Let me start with some background that you already know:
The venture capital model is predicated on one big concept: Investing capital in differently priced tranches over time as risk is removed from a developing entrepreneurial effort. It wouldn’t make sense to invest all the capital a startup would ever need on day one — how would you price it? What about the risk that the idea just doesn’t work? So the VCs (and their breathren) invest a bit at a time as milestones are reached. And ideally a new outside investor steps in at each of these funding events, to provide an outside valuation of the company at each stage.
When the system doesn’t work, when capital isn’t present at one of those stages, it has repurcussions for entire sectors as startups are bottlenecked, or even forced out of business.
There are a couple of well-identified such “capital gaps” that people point to often in the cleantech sector. I’ve heard both referred to at times as the “Valley of Death”, since they do bad things to the startups that are subjected to them.
One gap is in the very early stage of a technology-based startup that will take years to successfully commercialize its solution. VCs don’t like to hold investments for that long, and also many of these particular startups are fairly capital-intensive (at least relative to other early stage entrepreneurial efforts) because they require expensive researchers and research equipment and prototypes/pilots. Some of this gap is being addressed by the likes of family offices, foundations, government support, etc., but it remains a gap.
Another gap can then be encountered by many of these same types of startups later on, once they’ve successfully piloted their solution and it’s time to build that first commercial-scale production facility. VCs don’t like to fund project finance, and project finance firms won’t fund the first of any type of project, so building that first expensive facility is a big financing challenge. Some of these needs are being addressed by corporate partners via joint ventures, but it remains a gap.
Partly as a result (and partly because of the better returns-math when less capital and time is required) many cleantech VCs (including myself) have urged entrepreneurs to take on more capital efficient business models. If you avoid the long-gestation, capital-intensive efforts that hit these gaps, you have a better chance of finding funding in today’s tight funding environment.
But much to my chagrin, I’m finding a new capital gap has emerged that is impacting the more capital-efficient businesses as well. And it’s hitting them just when they’re showing good progress, which is particularly frustrating. This gap is hitting just post commercialization.
As milestones go, getting first revenues is a big one. According to the theory of venture capital, it’s the kind of significant de-risking that should make it easy to raise that next round of capital. So entrepreneurs and their backers often plan for a round of capital (typically Series B or Series C, for capital-efficient models) at this point in time. Which therefore also implies being somewhat low in capital at that point in time as well. Not a good time to find it suddenly harder than expected to raise that next round of capital. And yet, that’s what is often happening these days.
Why? There are a bunch of reasons, good and bad.
First, there’s the simple fact that there are many fewer check-writers in the cleantech venture sector these days. Generalists are still narrow-minded about the sector, and specialists have had trouble raising new capital from LPs. This just widens gaps all over, including at this phase.
Second, there’s been a real bifurcation of the sector into early stage and growth stage investors. And with fewer check-writers in each bucket, these investors can afford to focus very tightly on what types of deals are right in their wheelhouse. Early stage investors want to go in at the Series A stage, and are an especially rare breed besides. Growth stage investors want to go in once there are significant (say, greater than $10M) revenues, not at the early revenue stage.
Third, we’ve all learned that in many of the sectors under the “cleantech” umbrella, early revenue actually isn’t the inflection point we used to think it is. Basically, it’s actually pretty easy to get a few early adopters to put some dollars into trying something out, or even to find a handful of quite serious (but ultimately not indicative) early customers. These markets are often so fragmented and heterogenous that you can find a few unique paying customers and still not know if you have something that can scale quickly, or even if so, how. The long sales cycles in many of these sectors also delays the “hockey stick” startups hope for in their revenues. So while first revenue is still an important milestone, it’s not viewed by experienced investors as being as attractive of a milestone as many entrepreneurs expected it to be.
Fourth, the active growth equity investors typically have pretty large funds and therefore want to write pretty large checks. It’s not unusual for one of these funds to have an unstated but de facto $10M minimum check size. Add in follow-on co-investments from existing investors, and you’re looking at a $15-20M Series C. This not only may be much more than the capital-efficient startup needs, it also then drives up the valuation, because most venture rounds won’t take more than half of the company (so post-money valuation is an implied >2x the size of the round). The more money put in, therefore, the bigger the exit needed to justify the investment. Statistically, there aren’t many >$100M exits in any venture sector. Most of the time, in fact, growth equity investors are only interested in the companies they see as having clear potential to become a $1B value company and be an IPO candidate. Now take a step back and remember, we’re talking about a startup that at this point has only single digit million revenues… It’s entirely possible, in the eyes of the entrepreneur, but there’s still much to be proven in the eyes of the outside investor. In short, the need to write a bigger check forces the growth stage investors to either take on a pretty risky proposition (which they actually don’t want to do, so will instead pass) or to focus on later stage companies where the math is easier to get comfortable with even if the valuations end up higher. And on the other side of the table, if entrepreneurs do take the larger round, it pressures them to take a riskier path as well.
Fifth, while there are some smaller specialist venture firms out there that will write a smaller check into a Series B or Series C, I’m finding that their partner groups carry a lot of battlescars from the past decade. Past bad outcomes that significantly impinge upon their ability to invest into those same subsectors, even when it’s a different, improved approach. As knowledgeable specialists, they may “get” that this new effort is more capital efficient and has a different, smarter business model for downstream solar (for example), but they know that if they go to their LPs they’ll get criticism for having invested “in solar again” (for example). It’s a natural outcome of a sector where so many of the investors carry these battle scars, and it’s only an obstacle in some situations, but I’ve seen it come up now a few times.
You put it all together, and I’ve now witnessed quite a few times where entrepreneurs have worked hard to position themselves well for a growth phase, and yet find it difficult to raise the capital they need to make it happen. So I assume it’s happening somewhat frequently in the broader sector.
What should entrepreneurs take away from this?
1. Even if you have a “capital efficient” business model, know that this doesn’t insulate you from capital raising challenges. If you can, when raising that last round of pre-commercialization capital, take in enough so that you can push through the early revenue phase on to true repeat revenues. This often isn’t possible, but it’s worth thinking about. At very least, manage your costs and cash burn with this gap in mind.
2. Spend time well ahead of your Series B and Series C to get to know the most likely potential investors — and without pitching them at that time, make sure they know how your business model is different and how it works. That’s the best way to counter the “battle scars” factor.
3. Recognize that not all revenues are equal. I know it’s easy for me to say, but if you can, work to have those early customers be as indicative as possible of the broader market. A lot of these “early revenue” pitches I see involve early sales that, once you dig into the details, are pretty idiosyncratic. There are a couple of electric utilities out there, for instance, who are widely known to be willing to be trial customers of new solutions. Cheers to them! But because for now they remain unfortunately not indicative of the mass of their utility breathren, a contract with them doesn’t give the comfort to outside investors that the entrepreneurs might expect.
What are investors taking away from this?
1. I believe there’s now a very interesting investment opportunity in these early revenue Series B and C rounds. Obviously subject to all of the above concerns, but where there are capital gaps, there are often less competitive investment opportunities. Family offices and similar types of investors who are looking to become more active direct investors in cleantech might be particularly well-suited to take on this role, given check size and risk/reward dynamics.
2. I’m starting to see some of the larger growth stage firms see an opportunity to write a smaller check at this stage in order to give themselves a call option on the next, bigger round, when it would otherwise be much more competitive and harder to get in. It’s not being done broadly out there, but in a few instances structures can be put in place at this stage that are a win-win for both the company and the growth stage investors, when it’s truly a special company with big potential.
3. Early stage investors need to start planning for this gap, and be prepared to do an insider-only round if necessary at this stage. There are a lot of these happening in the market right now, for this very reason. But it’s best done with forethought put into communicating what milestones would justify the additional investment even without an outside lead, as well as to making sure that the existing people around the table have deep enough pockets to be able to fill this gap if necessary. Insider rounds aren’t optimal, so they need to be done only with discipline and not just as an automatic default option when the market doesn’t step up.
It’s ironic and a bit frustrating that the lower capital need of “next wave” cleantech entrepreneurs is itself leading many into this capital gap. It’s frustrating that the gap exists at all. And yet none of the above seems to be insurmountable to me. I suspect this is exactly the kind of capital gap that disappears as the market continues to come back in 2014 and on. But for now, it’s important for entrepreneurs to anticipate potential challenges at this phase, and plan accordingly.
Photo Credit: Cleantech Funding/shutterstock