PRIME Coalition: A New Funding Model for Radical Energy Innovation

tl;dr: PRIME launches today, bringing a new source of funding – philanthropic capital – to clean energy tech.

PRIME_fig1How will we scale the world for 10 billion 11 billion people? How will we double the size of the consuming class – people who eat meat and drive cars – without wrecking the climate or fighting resource wars?

A big part of the answer lies in deploying the best clean energy technologies we have today at massive scale. If we’re smart, we’ll focus those deployments on high-growth economies, where we can inflect the arc of consumption and deliver the biggest impact. My firm MNL Partners does this.

But an equally important part of the answer is coming up with new clean energy technologies that are radically better than what we have now. Olympic judges would assign a much higher “degree of difficulty” score to this, because birthing a breakthrough energy technology requires lots of money, time, and risk tolerance – more than the conventional start-up financing system supports.

PRIME Coalition introduces a new funding model for energy innovation that harnesses philanthropic capital. PRIME aims to birth true breakthroughs: clean energy technologies with planetary-scale impact.

. . . . .

Why do we need better clean energy technologies in the first place? Because the ones we have today aren’t that good. Don’t get me wrong – photovoltaics, wind turbines, and the like are the best technologies we have now and we should put them everywhere we can. But on a number of key metrics, we’ll have to do better to support a growing, prosperous world. Consider power density.

Human history is a journey on many dimensions – a journey of language, a journey of culture. To an energy nerd like me, however, it’s also a journey of power density. First we burned wood: Think of the amount of energy from burning a pound of wood as X. Then we burned coal – that’s about 1.8X. Then oil – 2.5X. Next, we split atoms: 2,000,000X – a huge advance!

Today’s clean energy technologies take us backward – not just pre-nuclear, but prehistoric. A typical coal plant produces around 100-200 watts per square meter of area, and a typical nuclear plant does about 400-500. But a typical utility-scale solar plant yields only about 10-20 watts per square meter – an order of magnitude worse.

PRIME_fig2As another example, while there’s plenty wrong with fossil-fired power plants, they have the virtue of being dispatchable – they possess a “volume knob” that lets us ramp their output up and down to match demand. In contrast, we only get solar and wind power when the sun’s shining and the wind’s blowing. We won’t replace coal with that.

A host of new, breakthrough energy technologies could outperform what we have today. They have been discovered, but not developed, and they’re ready to move from the lab into early-stage start-up companies. They span domains including energy storage, electrofuels, next-generation solar, thermoelectrics, advanced nuclear, and many more. These technologies are to the 21st century what photovoltaics were to the 20th.

So what’s holding them up?

. . . . .

We can answer that question by looking backward to see where past energy breakthroughs came from.

Let’s stick with power generation. When I look for the most recent example of a carbon-free power generation technology that reached mass adoption, I have to go all the way back to the 1950s. In 1951, scientists hooked a steam turbine up to a nuclear reactor and made emissions-free electricity (nuclear fission has its downsides, but “CO2 emissions” isn’t one of them). Three years later, researchers built the first practical solar cell (a photovoltaic with >1% conversion efficiency). Since then: nothing. How were these breakthroughs born?

PRIME_fig3We got nuclear fission from the Manhattan Project, a wartime effort sparked by fear of Nazi hegemony that cost $26 billion in today’s dollars. Nothing like it exists today.

Solar power came from Bell Labs, a massive corporate R&D operation lavishly funded with monopoly profits. We don’t have those any more.

“But Matthew,” you interject, “that’s not how we fund innovation in the 21st century. Today breakthrough technologies get productized by start-up companies, which are primarily funded by venture capital. We should look to start-ups – not government labs or corporations – for the next energy breakthrough.”

Rarely, venture capitalists make early-stage investments in energy game-changers – which historically need more than a decade to develop and even longer to scale up. But for the most part, that time frame is too long, the amount of capital required is too great, and the risks are too high. Venture investors need to show a return within 10 years, so they stick with what works, namely faster-developing businesses with lower capital requirements – think Instagram, bought for $1 billion at three years old with just 14 employees! When VCs do hard tech, it’s mostly in industries like pharmaceuticals that have much higher profit margins (and attendant valuations) than in energy.

Venture investors are smart. They know that there are fortunes to be made from transformative energy technologies, because the markets are huge. They’d be happy to back a truly breakthrough energy tech company – but only after its earliest stages, once a substantial amount of risk has been retired and the time-to-exit fits in a 10-year box.

This puts VCs in a race to be second. When no one is willing to go first, breakthrough companies don’t get launched.

PRIME’s mission is to go first.

. . . . .

PRIME is the brainchild of Sarah Kearney. Sarah ran the Chesonis Family Foundation, which between 2007 and 2010 disbursed $10 million in grants for energy-related science and engineering research at universities, primarily MIT. In parallel, she assisted the foundation’s benefactor with investments in clean energy start-ups. In the process she saw how the most game-changing ideas were paradoxically the least likely to be financed by traditional VC.

I met Sarah in 2010 when I was making venture investments in energy at Venrock. I roamed the halls of elite universities, getting to know the most enterprising professors and grad students whom I might earn the right to fund. At many of MIT’s best labs, I heard the same thing: A mysterious woman had shown up months before me and made a grant. I figured I should get to know her.

Over a period of years, Sarah and I traded notes on energy investing and the problem of early-stage funding. In January 2013 – after spending two years and an MIT master’s thesis on the topic – she sat across a table from me and outlined a solution:

  • Family foundations command lots of capital – $600 billion in 2011, of which $47 billion went out in grants.
  • Only 0.1% of this money went to energy innovation – despite the fact that many foundations believe in the power of technology to transform energy.
  • Foundations aren’t absent due to lack of interest, but because of two barriers. First, they have no way to distinguish the truly promising candidates. Second, if they want to do anything creative, the transaction costs are high.
  • A new intermediary could smash these barriers. On one hand, it could do the hard work of selecting and diligencing candidate companies, which requires deep domain knowledge. On the other, it could bring legal and accounting resources to bear that could reduce transaction costs.
  • If done right, this intermediary wouldn’t simply channel grants. It would enable philanthropic organizations to use a more advanced set of tools that let them earn a return on their concessionary dollars in the event of a breakout success – yielding more money to be given away in the future. These tools include program-related investments (PRIs) and recoverable grants. (Hence PRIME: Program-Related Investment Makers for Energy.)

PRIME_fig4I found Sarah’s ideas compelling and asked lots of questions about how the model would work in practice. We decided to team up to answer them. An intensive research process ensued over the next six months, involving about 150 interviews with donors, intermediaries, and generally smart people.

While we found a very high level of interest in the philanthropic community, we encountered an equally high education hurdle. Energy tech was new to family foundations and so were tools like PRIs; combined, this meant that PRIME would have to prove out its thesis gradually, one transaction at a time.

As a result, PRIME set three goals:

  • Raise sufficient operating capital to run a lean organization for two years. By mid-2014, eight visionary backers – six family foundations and two family offices – had stepped up to meet the target.
  • Receive a 501c3 exemption determination from the IRS. This would make PRIME an official public charity with a mission to harness philanthropic capital for energy innovation. We got it in September 2014.
  • Make a series of proof-of-concept investments to demonstrate the model (i.e. one-offs done with a “coalition of the willing” each time, not out of a committed fund). The first such investment was completed in May 2015.

. . . . .

The recipient of PRIME’s first investment is Quidnet Energy.

Quidnet tackles the problem of grid-scale energy storage – the mechanism needed to power the planet via renewables – with a radical new approach. It uses pressurized water as the storage medium within depleted oil and gas reservoirs. In the “charging” event, an electric pump pushes more water down, causing the reservoir to elastically deform – like a spring – and push back against the water. In the “discharging” event, a valve at the surface opens and the water rushes up to drive a pressure turbine, making electricity.

PRIME_fig5

PRIME facilitated Quidnet’s seed investment, the initial injection of capital that brought it from concept to company. Four investors joined: the Sorenson Impact Foundation (which made a PRI), the Will and Jada Smith Foundation (which made a recoverable grant), and two angel investors (who issued straight convertible debt). The money is being used not to simulate how the technology would work in a computer model (that had already been done), but to test it for real at a carefully-selected site in central Texas.

Quidnet shows the hallmarks of a PRIME investment:

  • A step change improvement. Most approaches to energy storage involve batteries. They are expensive. While these technologies can tap billion-dollar markets, they’re unlikely to reach the ultra-low-costs required to compete with fossil-fired generation. Quidnet can realistically achieve such low costs if the technology proves out.
  • A compelling team. Quidnet’s founding team pairs a business leader – a seasoned energy tech entrepreneur with multiple companies under his belt – with a technical leader who has top-tier reservoir engineering experience.
  • A high-risk experiment unsupported by conventional capital. The Quidnet seed round would not have happened but for philanthropic capital. When venture investors heard the pitch, their answer was “that sounds really promising and really risky – I’d like to learn more, but only after it works in the field.”

. . . . .

PRIME_fig6I co-founded PRIME and serve as chairman of its investment committee. (The other committee members will be announced this summer). We’re developing a comprehensive philanthropic investment process. It starts by screening the full universe of early-stage resource innovation projects (energy, agriculture, waste, water) for climate impact and for charitability, and then narrows them down based on attractiveness, misalignment with conventional venture capital, and potential impact at scale. An alpha version of this process led to the Quidnet investment, and the investment committee will go through a full-featured version of it this year.

PRIME’s unveiling today is the result of two and a half years of work, and the intellectual and financial contributions of many smart, committed people. It’s our hope that there are many more investments to come – and that PRIME will help build long-term philanthropic capital into an established funding source for world-changing innovation.

Posted in Philanthropy, Venture capital | Leave a comment

Square Pegs, Round Holes, and Innovation

I spoke a couple of weeks ago at the NextWave Greentech Investing conference (organized by my friend Rob Day at Black Coral Capital). My aim was to describe the past, present, and future of investment in energy and environmental innovation in a way that would not epically bore the crowd… So I brought props.

While I failed in my stretch goal to break something onstage, I hope I articulated the square peg/round hole challenge in this field. Here’s the video:

Feedback is welcome. I’ve also put up a version of the slides on the tools page.

Posted in Numbers, Venture capital | Leave a comment

Energy, Human Evolution, and Neuroscience

There’s a dividing line down the center of energy and environmental community. On one side are Amory Lovins types who say that we should focus exclusively on deploying the technologies we already have, because no breakthroughs are needed to scale the world for 10 billion people. On the other side are the likes of Bill Gates, who describes today’s solar and wind as “cute” and says we need radical innovation to keep the world turning.

While I don’t think either extreme is helpful I’m on the Gates side of the continuum.

My point of view is informed by my work as an investor, but just as much by my initial academic training in human behavior. Human beings are wired not to achieve some specific standard of living, but to always have more – “more than those around me, more than I had yesterday” – and evidence from sociology to brain imaging speaks to the fact. I gave the rapid-fire version of this thinking in the talk below from last month’s VERGE Boston event:

Take a gander and let me know what you think. At some point I’ll get around to writing up the long-form version of this thesis, which has sat half-composed on my laptop for several years now.

Posted in Consumers, Energy efficiency, Leprechauns | 4 Comments

Five Lessons Learned From Bringing Cleantech to China

tl;dr: Experienced cleantech CEOs leverage China instead of fearing it – enlisting self-interested partners to defend IP and manage risk.

This post was co-written with George Miller, an MIT MBA student who conducted this research while interning with me. A version of it also appeared at GigaOM.

One morning it dawned on me that of the nine energy companies in our Venrock portfolio, a third are focused on China – yet none of them planned it upfront. I figured it would be good to understand how other cleantech start-ups have approached the middle kingdom, so I enlisted MIT MBA student (and fluent Mandarin speaker) George Miller to interview a representative sample and collect best practices.

George spoke confidentially with 15 venture-backed cleantech start-ups that have set up Chinese operations. Every interviewee was either a C-level executive or VP of business/corporate development; the majority were CEOs. Nine of the 15 interviewees entered China primarily to sell into the domestic market, while the balance aimed to export from Chinese manufacturing facilities. The average company is 11 years old and entered China five years ago.

China entry timeline, 15 start-ups interviewed

Most of our research findings are confidential to Venrock and the companies interviewed, but some high-level conclusions deserve a broader airing.

China strategies have been mostly improvised. At all of the companies we spoke with, China is a big, board-level deal, ranking somewhere between “an important growth market” and “our sole focus.” Yet only four firms had a specific China plan at the formation stage, and three initially didn’t plan to enter China at all.

“In the company’s initial business plan, China entry was…”

Nearly all companies partner. The most common engagement model we found was a joint venture (JV) with a Chinese enterprise, represented by eight of the 15 interviewees. Six have set up distribution agreements but not full-blown JVs. Only one has gone it alone in China, with a standalone, wholly foreign-owned entity that manufactures and sells directly.

China entry approaches

IP is the big challenge. When we asked about key challenges experienced in China, intellectual property (IP) protection topped the list. This is no surprise – tales of IP leakage in the country are legion, with cleantech’s most glaring example being the outright theft of American Superconductor’s wind turbine software. General transparency in business dealings came second, and a cluster of people-related challenges followed. In contrast, interviewees didn’t find market access difficult: We heard that with strong government support and large pools of capital, the risk appetite for capital-intensive projects is greater than in most developing countries.

Key challenges cited in China entry

JVs are the solution. Conventional wisdom says to protect IP by building moats – like splitting manufacturing steps across sites so no one person knows them all, or supplying a key “black box” component from outside China. Our interviewees employ these moat-building tactics, but they think bridge-building works best: The technique rated most effective was forming a joint venture with a large Chinese partner, incentivizing that partner with outsized ownership, and relying on its self-interest to defend the IP. Notably, every interviewee with a JV ranked this tactic the highest.

“What IP protection method was most effective in China?”

JVs address secondary problems, too. When we delved into interviewees’ secondary challenges about transparency and people, it turned out that a strong JV partner was effective in resolving them as well. The stories we heard addressed…

…conflicts of interest: “We had no idea that the largest shareholders in [a potential distributor] are also in the seats of power at [the end customer]. Only once you reach the goal line do they open the kimono.”

…internal corruption: “One of the executives we hired was marking up purchase orders and taking kickbacks. He didn’t have a bad heart, and that practice is common in China – so instead of ‘firing’ him, we ‘retired’ him.”

…training: “Because our technology is so unique, we didn’t have trouble attracting and retaining talent. The challenge was educating them on exactly what we do.”

…workforce management: “It’s not just the government that’s socialist; it’s also the labor force. Financial incentives don’t work well. We used vacation time as a key motivator.”

It’s self-evident that these challenges can be mitigated by a strong in-country partner that knows the value chain and manages lots of people.

. . . . .

Chinese joint ventures are no walk in the park. The average JV in our sample was three and a half years old, had taken longer to get going than expected, and was considered too early to call as a success or failure. Interviewees complained about long government approval processes and culture clashes along the way, and we didn’t hear any silver-bullet tactics for doing it right: The best practices were all things you’d expect, including intensive background checks of partner executives, JV agreements that maintain “face” for both start-up and partner (usually relying on profit-sharing), and experienced domestic legal representation. And clearly, you’ve got to be obsessive about picking a trustworthy partner – American Superconductor’s widely-publicized IP dispute is, in fact, with its former JV partner Sinovel.

Despite all those caveats, I drew a clear conclusion from this work. Most cleantech innovation is happening in the U.S., but most adoption will be in growth economies building new infrastructure – with China at the top of the list. Chinese incumbents like Wanxiang, Shenhua, and ENN are scouring the west for technologies to pick up. In this environment, a cleantech start-up can either play defense at the barrel of a financial gun (see A123 Systems), or play offense, entering China on its own terms and timeline. If you’re going to do the latter, be prepared to partner up.

Posted in China, Unsolicited advice | 3 Comments

The State of Cleantech Venture Capital: What Lies Ahead

Footsteps end on path through the woods(A version of this post also appeared at GigaOM.)

tl;dr: Cleantech VC is receding because of poor short-term performance – no surprise in a post-bubble field with outsized time and money requirements. The category is about to go on a walk in the woods, where innovators will blaze a new trail.

In late 2011 I decided to write up an internal analysis I’d done at Venrock about the state of cleantech venture capital and make it available broadly. I’m a fact-based, research-driven guy, so I tried to shine the light of data on myths and realities in the field. My macro conclusion was that while it was really early, investment returns to date were on par with VC overall.

Much has changed since then. With 2012 numbers done and dusted, I figure it’s time to revisit this topic – again, under the light of data. I’ll frame this analysis with the questions I’ve gotten from VCs and entrepreneurs who’ve asked me for an update.

What’s happening to cleantech venture capital?

It’s receding.

Cleantech VC funding by quarter, 2011-2012 (US$ millions)

  • Investment fell 30% in 2012 – and even further at the early stage. The Moneytree survey numbers had cleantech VC investment falling from $4.6 billion in 2011 to $3.3 billion in 2012 – a 28% drop. Further, they showed first-time funding of new start-ups plummeting 58% to just $216 million, and shrinking as the year progressed: By Q4, first-time funding was just 4% of capital invested.
  • Limited partners are backing off. VC firms get the money they invest from limited partners (LPs) like foundations and pension funds. Last December Preqin called up 31 LPs that were invested in at least one cleantech-focused fund and asked if they planned to back any new ones in 2013. Only 22% said yes (down from 31% a year before).
  • The people are changing. Many VC firms parted ways with their cleantech teams in 2012. While February’s ARPA-E conference had a record number of attendees, venture investors were scarce – replaced by a bumper crop of corporate types.

Why is this happening?

Cleantech VC performance is substantially lagging venture capital as a whole. This wasn’t true in 2011, but things changed fast in 2012.

I arrive at this conclusion by comparing two data sets. On one hand, we have data on the interim performance of 19 cleantech-only VC funds as reported by the California Public Employees’ Retirement System (CalPERS), a big LP. On the other, we have equivalent data for the entire universe of VC funds from the National Venture Capital Association. (The data are expressed as “value to paid-in capital, net to LPs,” which means “the current value of the funds divided by the money put into them, accounting for what VCs pay themselves.”) By comparing cleantech-only fund performance with the full VC universe at the same points in time, we can see whether cleantech is doing better or worse than the asset class.

The answer is that cleantech went sideways in 2012 while VC overall did well. In September 2010, the cleantech VC funds were worth 0.90x the money paid into them while comparable VC funds overall were at 0.96x – roughly the same. Six months later the gap had widened, but both had risen in value and remained within spitting distance. By June of 2012, however (the most recent data available), the cleantech funds had declined slightly while the overall VC universe climbed to 1.23x.

Cleantech-only VC fund valuations vs. full VC asset class

This is why investment is stalling, LPs are hesitating, and cleantech VCs are thinning: Capital invested in other domains is showing a greater near-term return.

If minimal money had gone into cleantech, or if the macro environment were rosier, there might be more willingness to forge ahead. But today, fund managers assess the $25 billion worth of cleantech VC invested since 2003 against a backdrop of shale gas and climate apathy – and tighten the purse strings.

OK, but why is that happening? What’s driving weak cleantech VC performance?

Two factors. First, there have been too few exits.

Let’s consider the gold standard of VC wins – an IPO on a major exchange. When I last did this analysis, cleantech was overperforming on the IPO front: In 2009, 2010, and 2011, cleantech’s share of VC-backed IPOs exceeded its share of VC funding. (Note: One must apply an appropriate time lag to the latter – I used five years, which is informed by deal-by-deal fundraising data by cleantech start-ups).

This ended in 2012. Just as in the prior year, three cleantech IPOs took place out of about 50 VC-backed IPOs in total (6%). But cleantech’s corresponding share of VC funding rose to 10% – so cleantech was now underperforming on exits relative to capital invested, instead of overperforming.

Cleantech share of VC funding vs. share of VC-backed IPOs, 2004 to 2012

(Of course, most VC-backed companies exit through acquisition, not an IPO. But the M&A front looks no better for cleantech. When merchant bank Jane Capital counted up every acquisition of a VC-backed cleantech start-up worth more than $50 million in the last 10 years, it found just 27 of them.)

Second, the winners have disappointed post-IPO. When a start-up goes public, its VC investors rarely get to sell their shares immediately: They have to wait out a lockup period that typically lasts six months. Of the nine VC-backed cleantech start-ups that have done major-market IPOs since 2010 and have been public for more than six months, eight were trading below their IPO price at the 180-day mark.

Aftermarket performance of cleantech IPOs completed 2010-2012

In four of those cases, the 180-day share price was also lower than the price at the last venture round. That means VCs who bought shares in that round were under water when the lockup expired.

So is the pullback in cleantech VC justified?

Well, it’s certainly expected. The cleantech gold rush of the late 2000s saw hundreds of start-ups funded – many with identical propositions – that greatly exceeded the carrying capacity of their industries: For example, there’s no way that more than a handful of the 219 solar start-ups counted by Greentech Media in 2009 could possibly succeed. This dynamic isn’t unique to cleantech. The Internet VC bubble of the late 90s was the same story, albeit on a much larger scale.

But just as the boom-and-bust in dot com investment didn’t mean this whole Internet thing was a waste, the same is true for energy and environmental technologies. It’s very likely that multiple billion-dollar companies lurk among today’s cleantech VC portfolios. The question is – given the current retrenchment of capital from the field – how many of them will get the fuel to reach the finish line.

In the main, energy and environmental start-ups need outsized time, money, and risk tolerance to reach a big outcome. (That’s not true of IT-meets-energy “cleanweb” companies like Opower or Venrock-backed Nest Labs, but it holds for the deep-tech start-ups that comprise most of the category.) As our case study, let’s take First Solar, the pioneering thin-film solar maker. The company’s first instantiation was founded in 1990; it took 12 years to ship a product, was restarted in 1999, and consumed $150 million of equity investment (all Walton family money) before its 2007 IPO. But at that outcome, First Solar was worth $1.4 billion valuing the Walton stake at 8.4x. Two years later at the peak of the solar boom, it was worth 199x!

If this is what success looks like – that is, if the majority of cleantech start-ups will need more time and money to reach big outcomes compared with VC-backed companies overall – a few conclusions follow:

  • Funds focused solely on cleantech will have a longer and deeper “J-curve” of returns compared with VC as a whole. When they reach the same final return multiple, they will take longer to do so (impacting IRR). Midway through the journey, their performance will look like an “L-curve.”
  • To the extent that cleantech start-ups’ time to exit will be 10 years or more, it’s too early to call success or failure on the current crop – because most of them were founded in 2007 or later. Check back in five years.
  • Because the time frames to an outcome are longer and the amounts of capital required are greater, cleantech investment should be less spikey compared with investment in, say, Internet start-ups. And lo and behold, that’s pretty much what we see:

Internet VC bubble vs. cleantech VC bubble, time-aligned

Cleantech VC now is like Internet VC in 2001: on the downward slope of a bubble, albeit with a more gradual climb and a gentler descent. Note that Facebook was conceived in 2003 – the lowest point for Internet investing post-bust – and that in 2004, Google’s IPO kicked off the renaissance that persists today.

So is the cleantech pullback justified? The data says it’s too early to call. However, it also suggests that the time frame required to reach a conclusion will greatly stretch 10-year closed-ended funds.

(A diligent reader may point out my own numbers showing that when VC-backed cleantech start-ups have gone public, they’ve mostly done so in less than 10 years. My take is that most of these companies were rushed to public markets before they were ready – explaining the awful aftermarket performance.)

What happens now?

Cleantech innovation is about to take a walk in the woods. Justified or not, the established path of VC-backed investment is narrowing for a generation of start-ups. Some of those companies – and some of the investment managers that have backed them – will break off into the wilderness to find a new route.

In this environment, I see opportunities in:

  • Selective recaps. About 270 cleantech start-ups can be characterized as “late stage” (they’ve raised Series C rounds or later). Of those, about 150 have demonstrated proof of economics and are focused on scale-up. If capital keeps receding, there won’t be nearly enough money to fund them to exit – enabling savvy late-stage financiers to pick off the best of the bunch in recaps that reap disproportionate returns. In 2011 I thought this capital gap wouldn’t persist, because the likes of VantagePoint and Silver Lake Kraftwerk were out raising huge funds aimed at it; the failure and scale-back of those efforts leaves the opportunity open.
  • Cross-border plays. The U.S. dominates cleantech innovation, but China and other overseas nations dominate deployment. New vehicles are mobilizing to provide cleantech equity investment coupled with cross-border JV creation and operational help – including Formation8 and a stealth-mode firm I can’t reveal.
  • Strategic investment, rethought. Large corporations in industrials and energy have strategic motivations to foster cleantech start-ups: The likes of GE and General Motors want an innovation pipeline, while utilities want a stream of new equipment to rate-base. Institutions are forming to organize this activity in a merchant banking model, like Broadscale at the late stage and OnRamp Capital at the early.
  • Foreign techno-colonialism. While U.S. investors bemoan a lack of capital for cleantech, many foreign institutions are awash in it – and view American assets as being generally cheap. To U.S. start-ups, they will play a role somewhere on a continuum between savior (e.g. Japanese trading houses bankrolling cleantech start-ups to get the inside track on project financing) and reaper (e.g. Wanxiang’s A123Systems deal).
  • Philanthropic capital. The cleantech projects that would most change the world – think electrofuels, solar antennae, advanced nuclear power – are also the least likely to be funded, because they combine long time frames with extraordinary risk. There is a case to be made for impact investment in these fields using philanthropic capital as a charitable activity. A new effort called PRIME, backed by four visionary family foundations, is leading this charge.

It’s hard out there for cleantech. The woods are scary and the journey is uncertain. But pioneers are charting a new path through the thicket – blazing trails that others will follow.

Posted in Numbers, The State of Cleantech VC 2012, Venture capital | 8 Comments

The Very Curious Hybrid Boom

tl;dr: U.S. hybrid vehicle sales were up 61% in 2012. It’s unclear why.

Riddle me this: Why did U.S. hybrid sales take off last year?

Prior to 2012, hybrids looked like something between a fad and a niche. Sales peaked in absolute terms way back in 2007 and hybrid market share maxed out in 2009. Despite rising gasoline prices, it seemed that Americans cared neither about getting 50 miles per gallon or the environmental benefits thereof.

Then last year happened.

U.S. hybrid vehicle sales and market share, 1999 to 2012

Hybrid sales rose 61% to 434,498 cars in 2012 – the biggest absolute increase ever and the biggest percentage gain in seven years. Hybrids accounted for 3.0% of new vehicles sold, up 42% from 2011.

The big question: Why?

It wasn’t new choices. While nine new hybrid models were introduced in the States in 2012 (of a total 44 available), they accounted for only 9,708 hybrids sold (2.2%) – and the Prius took half the market like it has since 2009.

It wasn’t a price drop. Prius sticker prices fell $2,500 last year (about 11%) as Toyota restocked post-Fukushima, but prices of conventional non-hybrid cars from Japan dropped too.

It wasn’t higher gas prices. Retail gasoline prices were nearly flat from 2011 to 2012. (And if the gas price determined sales, hybrids should have peaked in 2008 and plummeted the year after; neither one happened.)

It wasn’t an improving economy. Real GDP growth was 2.2% in 2012 and 2.8% in 2010. Yet hybrid market share blew up in 2012 and shrank in 2010.

It wasn’t more driving. In fact, annual vehicle miles traveled per person fell slightly in 2012, extending a trend that started in 2004. “Peak car,” anyone?

U.S. gas price/GDP/vehicle miles traveled vs. hybrid market share, 1999 to 2012

None of these things correlate and it makes no sense! Any ideas?

Posted in Consumers, Numbers, Transportation | 10 Comments

Entrepreneur Tools: The Returns Analysis

tl;dr: To successfully target VCs, view your deal through their eyes.

pov2I got an outstanding piece of advice in my first job: “Always see the world from the other person’s point of view.”

If you’re trying to sign the pivotal customer, think from their perspective about what price they can accept. If you’re trying to recruit the killer engineer, understand how she weighs moving her kids when they’re halfway through elementary school.

And if you’re trying to raise capital from a VC – someone who invests other people’s money, and is out of a job if there’s insufficient return – analyze your own deal the same way he will.

I learned this the hard way.

In 2007 a somewhat younger and substantially less gray-haired Matthew was out raising a venture capital round for my previous company Lux Research. The good news is that it ended well – we were fortunate to bring on west coast VC firm Catamount Ventures, where partner Mark Silverman brought a rare combo of vision and pragmatism to the board. The bad news is that I wasted a lot of time pitching to firms that I should have known weren’t a good fit in advance, because the returns math couldn’t work for them.

My mission today is to arm you so you don’t make the same mistake.

When a VC investor hears your pitch, he’ll do math in his head to figure out if your company is in-bounds. (While bigger factors like team and market determine a “yes,” the math can rule out a “no.”) Typically, he’s answering two questions:

over90001) Can this investment move the needle? A venture investor can only attend to so many portfolio companies at once. To earn one of these limited slots, an investment has to be “needle-moving:” A successful outcome must be big enough in absolute terms to warrant a spot (regardless of the ratio of dollars out to dollars in).

As you can imagine, what’s needle-moving depends on the size of the fund that’s making the investment. A billion-dollar fund needs billion-dollar IPOs to return a profit; while investing $1 million into a company and getting $10 million back would yield a phenomenal 10x return multiple, you’d need 100 such outcomes just to break even! On the other hand, the same $10MM-for-$1MM return would be massive to a $10MM seed fund, where that single investment would put the fund in the black.

While there’s no magic number, a decent rule of thumb is that a needle-moving investment must return at least 10% of the fund to the VC in the success case. Here’s a close-to-home example: At Venrock we’re currently investing out of a $350MM fund. “Needle-moving,” according to this heuristic, is therefore $35MM. We tend to own 20% or so of the companies we invest in on average, so any one of them must be capable of being worth $35MM / 20% = $175MM when it’s bought or goes public – at an absolute minimum. If a successful outcome for your company would be getting acquired for $20-30 million dollars, you should not pitch me; target other investors with more appropriately-sized pools of capital who would view this outcome as a big win.

returnpaint2) Is the return multiple big enough? After assessing the absolute return, the math moves on to the return multiple, which is a relative measure. If everything goes right, how many dollars will I get out for each dollar I put in?

The return multiple that a VC investor seeks depends on the stage at which it invests, because of the time value of money: You earn about 8%/year if you make 2x your money over 10 years, but you could earn the same 8% by getting 1.08x in one year. As a result, early-stage investors (who invest at company founding and go 5-10 years before seeing an outcome) target higher returns than growth-stage investors, who aim to put in money shortly before the acquisition or IPO. Also, early-stage investors fund younger, riskier companies, most of which fail. Therefore they seek higher multiples in the success case than do growth-stage investors, who make some profit on most of the companies they back.

Again, there’s no magic number, but a good rule of thumb is that an early-stage VC needs to be able to envision a 10x return multiple if everything goes right. (A growth-stage investor, on the other hand, may see 2x to 5x as the target to hit.)

Armed with these principles, you can model the investment returns that a VC would get by putting money into your company, and use that information to target your investor search. Use the spreadsheet template that you can download here (which I’m archiving on the tools page) to do the math and model the return from the VC’s perspective. As inputs, you’ll need your financial projections (revenue, cost of goods sold, and opex); your capital plan (how much money you’ll need to raise and when); and a valuation metric (the spreadsheet uses price-to-sales, but you could also use price-to-earnings – in any case, set the metric by looking at comparable companies that have gone public or been acquired, and use a conservative consensus number in the model). What you’ll get out is the VC’s absolute return and return multiple.

As an example, consider this case:

returns_example3

Let’s say that this company is an energy analytics start-up trying to figure out if it should pitch to VC X, an early-stage investor with a $300MM fund. The company is raising a $10MM Series A aiming for a $15MM pre-money valuation, and thinks it will need another $25MM in two years to get to profitability. It believes it will have $80MM in revenue at year six, and an analysis of comparables shows that similar companies have been bought or gone public at 5x revenue. VC X would do half the A round ($5MM, purchasing 20% ownership) and invest its pro rata amount of the round to follow (i.e., 20% of the $25MM B round = $5MM more in two years), for $10MM invested over the life of the company (if everything goes right).

The good news is that, from VC X’s perspective, the investment clears the “needle-moving” hurdle. If the company hits its $80MM revenue target in six years, it’s worth $80MM x 5x = $400MM; VC X will own 20%, so its absolute return of $80MM is well above 10% of VC X’s $300MM fund size.

The bad news is that VC X can’t quite see its way to a 10x return. It’s going to put in $10MM in total ($5MM now and $5MM later) for an $80MM absolute return, yielding a multiple of $80MM / $10MM = 8x. This is good, but not excellent if it’s an upper bound; if it represents a true maximum it may not be enough. There would likely need to be compensating positive factors (phenomenal team, opportunity to expand to other markets, a pivotal early partner, demonstrably active acquirers) for this opportunity to compete against others.

A secondary point worth noting: The $10MM invested over the life of the company would be 3.3% of VC X’s fund – big enough to be a “real” investment worth a partner’s time, but not so large that it sucks up too much of the fund (VCs generally avoid putting more than 5%-10% of a fund behind any one company).

When you go through this exercise, run multiple scenarios – the VC you’re pitching certainly will! See what things look like with a slower revenue ramp, a lower valuation metric, a higher capital requirement (Venrock lore holds that companies typically require 2.5x more money over their lives than they anticipate at first fundraising), etc. However, I don’t recommend putting this kind of analysis into your pitch deck – it presupposes too much knowledge of the other party’s motivations and comes off as kind of arrogant. Keep it to yourself and use it to inform your financial plan.

Hopefully this tool will equip you for more successful fundraising. Let me know your feedback, and please point out my inevitable Excel errors for correction in an update…

Posted in Numbers, Unsolicited advice, Venture capital | 1 Comment