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

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Into the Valley of Death

Everybody is talking about how new breakthroughs—in energy and elsewhere—requires helping startups through the Valley of Death.  This is a well-intentioned but dangerous policy.

The valley of death refers to financial risks that start-ups face as they struggle to grow from small teams to going ventures. The dip of the valley refers to the debt—the negative balance sheets—that companies experience as they invest money now in hopes of making it back upon success (the accompanying figure provides a general description).

Nowhere is this valley of death more evident than in clean technology, where startups face a difficult combination of challenges. On the one hand, the challenge of teams seeking $50k to $5M or more in funding to begin translating their advanced science into industrial processes (moving thin-film solar or fuels from algae out of the lab and into commercial production) and, on the other hand, the challenge of funded startups trying to raise investments for the industrial-sized plants and equipment needed to utilize those emerging processes. Valley of Death Image If we want to bring these emerging ventures to market quickly and at a scale that impacts energy security and climate change, policy wonks and private investors alike are arguing, we must provide the financial support these entrepreneurs need to make it through the valley of death.

Now might be a good time to reconsider.

Saying that most startups perish in the valley of death is like saying that most patients die of cardiac or respiratory failure—the moment when the heart stops pumping or the lungs stops breathing. Indeed, doctors now take great care in noting not just the immediate cause of death but also the antecedent causes: patient died of [blank] due [antecedent cause] due to [antecedent cause].  Without looking past the obvious, few lessons can be learned.

Innovation policy must similarly take great care not to confuse the ultimate with the antecedent causes of failure. Running out of money is the ultimate cause of death for most all ventures. Without considering the antecedent causes, it’s also a dangerous basis for policy decisions.

In addition to financial capital, there are three other forms that at different times can be significantly more valuable: physical capital (the physical resources someone has already acquired and organized), intellectual capital (the knowledge and skills someone has acquired and organized), and social capital (someone’s social network, or access to the capital “stocks” of others).

While a startup’s balance sheet might clearly show where they stand with respect to their financial and physical capital, it does little to reveal their intellectual and social capital. And yet for companies to avoid their own untimely demise, they depend as much or more on knowledge, experience, and ability to manage their company’s fortunes—and on their social networks to discover, guide, and acquire the critical resources they will need to succeed.

Supporting the success of small companies advancing clean technologies requires more than financial or physical capital—it requires ensuring these companies have access to the best knowledge and experience, and the right social networks, as they get started.

The energy sector is extremely large, bureaucratic, and entrenched. The competitive landscape in which new companies hope to thrive is a product of regulatory policies and industrial coordination that takes place in places and ways that are difficult for entrepreneurs to see let alone access. Yet this is a large portion of the knowledge and networks that new companies must acquire if they are to survive and make a difference.

Institutions are emerging to provide new startups in clean technology with these resources. At UC Davis, for example, the Green Technology Entrepreneurship Academy, in coordination with the Graduate School of Management and with support from the Kauffman Foundation, brings scientists and engineers from across the country to explore the commercial potential of their research with instruction and mentorship from leading entrepreneurs, investors, and corporations. The emphasis is on combining entrepreneurial knowledge and networks—the critical intellectual and social capital that new ventures need before the financial capital can be put to best use.

Similarly, the Energy Efficiency Center supports promising new ventures advancing energy efficiency by providing access to their established network of university researchers, manufacturers, venture and corporate investors, electric utilities, energy service companies, and major energy customers such as the state of California and Walmart.

As the Department of Energy begins funding it’s new Energy Hubs with an eye toward commercializing new research breakthroughs, it should seriously consider how it will provide these emerging ventures with the right capital to succeed.

Indeed, the valley of death may be an apt description for other, less valiant reasons. The term came from Lord Alfred Tennyson’s famous poem, “The Charge of the Light Brigade,” describing the tragic british cavalry charge over open terrain in the Battle of Balaclava, in the Crimean War, in which 278 of 607 were killed or wounded within moments.

To those who witnessed it, the charge of the light brigade demonstrated both the courage of the British soldier and the incompetence of their command. The soldiers died because they rode directly into withering crossfire from three sides. Wrote the war correspondent William Russell:

“At 11:00 our Light Cavalry Brigade rushed to the front… The Russians opened on them with guns from the redoubts on the right, with volleys of musketry and rifles.

They swept proudly past, glittering in the morning sun in all the pride and splendor of war. We could hardly believe the evidence of our senses. Surely that handful of men were not going to charge an army in position? Alas! It was but too true — their desperate valor knew no bounds, and far indeed was it removed from its so-called better part — discretion. They advanced in two lines, quickening the pace as they closed towards the enemy. A more fearful spectacle was never witnessed than by those who, without the power to aid, beheld their heroic countrymen rushing to the arms of sudden death.”

Poor intelligence, miscommunication, and unthinking obedience on the part of their commanders were the antecedent causes of the Light Brigade’s valley of death. Companies run out of money for all sorts of reasons—including perfectly good ones: the market wasn’t ready, the technology couldn’t scale, or the economy tanked.  But some of those reasons might have been avoided.

Public financing of new ventures can prolong a company’s life, but it won’t fix poor planning, miscommunication, or blind faith. Money hides more bad decisions than it cures. To ensure companies make the transition from small venture to a sustaining business, financial capital may be the last form of capital startups need.

Public finance is an attractive tool for federal policy makers—it is easily wielded and often well-publicized. But it alone will not save clean tech entrepreneurs from riding bravely into their own valleys of death. Investing in the infrastructures that invest intellectual and social capital in these emerging ventures may be a more valuable and more critical intervention.

While we were waiting for the google of electric cars…

 

While the DOE was out investing in startups like electric car manufacturers Tesla ($465M) and Fisker ($528M)—or rather guaranteeing loans, the equivalent of investing minus the equity—the regular old car companies were not sitting on their hands. In fact, while Tesla has ramped up production of its $109,000 Roadster to roughly 100 units per month, Nissan has announced its new $25,000 electric car, which will go on sale in the U.S. in December.

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The Low tech, high stakes world of innovation

A few recent and distantly related events have strong implications for our thinking about fostering revolutions in energy.  In particular, the challenge of pushing old and large industries to adopt new technologies in hopes of making widespread change.

The first incident was PayPal's recent global service outage.  It lasted only about an hour:

"About an hour ago, PayPal started experiencing site issues
that affected the ability to send and receive money. We have all hands
on deck to get this fixed," said PayPal spokesman Anuj Nayar in a blog post about noon PDT. "We're really sorry for the inconvenience."(CNET)

According to PayPal executives, the company processes $2,000 in transactions every second, so an hour outage cost vendors who rely on PayPal about $7.2 million. PayPal's Total Payment Volume in 2008, according to the company, was $60 billion—"nearly 9 percent of global e-commerce and 15 percent of US e-commerce."

The second incident came in a distinctly different field.  This May, Lennar Homes, acknowledged its use of a new and defective Chinese-made drywall.

Lennar Corp. has identified 400 homes in Florida that have confirmed
problems with defective Chinese drywall, and it has set aside $39.8
million to repair the homes, the Miami-based home builder said in a
securities filing Friday. (WSJ, 5/31/09)

The drywall problem has affected more than just Lennar Homes, estimates of 100,000 houses built in 2006 and
2007 with the suspected Chinese
drywall.  According to the Wall St Journal (WSJ, 8/06/09):

Experts estimate it costs about $100,000 to pull out bad drywall and
replace corroded electrical wiring and appliances in an average-sized
home, and the problem is shaping up as a costly disaster for homeowners
and the battered housing industry. Many homeowners are hoping the
federal government will step in with some sort of aid similar to that
provided for victims of hurricanes and tornados, as well as a
moratorium on mortgage payments.

If proven a health hazard, the total cost to the construction industry for removing the tainted drywall adds up to approximately $10 billion in repairs.

For the small business owners relying on PayPal, an hour of lost revenue is costly.  But to the small contractors and drywall subs who may have to replace existing drywall, this kind of problem can put many of them out of business altogether.

Really sorry for the inconvenience

The two incidents together highlight a particular problem when thinking about the stakes of innovation.  High technology generally has an aura of high risk, of bold visions and big leaps.  And yet the real risks—the stakes—may have less to do with the innovation and more to do with where it's going.

As central as PayPal and other recent computing and internet innovations have become in our lives (think iPhones, Blackberries, Apples, Google, and Amazon), they're no match for the ubiquity and taken-for-grantedness of so many technologies that have become invisible and embedded in our lives. Think drywall, and then insulation, lighting, electricity, gasoline, internal combustion engines, tires, and on and on.

The risks of adopting a new product or technology are very different when it's a new behavior and relatively distinct from so many other aspects of life. While it seems as though they have become central to our lives, we're actually quite resilient when our computers crash, our internet access goes down, our cellphones drop calls.  We can manage. And anyway, why worry?  A few years down the road and we'll have moved on. Our biggest concern is whether we can keep our email address of cell number.

So a small business adopting Paypal is very different, in other words, from a small business adopting a new brand of drywall, putting it up, and then putting over that drywall the household electrical outlets and light fixtures, the trim, the paint, the finished flooring, the furniture, and a real live family. The low-tech product requires a larger commitment because the contractor (and home-owner) have to live with it for decades and, should it fail, has considerably more costs than simply replacing it. 

And that's just drywall.

Consider today's headlines around the energy revolution. Utility-scale solar and wind sound like technological breakthroughs, as does the smart grid.  But the utilities adopting them take the same risks as the contractor: they have to live with their choices for decades, indeed they are liable for those choices. 

At 34 years old, Microsoft is long past a start-up. It's operating systems are running approximately 90% of all personal computers, and yet the public has been relatively tolerant of the bugs, incompatibilities, and poor performance of its latest version, Vista (which to date has over 360 million users).  Imagine waking to find that your utility has installed an upgraded version of your power meter, and half of your appliances are no longer compatible. Or worse, imagine that your new Microsoft CE power meter has a virus (questions about the security of the smart grid are finally starting to surface).

Now imagine you're the utility. Would you bet your company on someone's high tech product when mistakes in low tech choices carry high stakes?  The moonshot and Manhattan project were high-tech, but these projects never faced the challenge of adoption by a reluctant market.  Investing in the next energy revolution requires accounting for the market: those who would commit their businesses to adopting, installing, and standing behind the new technology for decades. 

Are we designing solutions low-tech enough for them?

Modeling the costs of greenhouse gas reduction

Taking measures to reduce greenhouse gas emissions over the next
decades raises fears among some that  our economy would be adversely
impacted.  Of course, not taking measures, as the UK’s Stern Report argues, could be worse. 

Nonetheless, some nice researchers at Yale conducted a meta-analysis of
the current models for estimating the economic impacts of GGH reduction
measures, identified the seven major assumptions that control 80% of
the differences in estimates, and created a tool to allow anyone to
plug in their own version of these assumptions.

You, too, can play economic advisor: http://www.climate.yale.edu/seeforyourself