods are generally not trendy, so it’s not like buying the newest consumer gadget, in which edginess or coolness matters and people may buy on a whim.

Financing Risk

Of course, ventures burn through capital.  That’s why venture capitalists exist.  But, it’s one thing to burn through a few million dollars of capital raised in a couple of rounds of financing, than to require hundreds of millions of dollars of capital raised over 5, 6, or more rounds of financing.

The former typifies many ventures in the information technology space.  It’s not that expensive to hire a few programmers and develop a commercial solution that can start generating revenues.  Once a company gets to breakeven, the entrepreneur can consider raising boatloads of cash to accelerate growth, at pretty favorable terms, because the business concept has been validated:  the appeal of the value proposition, the go-to-market strategy, and the profitability of delivering on the promise to customers. 

Alas, the latter typifies many ventures in the cleantech arena.  Whether you’re developing a new solar technology, a new biofuels concept, a new vehicle, or a new battery — each of these requires a lot of technical equipment and engineering/scientific staff to prove out the physical aspects of the technology.  (Physical stuff is a lot more expensive than virtual stuff!)  Also, once it’s proven in concept, then — because of the risk-averseness of the customer base — the technology often either (1) needs to be proven at large-scale before it will be bought commercially, or (2) requires major manufacturing scale-up investments required to achieve economies of scale to reach price points that will be viable in the marketplace.

Raising tens of millions of dollars over multiple rounds of financing brings a huge element of risk into play:  when your next round of capital is required, what will be the condition of the financial markets at that time?  Notoriously volatile, if the capital markets are bearish, it will be damn hard to raise big bucks at attractive terms — no matter how well you’ve held up your end of the bargain as an inventor/entrepreneur.  The investors who came along for the ride in the early days will be squashed alongside of you, and avoiding this fate is why many early-stage VCs (like me) are attracted to investment opportunities that don’t require a lot of additional capital to be raised in later rounds.

Policy Risk

This is arguably the biggest risk factor in the cleantech universe.  As I’ve discussed many times in previous posts, cleantech is largely shaped by regulations and legislation:  environmental laws, utility regulations, tax incentives, permitting rules, and on and on and on.  These issues dramatically affect the economics, the market potential and in fact even the applicability of cleantech technologies.  This is arguably much more so the case than for any other segment of venture investing (with the possible exception of health care and life sciences).

The entrepreneur must understand that this issue is so scary to potential investors because the rules of the game that may make a cleantech opportunity favorable can be changed essentially by whim to make an opportunity unfavorable.  A solar entrepreneur can tout his/her business model based on a feed-in tariff in Germany — but if that feed-in tariff is wiped away by some political or budgetary force, the business model becomes unviable, the venture dies, and the investor loses his/her capital.

Thus, it takes a particular kind of venture capitalist, one who can assess the degree by which a particular set of laws or regulations are stable, to participate in the cleantech realm.  Some policies are much more stable than others.  If a cleantech venture requires a particular policy to work, that policy better be very stout across the political spectrum, and not strenuously opposed by a phalanx of powerful (read, wealthy and willing-to-spend) incumbent companies, if the entrepreneur wants to raise any significant amount of capital from institutional investors beyond the “three f’s” of friends, family and fools.

Execution Risk

Even if you’ve got all the conceptual risks boxed in and managed effectively, the company still has to perform.  This is as true in cleantech as it is in any other sector.  The sales force has to close sales.  The production side still has to deliver at the costs and quality that were promised to the customers. 

This is not nearly as easy as people think.  It requires a dedicated team, led by disciplined and principled entrepreneurs who can artfully dance around obstacles that are encountered many times every single day.  Ultimately, venture-building is all about people.  And, venture investors spend a lot of time considering the key team members in each deal — both when evaluating a potential investment, and even more so after an investment has been made by seeking to fill out the team with critical skills that may be deficient.

In the cleantech world, there are relatively few accomplished entrepreneurs — though, thankfully, this is definitely changing for the better, as the cleantech sector attracts talent from other realms of technology, due both to the size of the opportunity and its importance to the world.

I liken the game of venture-building to walking the length of a football field strewn with land mines:  you might negotiate 95 yards successfully and be within 5 yards of the end-zone…and then blow up.  Any one of these risks can kill or seriously damage a venture, and they can arise at almost any time.  There’s lots of risks for any venture, and maybe a bit more or a bit more acute for cleantech ventures than for other sectors of the economy.  As a result, few big winners have yet to emerge in cleantech venturing.  For every cleantech company that has IPO’ed — most recently, Solazyme (NASDAQ: SZYM) — there are probably twenty that have crashed-and-burned ignominiously or are sputtering along in zombie-land.  And, even many of the ones that have IPO’ed have withered in the glare of Wall Street.

My nominee for most successful cleantech venture would have to be First Solar (NASDAQ: FSLR), which is now a dominant player in the solar photovoltaics marketplace.  With a current market capitalization of over $10 billion, it’s clearly a big-time winner since its IPO in late 2006.  So it seems like it should be a poster-child for cleantech VC success — until one considers that it was formed in 1999, as a restart of a prior venture called McMaster Energy that spun out of the University of Toledo in the late 1980s, and had the hardest time in raising any capital for years.  In other words, it was about 20 years from the time of true technological origin to commercial success for First Solar — not to mention, a lot of washed-out investors along the way.

A good venture capitalist has to be either a highly-skeptical optimist or a very open-minded pessimist to survive and be able to hold in mind simultaneously the great rewards and the large number of risks associated with a promising cleantech investment opportunity.  Entrepreneurs must also juggle both perspectives, but at least in the “selling” of their ideas to prospective funders, most tend to focus solely on the upsides.  We venture capitalists cannot afford that luxury.  As a result, I like an entrepreneur who has thought through all the risks,and rather than tip-toes around them to avoid mention, proactively speaks clearly as to how the risks will be addressed.

2 replies
  1. @hermanowicz
    @hermanowicz says:

    Very well articulated set of principles – should be a must-read for budding entrepreneurs. Just to add on more point: from the perspective of VC the entrepreneur with a plan for a better battery, turbine or other gizmo is not competing against another battery, turbine or gizmo but rather against a plan for a new social network or perhaps a medical device. It is common for entrepreneurs to focus on their field where they have technical knowledge to forget that for the VC the fundamental question is where to allocate funds for best return across all sectors.

  2. Alok Bhargava
    Alok Bhargava says:

    Thanks Richard for a great piece! This is a great article that clearly elucidates the major risks that accompany cleantech investing. In biofuels the process is even more complex because intermediate products prior to full commercialization are not indistinguishable from the final product. For example with regards to solar, an electron produced at $2 per kWh is still indistinguishable from an electron produced at $0.06 per kWh. Not so for biofuels that need to build multiple plants to eventually get to commercialization. In the meantime they continue to need capital and end up getting distracted into producing other monetizable goods, but that are not directly related to and are a distraction from the final product. In addition to the risks cited in the article, majority equity funding makes it difficult to recapitalize them with private $$ – unattractive capital structure for more equity funding and too much technology risk for project finance.
    Alok Bhargava

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