I drafted this memo in early 2003 for a venture capitalist friend of mine, well before the bubble in cleantech. In light of the back and forth on the recent Solar City IPO, I thought it was worth revisiting. Some of the points were pretty prescient, calling out many of the challenges cleantech investors and exits have faced, nearly a decade before they faced them.
Risk Economics in Energy Technology Investing
We believe there is substantial economics to be made from venture capital investment in energy technology, especially focused on clean energy and high efficiency or environmentally friendly applications.
However, investors unfamiliar with the sector tend to under-price risk and overestimate stage in technology development and commercialization in energy technology.
Much of this miscalculation can be boiled down to the fact that adoption rates of new technology in the energy sector generally tend to be slower than more traditional venture capital industry sectors. This tends to be true for a couple of reasons, and has a number of implications for venture capital investment in the sector. We have tried to lay out a few thoughts for potential investors in the space, which though they by no means constitute an all-encompassing investment model, should be helpful in decision-making.
Integration / Customer Hurdle Issues – This is a sector that tends to be very risk averse in new product and technology acceptance, and does not tend to pay for technology before the product stage, with an attitude of “we as the customer are already taking a huge risk by simply changing our operating procedures or letting you have access to our mission critical, extremely expensive infrastructure, why would we pay you, too?” This situation is often characterized by very entrenched channels and customers, with multiple levels capable of “saying no”, and a long process to “yes”. As result the level of product testing is substantially longer than other sectors as well. One implication (also see “Cheap” Technology below) is that technology businesses that have access to customers or are in integration areas tend to be under-priced by investors relative to technology developers. This under-pricing can be especially true if the business has a vision to acquire technology or IPRs from developers as a price of admission to a customer base. This set of issues also raises a second set of implications in the engine industry, where the major engine manufacturers, while they are often under pressure for change, are not exactly adept at handling new technology adoption, in part since they sell almost entirely through low-tech dealer networks, and only partially touch the end customer themselves. Another risk issue here is that investors in technology development have tended to underestimate the power of entrenchment in both customers and channels, and as discussed below, run a risk of being caught in a bind as a one-product wonder without the depth or breadth of solution to protect market share.
R&D vs. Product /Market Development Investments – Because of the slowness of adoption rates, the relative risk of R&D investment bets to product /market development investment bets tends to be substantially higher than in many other sectors. The implication is that early stage investment (pre- purchase orders) should be done at lower valuations than the same stage in other sectors, while later stage (post purchase order) investment can potentially be done at higher valuations, while achieving the same risk adjusted IRR. Another implication is that investors often should expect some level of public funding support for technology development as a prerequisite for investment, not as a driver of additional valuation.
“Eternal Pilots” – This industry tends to be under significant environmental and PR pressures and as a result companies in the space tend to make limited investment of resources and capital in numerous pilot programs and “evaluations” that do not have significant likelihood of moving forward in a major way, but may run for years. This has been especially true of regulated utilities that could often in effect price through some of the cost, or were expecting to bear the cost anyway as part of a PR or ongoing market vision program, as well as major energy companies, who have huge margins, and tend to have massive and far-flung R&D programs. This tends to obscure the vision of VC investors looking to bet on strategic relationship “traction” as a way to proxy potential product adoption. In other words, one can easily overestimate “traction”, and investors often tend to overestimate the life cycle stage of a new technology. The newer the technology, the higher the over-estimation risk would tend to be.
Political Process – This industry tends to be very politically sensitive. And the entrenched leaders tend to be much better than the startups at managing this process. One thing this means is that significant public/government backed or public/private capital is available to fund R&D in the area, and that government/military business can often be viewed as core customer base. It also means that technology development requiring regulatory or legislative drivers can be much riskier than in other sectors.
“Cheap” Technology – Given the above, existing technology tends to be “cheap” on the venture capital scale, and contracted or visible business tends to be the driver of value. Part of this is because the technology is often developed with “cheap” public dollars. The other way to think about it is that if you have the market and access to customers, attractive, proven technology at the product development stage can often be acquired for essentially pure upside. While this may not call into question a particular technology development investment program, it again does have implications for the value of that technology as opposed to the value of a going concern.
Make One Bet, Not Two – To follow on that point, one implication is that an effective investment strategy may be to accept either technology development risk, or market risk, but not both. In that, an investment in technology development not be made unless there was a near certainty of obtaining public funding to offset substantial portions of the cost or customer purchase orders once product development is completed, or that investment in customer ramp or market development not be made unless the technology is proven and has extremely limited risk of failure. Betting on early stage companies that neither have a “locked-in” customer or completed technology may tend to be an extremely risky bet, and should perhaps be done only at quite low valuations relative to other industries.
Gross Margin Ramp – Another area of typical miscalculation is in profitability of new technology. The sector tends to be a bit more “custom” in its product demands than some industries, and one major bet that has caught investors is cost structure/timing of volume orders. This is an area where it has proven extremely difficult for many companies to develop enough business to move gross margin positive, let alone operating profit. A common mistake is to over build manufacturing capacity in an often desperate race to get a marginally cost effective technology to an acceptable cost point to achieve venture like growth projections, when a more effective strategy often might have been to build low volume, higher cost point premium solutions for a smaller market in order to maintain the business during the often long process of technology adoption. Such a strategy, which tends to be ignored by venture backed startups until too late, can be a key element in reducing the timing risk in this sector. Part of the issue also stems from technology companies misunderstanding the price point potential and impact on their net price to manufacturer from channel and integration costs, a particularly sore point now to many companies betting on distributed generation technology, as is the point below.
One Product Wonders – Unlike other sectors where large companies are quite adept at acquiring in new products and technology lines, this is a sector where major competitors tend to be more likely to make a build vs. buy decision. This tends to be more true for high margin components of an overall solution, exactly where technology investors tend to play. Often investors have found that their supposed channel is in fact their most successful competitor, even despite the fact that the channel may not very good at the solution. The result is that investors often overestimate how far a single product company can go, and overestimate how badly a potential strategic partner or exit will view that they need a particular technology solution.
While none of these points are meant to invalidate particular investment strategies, they are meant to be points to consider when risk adjusting and developing pricing / valuation strategies for energy technology investments. At the end of the day, we tend to feel that technology companies in this sector, when compared to many other venture capital investment sectors, should be priced much more closely on visible cashflows than value of technology or market potential, or by “stage”, where the risked economics may not be as easy for an investor to define.