Cleantech Venture Investing: On the Deathbed or Merely Resting?

as posted to CleanTechBlog.com

Two weeks ago, I sat on a panel of eminent (that is, other than myself) cleantech venture capitalists at the New England Venture Summit to discuss our sector as we approach the end of 2012.

The basic theme being explored was whether we should be optimistic or pessimistic about the current state of affairs for cleantech investing.

As I noted in my opening quip:  “I have friends on both sides of this issue, and on this issue, I’m with my friends.”

Seriously, it’s easy to understand being pessimistic.  While the data on cleantech venture capital investing activity has been mixed and erratic over the past few years, the qualitative indicators have led to a plethora of articles during 2012 suggesting a cleantech “bust”.  True, the litany of woes is substantial.

  • Several high-profile venture capital firms have retreated from or at least strongly de-emphasized cleantech investing, and other cleantech venture firms are widely thought to be in challenging positions likely precluding a next fund for ongoing viability.
  • Valuations on cleantech investment rounds have experienced significant downward pressure.
  • While early-stage deals can get done, the trend is towards focusing on later-stage deals, and ventures with long histories but only limited customer traction and modest revenues (less than breakeven) will find it difficult to obtain the next round of capital at favorable terms.
  • The Solyndra debacle has been an excruciating black eye for venture-backed cleantech deals in general.
  • Very low natural gas prices from the shale bonanza make it difficult for many energy-related cleantech firms to compete economically with their products.
  • The Republican party has successfully made cleantech a political litmus test, which in turn means that roughly 50% of the U.S. population views the sector with a general sense of skepticism or disdain.

When you sum this up, it’s pretty tough to be a cleantech venture investor these days.   But, there’s also a strong case to be made for cautious optimism, too.

Taking the long view – which I can to a fair degree, since I’ve been playing in this sandbox in various capacities for nearly 15 years, far longer than most observers – the situation we face today is not as discouraging as it was in the late 1990s (when only ventures called ______.com could get funded) or in the 2002-2005 era (post-9/11, post dot-com meltdown, post-Enron, still-cheap oil).

A much-needed cleansing of the sector is going on, a case of Schumpeterian “creative destruction”.  I suspected then, and am pretty convinced now, that a significant cleantech venture investment bubble occurred in the 2006-2008 timeframe.  The confluence of rapidly rising oil and natural gas prices plus greater political consensus about climate change (recall that 2008 GOP Presidential candidate John McCain supported carbon-mitigation policies) drew in not only too-much capital, but also investment professionals that – in my opinion – weren’t applying a prudent set of commercial perspectives when making bets in the uniquely challenging cleantech space.

Simply put, venture capitalists drawn into cleantech from other sectors – either software or healthcare – because it was the “new new thing” employed many of the tricks they used (often successfully) in the past, but which don’t necessarily work so well in cleantech.  Combined with ever-increasing sizes of venture funds, which need bigger investments to “move the needle” (i.e., generate returns upon exit sizable enough to be noticeable), excessive quantities of capital were thrown at a number of cleantech ventures before they were ready to make productive use of such resources.

Using a pricelessly-wise idiom that I first heard from legendary venture capitalist David Morgenthaler:  “Getting nine women pregnant won’t get you a baby in one month.”

Not surprisingly, too many capital-intensive cleantech deals got funded, focused on a too-narrow set of investment theses, including thin-film solar, lithium-ion batteries, electric vehicles, and second generation biofuels.

Clearly, there will be a shakeout in cleantech investing.  More ventures will go bust.  More cleantech venture capitalists, and venture capital firms active in cleantech, will withdraw from the space.  Only the strongest will survive.

Yet, those that survive will almost certainly be better prepared to prosper in the next uptick in cleantech venture investing.  And, the deals will be more attractive:  valuations will be lower, business plans and models will be sounder, and leadership teams will be more seasoned.

Yes, there will be a rebound in cleantech.  I’m not going to predict exactly when it will become fully evident, but it must happen.  After all, the overall fundamentals in support of the cleantech thesis still remain:  growing populations and increasing standards of living worldwide who are demanding greater environmental protection while simultaneously competing for finite (in many cases, dwindling) essential resources such as energy, water and food.

The members of the panel on which I sat generally reiterated the same basic themes:  capital-efficiency of scale-up, clear technological differentiation and economic superiority, greater involvement of corporate venture capital as funders, working early with strategic partners (future acquirers) to accelerate market penetration, improved teams with relevant entrepreneurial experience from prior cleantech ventures.

Paraphrasing Mark Twain, the death of cleantech venture investing has been greatly exaggerated.  Although it may be “stunned”,  it’s not “just resting” or “pining for the fjords”, either.

The cleantech venture capitalists who will be successful in the future are today still working hard on their portfolio companies.  Most will not be noteworthy exits.  Some will need to be terminated, others “worked out” through turnarounds and restructurings, with a few winners coming out at the end of the process.  Not all the winners need to be “the next Google” or even “home runs”, but rather solid companies producing good (if not outrageous) rates of return to investors.

This restructuring of the cleantech venture sector will take time and be painful for pretty much everyone involved.  But it’s the price to be paid to stay in the game, and will surely separate those who are truly committed and capable from the “wanna-bes”.

I intend to remain engaged for the rest of my career, and will be working diligently to continue to earn the right to do so.

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Cleantech VC Etiquette

as posted to CleanTechBlog.com

Being a venture capitalist is not easy.  Being a cleantech venture capitalist is especially not easy.

I remember Ira Ehrenpreis of Technology Partners, one of the deans of the cleantech VC community, commenting archly several years ago at one of the too-many cleantech investment conferences:  “We need a poster child for cleantech venture capital success.”  Well, generally speaking, we’re still waiting.

There aren’t that many cleantech venture capitalists.  You know who you are.  I know, or know of, most of you.  We need to work together, to help each other, achieve some good successes in cleantech venture financing, so as to improve the well-being of our sector.  This will be to our collective benefit.

So, I write a simple plea to my fellow cleantech VC practicioners:  can you at least respond to emails?

I’ve worked on both sides of the cleantech venture finance table — both in trying to raise capital for ventures, and in making investments in ventures — for nearly 15 years.  And, I submit that the courtesy of most investors in the cleantech space is pretty appalling.

Too frequently, when I send an email to an investor claiming to be interested in cleantech deals, inquiring if they potentially would consider looking seriously at one of the deals with which I’m involved, I encounter deafening radio silence.  Nothing.  Not a peep.  As if my message went into a black hole.

Of course, most of these investors probably want to say “No, thank you,” and don’t want to take the time to respond or the effort to come up with a gentle gracious turn-down.  But, really, how hard is it to reply?  I would appreciate some kind of an indication to my emails, to at least ensure that you received the email (i.e., I’ve got the right address), and maybe get some useful feedback.

Not to pat myself on the back inordinately, but I try damn hard to be responsive and make useful suggestions to anyone who sends an email to me seeking financing, in the aim of building goodwill and helping the sector as a whole.  You might even call it trying to foster good karma.

Look, I’ll make it easy for you:  here’s a generic email response that you may feel free to use.

 

Dear Richard,

Thanks for your email regarding [venture name].  I appreciate you thinking of us.  Unfortunately, we are not in a position to consider an investment, because [choose one or more of the following]:

a)  It’s too small

b)  It’s too big

c)  It’s too early

d)  It’s too late

e)  It’s geographically inconvenient for us

f)  We have a competing investment in this space

g)  We’ve had a similar investment before that didn’t work out well and thus are not attracted to this space

h)  We’re in-between funds and don’t have capital to deploy at present (bonus points for candor!)

You might consider contacting [insert cleantech VC name/firm here], as he/she/they might find this opportunity to fit nicely into their sweet-spot.  Good luck!

 

See, that wasn’t that hard, was it?

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CleanWeb: The Intersection of IT and CleanTech

as posted to CleanTechBlog.com

For many observers, the bloom is off cleantech venture investing.  The challenges are numerous and increasingly well-known:  capital requirements are too large, the non-market (i.e., regulatory/political) forces are too influential, the incumbents are too strong, the sales cycles among risk-averse customers are too long, the technological issues are too profound. 

As reported in this posting, this negative view of cleantech venture capital is held especially strongly by Peter Thiel, one of the early principals of PayPal and a highly-influential voice within the capital markets and financial community — especially in Silicon Valley.

Oh, for the glory days of venture investing!  Where in cleantech is the next Google, Yahoo, Facebook, Microsoft, LinkedIn, Amazon?  Anyone, anyone?  Bueller?  Bueller?

A nascent movement is growing in response to this queasy inquiry.  At the center of this movement is “CleanWeb”, which focuses on the ability to harness the ever-expanding powers of intelligence for greater efficiency in physical resource management.  At the center of the CleanWeb phenomenon is Sunil Paul, the founder of Spring Ventures and a co-founder of the IT company Brightmail, which was eventually acquired by Symantec for the tidy sum of $370 million.

As Sunil and his Spring Ventures partner Nick Allen argue in this article from a recent issue of Technology Review, many of the enabling physical sciences discoveries to significantly change for the better our energy production and consumption have already been achieved.  “What hampers [them] now is poor sales channels, complex financing and incentives, and a failure to communicate with customers.  That makes them ripe for disruption by the application of IT, which will drive the next phase of cost reduction and implementation.”

More good news:  as Stanford Professor Jonathan Koomey argues in another article in the same issue of Technology Review, there’s a lot of remaining untapped upside potential in the CleanWeb.  Koomey writes that, according to some calculations by the crazy-genius physicist Richard Feynman, the energy efficiency of computing theoretically could improve by at least four more orders of magnitude from today’s levels, and it appears that the trajectory of improvement is a factor of 100 every decade.  So, we’ve got a long way to go. 

Or, put another way, as Koomey does:  today, the world’s most powerful computer (the 10.5 petaflop Fujitsu K) consumes a whopping 12.7 megawatts — an entire town’s worth of power — but a similarly capable machine two decades from now would consume as much electricity as a standard household toaster.  If you doubt that this degree of improvement can be achieved in 20 years, Koomey notes that today’s MacBook Air — if operated at the efficiency of 1991 computers — would fully discharge its battery in merely 2.5 seconds.

Sunil, Nick and their confederates have been organizing a series of regional CleanWeb Hackathons, bringing together information technology professionals to develop new code for “optimizing resource use and accelerating cleantech development.”  The first hackathon in (you guessed it) San Francisco last September was said in this article by GigaOM to have drawn 100 participants and resulted in 14 cleanweb applications.

The space of CleanWeb is pretty broad.  In our venture capital firm, Early Stage Partners, we’re seeing an increasing number of software-based business plans that – whether directly or tangentially – result in lower consumption of energy, and correspondingly lower emissions.  You could call any of these “CleanWeb”. 

One of ESP’s portfolio companies — Cleveland-based LineStream Technologies, spun-out from Cleveland State University by licensing the control systems innovations developed by Professor Zhiqiang Gao — clearly fits the CleanWeb category, as its proprietary algorithms enable much better management of both industrial and consumer applications.  This improved management usually results in lower energy consumption, and the reduction in energy consumption translates to lower costs, which is virtually always a good thing for prospective users.  The environmental benefits of lower energy consumption are nice, but incidental.

These CleanWeb business models often aren’t subject to the litany of challenges listed at the outset of this posting:  capital-intensity, regulatory impediments, incumbent opposition, long sales-cycles, or challenging physical innovations.  Accordingly, they may be relatively well-suited to venture capital investment approaches – more so than pushing for the next breakthrough in batteries, solar energy, fuel cells, wind, biofuels, nuclear or other cleantech sector involving a physical discipline.

A complaint leveled by some observers – such as in the closing paragraphs of this report by one of my favorite cleantech writers, Eric Wesoff of GreenTechMedia, on Thiel’s diatribe against cleantech venture capital — implies that CleanWeb investors are too wimpy.  The thinking seems to go that venture capital practices developed from investing in software start-ups just can’t handle the big/tough but necessary challenges of cleantech.  The CleanWeb innovations on which such investors are focusing, while nice, may be just “cherry-picking”, and not truly transformative.

Perhaps.  However, I would argue that the primary role of private capital is to make good returns, period.  Most investors don’t place their money in the hands of others (i.e., venture capital firms) to effectuate social change, no matter how desirable such change might be.  Venture capitalists can’t afford to break their picks fighting fights that they can’t win, or would have to spend inordinate amounts of capital in order to win.

Those battles need to be fought not by investors but rather by participants in the arenas of politics and laws.  Those battles set the rules of the game, within which investors and competitive market actors subsequently play.  

In my view, the rules of the game are in many ways stacked against those of us active in cleantech, and it is entirely appropriate to seek — in a fair and just manner – to change those rules.  But, it is unreasonable to expect professional investors to deploy capital imprudently, flying in the face of unfavorable rules. 

And, it is unreasonable to expect professional investors to be able to dedicate more than a modest portion of their time or effort in the public debates.  Their investments, and their investors, properly demand the majority of their attention.

In contrast to many investment opportunities in energy supply or storage technologies, CleanWeb faces minimal headwinds.  It may well be lamentable that renewable energy faces stiff headwinds, some of which may stem from outdated or inequitable rules, but that sentiment doesn’t change the harsh realities.

Virtuality does have its virtues.

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Cyberspace Is Here

IN 1984, the science fiction author William Gibson published Neuromancer, a novel that described a future in which corporations, governments, and criminals engaged in commerce–licit or illicit–in a netherworld of software. He called this world “cyberspace.”

Looking around at the developing world of eCommerce, social media, targeted marketing, and hacking, it is clear that the world William Gibson imagined is here. We call it the “cloud.”

Some of the ramifications of the emergence of cloud computing were discussed at a panel at the 2012 Michigan Growth Capital Symposium. A video of the panel can be viewed here.

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Crowdfunding: Love It, Hate It, or Wait and See?

I have been asked by a variety of people to comment on the crowdfunding bill that was signed today into law. The bill, introduced first by Massachusetts Senator Scott Brown as the CROWDFUND Act, was subsumed in the larger Jumpstart Our Business Startups, or JOBS Act.

The purpose of the crowdfunding portion of the act is “To amend the securities laws to provide for registration exemptions for certain crowdfunded securities, and for other purposes.”

The bill will also (according to Senator Brown’s web site):

  • Allow entrepreneurs to raise up to $1 million per year through an SEC-registered crowdfunding portal;
  • Free people to invest a percentage of their income. For investors with an income of less than $100,000, investments will be capped at the greater of $2,000 or 5% of income. For investors within an income of more than $100,000, investments will be capped at 10% up to $100,000; and
  • Require crowdfunding portals to provide investor protection, including investor education materials on the risks associated with small issuers and illiquidity.

The bill also provides for exemptions from certain Sarbanes-Oxley requirements for entrepreneurial companies.

Most of the questions I have been asked about crowdfunding have been framed in this way: “Will it be good or bad?” This is usually followed by the comments that “entrepreneurs will like being able to raise capital on the Internet” (good) and “there will be fraud” (bad).

“Good” and “bad” are moral terms, and I tend not to place moral judgements on business matters (only on the behaviors of individuals).

Crowdfunding will be an experiment. There will be a variety of outcomes, many of which we cannot predict today. We will see what happens after it has happened. Some of what occurs will be anticipated, and some will surprise. Some of the outcomes will result in further legislation and regulation (more on that later). That is the nature of experimentation.

Will crowdfunding enable entrepreneurs to raise capital over the Internet? Undoubtedly.  There are precedents in how the Internet enables financial innovation, including microloans and secondary markets for private company shares; crowdfunding is a natural extension of those.

Will the net effect of crowdfunding be beneficial to the entrepreneurial economy? Perhaps. Underlying the concept of crowdfunding is the assumption that the wisdom of the masses is superior to the wisdom of experts. Deals that don’t get venture funding, the argument goes (and venture capitalists only fund 1% of what they see) will be funded and some of these will be successful, showing that VCs don’t know everything.

As a professional venture capitalist, I would like to believe that my investment decisions are better than those of a group of people with varying skills, experiences, and backgrounds, but there are many instances in which the wisdom of the masses has been shown to be superior to expert opinion. We call the collective decisions of individuals “markets” and self-created markets often perform better than the decisions of experts.

I loved it last year when a group of iterating and collaborating online gamers with no particular understanding of biology quickly discovered the structure of a protein that is important in AIDS research, when experts had been unable to do so for years.

Will fraud occur? Undoubtedly. Just as surely as Adam bit the apple. When it happens one outcome will be the usual gnashing of teeth and media overexposure, hearings in Congress, and reactions in Washington…

…which leads to the subject I really want to write about: this bill wouldn’t be necessary if Washington hadn’t overreached into capital markets with previous rounds of legislation and regulation. Even with the best of intentions, today’s legislation will create unintended consequences that will result in more legislation and regulation, which ultimately results in a house of cards. And once legislation and regulation are in place, it’s much harder to undo them than to pile more of the same on top of them.

The basic regulatory schema of capital markets was laid down by FDR during the Great Depression. Layered on top of that are decades of tweaks and additions, but there has been no fundamental analysis of whether the infrastructure of financial market regulation makes sense in today’s world, only the adding of more layers on top of the old.

Consider Sarbanes-Oxley, Dodd-Frank, and the corollary regulations and rules that they have spawned. I remember clearly that advocates of Sarbanes-Oxley claimed, in the wake of the Enron and Worldcom scandals, that it would affect only large public companies. Yet an entire schema of regulation was erected that has now reached down into the earliest stage companies.

Start-ups with little or no revenue now have to annually pay somebody for a fairness opinion on the price of options. Options have to be expensed as if they are a cash expense. Start-up company CFOs have to personally verify financials, under compulsion and with threat of personal liability.

Venture funds have to spend hundreds of hours building and tweaking PWERM and liquidation cascade models to provide false specificity to year-end portfolio company valuations, when everybody knows that the models are based on speculative assumptions about the future.

Under the Dodd-Frank law, venture capital funds now must register with the SEC, fill out reports the purpose of which is unclear and submit them to faceless bureaucrats whose understanding of venture capital is unknown–in other words, spend scarce resources dealing with a whole new layer of compliance and reports they must make to regulators in Washington, even though the rationale for the Dodd-Frank laws was to prevent a recurrence of the recent financial crisis that had nothing to do with venture capital.

Both laws clearly illustrate the trend towards tightening federal control over financial markets. This must be worrisome for entrepreneurs and venture capitalists alike–even if they like crowdfunding–because by nature, federal legislators and regulators seek one-size-fits-all regulatory schema for complex market issues about which they seldom have deep understanding. Their objective is control, often with limited understanding of and justification for what they are trying to control. Control, inevitably, suppresses innovation.

Some of the consequences of Sarbanes-Oxley very likely include a generally depressed exit environment for venture-backed companies, a decline in IPOs in the U.S., the export of the IPO market overseas, and a decade of poor returns for the VC industry. This has created perturbation in the VC industry and affected returns for investors in venture funds. As many of these investors are pension funds and endowments, the ripple effect carries through to their ability to meet their obligations.

What does this have to do with the crowdfunding legislation? Washington is having to fix a problem that it very likely created.  The insidious nature of the federal political process is that it invites narrow groups such as entrepreneurs to engage around narrow, specific legislation that seems to suit their narrow current needs, without looking at the larger long-term consequences of tightening federal control.

Crowdfunding may fix some current problems, but it will undoubtedly create new ones. Of one thing we can be sure: the intrusion of federal government into financial markets will not decrease. The SEC and accountants have already voiced their opposition to this legislation, and we can be certain that they will continue to find fault with it, pounce on the inevitable problems that occur, and argue for…more legislation and regulation.

Benjamin Franklin famously said that “nothing in life is certain but death and taxes.” I’ll add to that “regulation.”

We would be better served with a complete reevaluation of the regulatory schema for modern financial markets and a retirement of legislation and regulation that no longer makes sense than with the constant layering of the new on top of the old.

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IT Deal Flow in Ohio

Quietly, without much national notice, Northeast Ohio is beginning to generate some very interesting growth and early stage IT companies in SaaS, Web, ecommerce and other segments.

In the SaaS area, TOA Technologies is breaking through to become a world class enterprise solution to “the cable guy” problem. The company’s time-based predictive software enables businesses that deliver a product or service to better manage the scheduling, delivery, notification, and communication process–resulting in significant cost savings and improved customer service. The company is headquartered in Beachwood, Ohio, a suburb east of Cleveland.

Another rapidly growing SaaS company is OnShift, which helps companies with shift-based staffing to manage scheduling and, particularly, overtime. Easy to install and use, OnShift provides payback to customers in less than six months. IN 2011, OnShift quadrupled revenue and increased customers served from 170 to 500. The company is headquartered in the Playhouse Square district of downtown Cleveland.

Sparkbase, headquartered in a rehabbed brick industrial building on Superior Avenue in Cleveland, provides white labeled gift and loyalty programs to the Independent Sales Organizations that service retail merchants. The company has recently added more than a dozen employees as it grows to keep up with customer demand.

Intelligent Mobile Support, another Cleveland-area company, provides a cloud-based way for mobile employees to access masses of company technical documents. This is a big problem for companies that provide technical equipment to customers and need field technicians to have fast access to massive amounts of technical documentation.

If you want to talk about “big data” look no further than Cleveland’s Explorys, which is creating powerful databases and tools to enable healthcare organizations to harness their data for improved Enterprise Performance Management.

How did all these great companies, and more, come to be in the Cleveland area? Reasons vary, but include lifestyle, cost of doing business, support resources, capital, and low employee turnover.

Stay tuned for more great things to come.

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The State of the Venture Capital Market

The venture capital market is shrinking; the venture capital market is growing. The venture capital model is broken; venture capital will generate disproportionate returns in the next economic cycle. All the returns will be generated by the top firms in Silicon Valley; venture capital firms serving underserved geographies will outperform the class. You can hear all of these opinions, and many others, in commentary about the venture capital industry today.

What is one to make of these varied and sometimes conflicting messages? The Early Stage Partners team continues to believe in venture capital as a class of capital, particularly early stage venture capital. We believe in our approach to investing. We believe in our portfolio, which is maturing nicely. A number of ESP portfolio companies are outperforming their peers and we didn’t lose a single company during the economic downturn.

In the Midwestern geographies in which we concentrate our investing activity, entrepreneurship is burgeoning. Demand for early stage venture capital is greater than supply. Terms are favorable and the entrepreneurial ecosystem is supporting the formation and growth of many companies. There is a greater understanding among entrepreneurs of what it takes to drive venture-backed companies to profitability and exit.

At the same time, there is turbulence in the venture capital industry overall. Top firms are raising larger funds than they projected. Other firms are struggling to raise any capital at all. The National Venture Capital Association estimates that one-third of firms that existed ten years ago will soon depart the industry. We are clearly in the middle of a shift in the venture capital industry. What it will look like at the end of the cycle, nobody can predict.

Early Stage Partners is committed to being successful in whatever environment in which we operate. Our model has evolved and will continue to evolve. One reason that we didn’t lose any companies during the economic downturn was that we spent a lot time financing portfolio companies from non-traditional sources such as wealthy individuals, family offices, and angel networks. Venture capital financing dried up, and we innovated. That’s what entrepreneurs do, and one of the principal reasons that we are passionate about working in partnership with outstanding entrepreneurs is that we’re entrepreneurs ourselves.

The next two years will be interesting times for the venture capital industry. We look forward to continuing to share our progress with you.

We keep a running tally of portfolio company successes with updates to our Web site (http://www.esplp.com), though we try not to overwhelm you with information. By registering for our RSS feed on the Web site, you can be instantly notified when we add exciting news—usually a couple of times a month.

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