Misguided Policy: Following venture capital into clean technology

The Solyndra debacle raises significant questions about how to best pursue a clean tech revolution. As I argued before, most of these questions will go ignored in the scramble for political advantage but several others are raising the same questions (E.G., Real Solyndra Scandal).  A good post by Bruce Krasting actually brings testimony from an engineer with Solyndra that makes the company look very much like any other venture-capital backed business—consuming cash as fast as possible to grow as quickly as possible to meet a rapidly closing window of opportunity.

In particular, the Department of Energy’s recent loan guarantee program, through which Solyndra received its loan guarantees. has backstopped roughly $2 billion to venture-capital backed clean tech startups with the honorable motive of fostering a clean tech revolution. In a search for means to foster a clean tech revolution, the Obama Administration made venture capital a cornerstone of its energy policy. Yet, despite venture capital’s leading role in clean technology this past decade, we don’t really know when it works well and, as importantly, when it doesn’t.

Last spring, my colleague Martin Kenney and I completed a research paper that looked at the boundary conditions underlying venture capital’s success and its appropriateness in pursuing a clean tech revolution: “Misguided Policy: Following Venture Capital into Clean Technology.”  The paper looked directly at the funding of Solyndra, Tesla, and other new ventures. It is forthcoming in California Management Review but, given the circumstance, wanted to introduce it here.

Download Hargadon Kenney 2011 CMR Misguided Policy Following Venture Capital 110726

Clean Tech, Federal Policy, and the lure of innovation

The effort to mitigate climate change by reducing global carbon emissions is a technological and economic challenge beyond anything we’ve experienced before. Most of the options, however, require significant regulatory restrictions and, hence, extremely difficult political choices.

The most alluring option is innovation. Since the 1950s, both parties have waved the promise of innovation at all varieties of social ills.  After all, such revolutions brought us the transistor, the personal computer, the Internet, the cellphone, google and youtube (the fact that we never asked for these is a post of a whole other color).  In the case of a clean technology revolution, nothing appears simpler than applying the same model that brought us those many splendors.

The late German economist, Joseph Schumpeter, described this particular process of innovation as opening new economic spaces. New economic spaces emerge when new technologies, new organizations, new legal and regulatory structures, and human and financial capital converge to create new opportunities for profitable economic activities.

Initial ventures—combinations of private capital, new technologies, and entrepreneurs—succeed, drawing others to follow in their wake. Recall the emergence of semiconductors in the 1960s, biotechnology in the 1970s, personal computers in the 1980s, Internet companies in the 1990s, and social media companies in the past decade.

In an attempt to ensure the success of a few early ventures, the DOE provided loan guarantees to a select few that already had the imprimatur of prominent venture capital backing.  The question is, what does this backing tell us about the likely success of a particular venture, let alone an entire economic space?
The value of venture capital

The success of a number of VC-backed companies shows what a powerful role such investors can play in fostering new industries: Amgen, Applied Materials, Apple, Biogen, Cisco, eBay, Federal Express, Genentech, Google, Intel, Netscape, MCI, Oracle, PayPal, Skype, Southwest Airlines, Sun Microsystems, and Yahoo!. That success comes, in part, because venture capitalists invest firms with much potential but few assets beyond their founders’ intellectual capital and business plans, filling a need for capital that other institutions will not touch. Second, VCs conduct extensive due diligence before investing and, once an investment is made, commit significant time by serving on the board of directors, making introductions, helping craft strategy, and helping with the growth of the firm. This is all good.

So when might venture capital not be the best means to lead change?  In other words, are their limits to venture capital’s ability to finance technology revolutions?

More specifically, is VC-financed entrepreneurship the best approach to fostering a clean tech revolution? The research behind this article was originally summarized in one of my earlier posts, some of which I append here.

The Boundary Conditions of Venture Capital

Venture capital investing does well when three closely-related conditions are present.

1. 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.

2. 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).

3. 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.

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 clean tech risks wasting money and, more importantly, undermining the ways innovation moves forward in transforming more traditional industries.

So should we abandon investing in clean tech? 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.