The Role of Venture Capital in Green Tech Innovation
Everyone is calling for a revolution in the ways we produce and consume energy and for the past year policy makers have been investing billions in this pursuit. But, if their investment models are wrong for the green tech sector, their actions will cause more harm than good. For the Obama Administration and the U.S. Department of Energy (DOE), venture capital financing has become one of the leading models.
Venture capitalists work closely with start-ups to bring new technologies to market. Google, Genentech, Intel, Cisco and others were funded this way, so it seems natural for the federal government to follow venture capital’s lead in identifying and investing in new green tech ventures on hopes these new ventures will have similar impacts.
And invest they have, with large loan guarantees to VC-backed start-ups like electric car manufacturers Tesla ($365M) and Fisker ($528M) and solar manufacturer Solyndra ($535 mil). These investments—make no mistake, loans to startups are the equivalent of equity-free investments—are being guided by former venture capitalists now working closely with, or for, the DOE, which now has more than $50 billion in loan guarantee authority to advance nuclear, clean coal, advanced renewable and energy efficiency technologies.
Is this the right investment model for a green tech revolution?
This is a critical question, what with Tesla's recent IPO. Tesla's IPO and subsequent performance is the stalking horse of the green tech IPO market. It is also a good measure of the return to irrationality of the stock market.
Tesla raised $226M (less than they owe on their DOE loan) and despite having delivered a total of approximately 1,000 cars since introducing its Roadster in 2009. Moreover, Tesla is a long way from profits and is pinning its real growth not on the 7-figure Roadster but on the mass-market sedan due in 2012 (similar to what Nissan will introduce in 2010 as the 2011 Leaf for about half the price
Of course, this follows on the heels of last year's green tech stalking horse, A123 Batteries (another VC-backed firm). A123 went public in September 2009 priced at $13/share and immediately jumped to over $20. Today they're trading at $9, though thanks to the market's rationality this gives A123 a market cap of roughly $1B based on $92.3M in revenues in the past year (which produced $96.77M in losses).
In the end, however, the investment of public funds into green tech companies will ultimately be measured not by IPOs and the resulting profits for bankers and investors, but by its ability to replace existing technologies embedded in large, well-established markets like automobiles, energy, residential and commercial buildings.
VC investing in Green Tech
For all but a few opportunities, this investment strategy may not work. Yes, a few companies and their patient and visionary investors have done well. Silverspring is one example—having painstakingly built a smart meter company from before green was the next next thing. Others who are quietly building new materials or other supply chain innovations may also succeed. Yet most "green tech" markets don't meet the criteria for effective—and profitable—venture investing.
Why? Because venture capital investing does well when three closely-related market conditions are present:
Large and fast-growing markets. VC-backed companies don’t create new markets, which often take decades of collective action to form. Instead, these ventures exploit the hyper-growth phase, when early adopters arrive en masse, to transform the market. Yet the markets most needing green technology are already large, growing slowly, and heavily regulated, making it extremely difficult for such innovations to take root.
Growth in the global energy market, for example, has been non-existent for the last decade (0.14%). 2008 saw 3% growth, still a far cry from the double-digit growth of information technology markets in their heyday, and yet new wind and solar (PV) technologies contributed 0.23% and 0.01%, respectively, to that growth.
Investing in individual companies will not transform these established markets, and may even hinder the process. Assuming they deliver, how much impact will Tesla's promised 120,000 cars in 2013 have in a market that annually consumes 10 million cars? Better to invest—through open technology platforms and enabling policies—in collective action that prepares nascent markets, like microgrids, to grow and transform.
Strategic benefits from scaling quickly. Unless a company can become the dominant player by getting to market sooner and growing faster than competitors, there is little advantage to investing significant venture capital in them. In IT and life sciences, most of the costs lie in product development; once in production, small companies can scale quickly with a growing market. Not so with green technologies like wind, solar, biofuels, or even nuclear, where scaling production, distribution, and installation often runs to 10X the costs of developing the technology (and continues to grow relatively linearly with the growth of the company).
Investing in proprietary capital projects for individual companies—even to help them scale up to the next level—will not support their continued growth let alone provide spillover benefits to others that follow. Not to pick on Tesla again, but considering Nissan's existing infrastructure, from a supplier base to manufacturing to sales and support, it's no wonder they can promise 50,000 cars a month relative to Tesla's 10,000. Much of Tesla's loans will go to building what the rest of the auto industry already has and which, if Tesla goes under, won't need. Better to invest in creating improving shared infrastructure (and lessons learned) that all ventures can build upon.
Large and rapid payoffs. For venture capital investing to be profitable, start-ups must pursue strategies that enable them to go public or be acquired, and fairly quickly—within five to seven years for the venture fund to be successful—or die trying. Historically, only 14% of VC-backed companies go public and another 33% are acquired (though rarely at desired returns), more than half of all ventures fail outright or ignominiously fading away. With these odds, winning bets must return 10-20 times their investment to offset a fund’s failures. Given the relatively slow transformation of green technology markets and expense of scaling up, however, few green technology companies will generate the kinds of returns that justify VC investing.
Applying the venture capital model may hurt the very companies it hopes to help by pushing them grow fast and exit early. Tesla made it all the way to IPO. Others, like Solyndra, for example, may not make it across that finish line. But when these companies face continued losses and significant capital investments still ahead, should this be considered the finish line? New companies need to build slowly and in pace with the market and, when scaling, in close partnerships with established firms. IPOs and other rapid payoffs may not fit the needs of mature, slow growing markets.
In short, venture capital has fostered innovation by picking and backing those individual companies that can best exploit markets in moments of relatively sudden and rapid growth. Blindly applying this model to green technology, however, risks wasting money and, more importantly, undermining the ways innovation moves forward in transforming more traditional industries.
Does this mean we should we abandon investing in green technology? Absolutely not. We just need to invest wisely. The best investments will not come from backing individual companies but come from reshaping the competitive landscape—creating the opportunities for new business models and markets that enable the unique strengths of green technologies to emerge and develop. Consistent regulatory policies and open technology platforms will benefit all ventures and foster collective action to shape emerging market opportunities.
How much do you think sheer size of the capital required to get to meaningful milestone plays a role? I mean, it seems to me with many of the VC success stories in the last 20 years, the amount of money spent to get to a product or very meaningful milestone was often measured in millions or tens of millions, whereas with examples like Tesal, you have investments of hundreds of millions before there is a real market test. It seems that this would limit the number of companies that will be able to raise capital to get to that point. In the late 90’s, there were dozens of web search engines trying to be the place to go. Now we have Yahoo, Google, Bing and maybe a few others. But we don’t have dozens of Teslas, at least not getting that kind of funding. And it seems like the capital hurdle of building an innovative, competitive EV is simply going to be a lot higher that Sergey and Brin coming up with Google.