By Matt Lecar
Traditionally, the venture capital (VC) investment model seeks to achieve extraordinary investment returns by placing high-risk bets on young, high growth, privately held companies with unique technology or business models.
Venture is actually quite small in relation to the overall investment economy. According to the National Venture Capital Association, all of US VC invested $28 billion in 4,000 companies in 2008 (and only $17 billion in 2,800 companies in the financial meltdown year of 2009). By contrast, the largest pension fund in the US, the California Public Employee Retirement System, alone commands over $200 billion in investments under management (including all classes of public and private equity, bonds, real estate holdings, etc.).
Yet, VC has had a disproportionately large impact through its role in the creation of vast new industries and wealth over the last 30 years – notably in IT, software, the internet, and life sciences. Many household name companies such as Google, Yahoo, and even FedEx and Starbucks, were originally backed by venture.
In the last few years, a number of VCs have been active in the emerging clean technology (or “cleantech”) arena – a broad umbrella that includes not only energy and alternative fuels, but air, waste, and water treatment, carbon management software, green building, and more. Increasingly, these investors have begun to explore smart energy as a segment or “theme” within their cleantech portfolios, though it is still early days and the jury is out on how these investments will fare. Metaphorically, VCs are “dipping a toe” in smart energy. How warm will they find the waters?
SMART ENERGY PROS AND CONS
Viewed from the perspective of venture capital, the transition to a new smart energy infrastructure presents some appealing fundamentals, but also some significant challenges. On the positive side of the ledger, energy is a large, established global industry with many discreet high value problems to solve. In a multi-trillion dollar market, even “niche” solutions can be billion dollar revenue opportunities… big enough to generate VC type returns for the successful innovator. And the change drivers in the energy industry are accelerating rapidly – aging infrastructure in the developed world, rapid demand growth in the developing world, and increasing environmental constraints and policy mandates for cleaner generation and increased customer energy efficiency, all add up to a near “perfect storm” for innovation.
At the same time, innovation in established markets is hard – much harder than in the “white space” of a new industry like the internet. There are entrenched competitors and distribution channels, as well as other less obvious barriers to entry for young companies. There are issues of scale and capital intensiveness – energy is not software, where code is written once and reproduced a million times. In general, the commercialisation of new grid technology from lab scale to utility deployment (conceptually, from a few kWs to tens or hundreds of MWs) requires many years and several hundred million dollars in project capital (a type of risk averse financing not readily available from VCs, nor from much of anyone else these days). Moreover, the culture and incentives of the utility business are radically different from the highly competitive product industries where VC has historically cut its teeth. The high reliability, highly regulated nature of the core business discourages risk taking by utility management. The rewards for innovation are typically muted, while the potential penalties for failure can be severe.
Finally, there is a huge mismatch in terms of time scale: venture invests for a relatively quick “exit,” hoping to liquidate its interest in a company within 5-10 years. By contrast, the utility industry plans and builds on a much longer road map – California’s recent expansion of Path 15 transmission capacity took 14 years from first application to final commissioning. Even AMI – the leading example of a smart energy technology that is “ready for prime time” – has been around in the industry for over 20 years and is only now getting serious traction. For financial investors, with no long run strategic stake in the utility business, these timelines represent an almost insurmountable hurdle.
To take a concrete example, as a VC, I evaluated one promising energy storage technology – a flow battery design that seemed well suited for grid scale applications, such as managing the intermittency of renewable generation resources. Yet, as an early stage investor, the 10+ year development timeline and $50 million+ price tag to even enter this market were strictly prohibitive. There was simply no way to make the maths “pencil out” to yield the level of return required by my fund investors, or to maintain sufficient influence over the company’s strategy (in order to protect that investment), when much bigger financial players would have to be brought in before the company had proven out its story.
LOOK TO THE CUSTOMER
So with so much challenge, where are the capital efficient, VC friendly niches in smart energy? According to Tim Woodward, managing director at Nth Power, a leading energy specialist VC firm, energy efficiency and premisebased energy management is the best near term bet – starting with commercial and industrial (C&I) customers and migrating down to the residential level. This is because C&I decision makers are typically financially motivated and can be convinced by a positive return on investment (ROI), while residential homeowners make emotional purchase decisions – and, so far at least, few vendors have figured out how to make saving a few bucks off your monthly utility bill as exciting to consumers as, say, a new iPad or Wii.
Woodward notes that traditional “smart grid” markets – with the utility as customer – are not an attractive environment for venture funded start-ups, as utilities tend to focus on big balance sheets and purchasing from established, brand name vendors. For a venture investor, this means a start-up can build a better mouse trap, but still not have a ready market. In order to sell to utilities, it must first convince a GE, Siemens, or ABB to test its widget, market it, package it into a complete solution, and stand behind it with the full weight of its global brand and reputation… that’s a pretty big hill to climb for a small company with a short lease on life. Woodward reports that utilities are gradually becoming less of an obstacle to innovation, but do not yet represent a “vibrant” channel to the customer that would overcome these inherent barriers.
LOOKING FOR THE EXIT
In the end, the VC opportunity will be defined by successful exits, which in VC parlance means the sale of a portfolio company (through either an acquisition or public offering) at a high multiple on invested capital (canonically, 5-10x). Remember, while a few VC investments succeed spectacularly, the majority stumble along or fail utterly, so the few “home runs” in a VC’s portfolio have to make up for a lot of singles and pop flies.
The IPO log jam – which long preceded the broader market collapse of 2009 – appears to have eased a bit. A few prominent cleantech companies are currently in the registration process with the SEC (Silver Spring, Solyndra, and Tesla Motors). However, the window is still open only a crack and there is concern that those that are going public do so from a position of weakness, rather than strength – in the cases of Solyndra and Tesla Motors, both businesses have been successful obtaining large blocks of federal stimulus money (largely in the form of loan guarantees) but have exhausted the sources of private equity to grow their business and need access to the public markets. If these IPOs do not move forward and hold their value, it may have a chilling effect on the long queue of other companies lining up to enter the chute.
Going back to Woodward for the final word, if 2009 was a year of retrenchment across the board, he says 2010 is a year that shows “a lot of promise” for VC investors in smart energy. But whether that promise can be converted into profit is the big question that has yet to be answered.