The Flow of Venture Capital Into Clean Technology Ventures
                     Research Results




                    J...
The Flow of Venture Capital Into Clean Technology Ventures

Introduction

This paper outlines the barriers investors, as c...
The Flow of Venture Capital Into Clean Technology Ventures

investment desired, and lacking strong entrepreneurs or facing...
The Flow of Venture Capital Into Clean Technology Ventures

On the most basic level, the alternative energy category invol...
The Flow of Venture Capital Into Clean Technology Ventures



The researchers found that the amount of venture capital flo...
The Flow of Venture Capital Into Clean Technology Ventures

A high proportion of general partners and other investment pro...
The Flow of Venture Capital Into Clean Technology Ventures

It is also true that investments in areas other than technolog...
The Flow of Venture Capital Into Clean Technology Ventures

consultants and industry experts to help them examine markets ...
The Flow of Venture Capital Into Clean Technology Ventures

energy companies17 were funded by fewer dollars at every stage...
The Flow of Venture Capital Into Clean Technology Ventures

Solar was founded in 1994 and IPO’d in 2000. In software, Actu...
The Flow of Venture Capital Into Clean Technology Ventures

and semiconductor firms should be able to obtain returns of 5x...
The Flow of Venture Capital Into Clean Technology Ventures

An important source of entrepreneurial opportunity is the appl...
The Flow of Venture Capital Into Clean Technology Ventures

fact, coupled with the downward trend in cost per kilowatt-hou...
The Flow of Venture Capital Into Clean Technology Ventures

of the argument in support of funding their enterprise, entrep...
The Flow of Venture Capital Into Clean Technology Ventures



Lastly, unless there are significant changes in the way both...
The Flow of Venture Capital Into Clean Technology Ventures

APPENDIX ONE
Investor Decision Metrics

There are six major cr...
The Flow of Venture Capital Into Clean Technology Ventures

APPENDIX TWO
Interview Questionnaire Sample Set

Each intervie...
The Flow of Venture Capital Into Clean Technology Ventures

APPENDIX THREE
Types of Research Participants

The following l...
The Flow of Venture Capital Into Clean Technology Ventures

APPENDIX FOUR
Partial List of Energy and Materials Venture Inv...
The Flow of Venture Capital Into Clean Technology Ventures

78. Parker Venture Management                         98. Sun ...
The Flow of Venture Capital Into Clean Technology Ventures




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The Flow of Venture Capital Into Clean Technology Ventures ...

  1. 1. The Flow of Venture Capital Into Clean Technology Ventures Research Results Jeff Steen & Paul Frankel Associates The Center for the Study of Fiduciary Capitalism St. Mary’s College 1928 Saint Mary's Road Moraga, CA 94575 www.fidcap.org © Copyright March 2003
  2. 2. The Flow of Venture Capital Into Clean Technology Ventures Introduction This paper outlines the barriers investors, as cited by the investors themselves, preventing risk capital (more specifically, venture capital) from flowing at higher rates into industries which offer investment opportunities in technologies that simultaneously provide both environmental and economic benefits. The authors conducted first person, qualitative interviews with leading venture investors in order to determine the reasons these investors either would or would not invest in so-called “clean-tech” opportunities. Venture capital in the information technology industry has funded advances ranging from the oscilloscope to the mainframe; from integrated communications processors to unstructured data mining software. These innovations allowed society to use information through the advanced application of improved technological innovations. These technological advances were often funded by, and provided outstanding returns to, venture capitalists. Many industries meet the criteria known as “clean-tech”, yet for some reason, these opportunities lack the vast inflow of venture capital that typically characterizes the information technology sector. Utility industries such as energy generation, water distribution, and waste treatment have vast opportunities for improvement in efficiency, flow and utilization that are in many ways similar to those characterizing the value propositions of information technology applications. For example, utility industries rival the information industries in terms of annual revenues. Many experienced professionals are available to lead new ventures, and numerous innovations may be utilized to improve the performance of such industries. Yet the stream of venture capital currently flowing into the utility industry is significantly less than that generally received by the information technology industry. The purpose of this study was to inquire of investors what barriers they perceived to be restraining the flow of capital into so-called clean-tech ventures. The authors chose to compare investments in the software and semiconductor industries with investments in the alternative energy technology and materials science industries in order to bracket the study. These industries were chosen as a cross-section designed to represent different investment profiles, industry characteristics and investment dynamics. Background Traditional venture capital and other high-risk investors typically search for a number of telling factors: a large market opportunity with customers who are ready and willing to make purchases; superb management talent with a track record of success; and a unique, if not disruptive, technology advantage that is relatively facile to protect (See Appendix One). These characteristics represent the general high level tests that a company must pass before a venture investor will consider an investment. Once these thresholds are surpassed, a far more detailed analysis is undertaken. When investors were asked why they are unwilling to invest in so-called clean-tech, or “green”, industries,a number of reasons were cited: too risky, incapable of producing the returns on 10/20/03 The Flow of Venture Capital Into Clean Technology Ventures.doc 2 Copyright 2003 – Jeff Steen, Paul Frankel
  3. 3. The Flow of Venture Capital Into Clean Technology Ventures investment desired, and lacking strong entrepreneurs or facing too many market hurdles, among others. However, when probed, these same investors often admit to basing their own views on feeling and bias, not on any significant analysis. These myths, as we call them, are each partially true, yet insufficient to completely explain the slow rate of risk capital flow into clean-tech companies. These myths, the realities, and some potential remedial prescriptions will be explored below. Our research found that barriers to investment fall into five main areas. These myths, strongly held by venture investors, are as follows: 1. Money flows where money knows. 2. There are no ROI’s for investors in these industries. • Capital requirements are too large. • Time horizons are too long. • Successful exits are rare. 3. Regulatory structures make these industries unattractive. 4. Clean technology is still underdeveloped. 5. Entrepreneurs in these areas are weak in business expertise. The researchers’ working hypothesis is that the efficient exchange of information between entrepreneurs and venture capitalists will reduce barriers to capital flow into clean-tech companies. An influx of capital will catalyze business and technological innovations that offer both positive economic returns as well as strong environmental benefits. The researchers believe that within the capitalist system of the United States, upon where this study concentrates, the only true value proposition for positive, sustainable ecological improvement is profit. Therefore, the researchers want to encourage capital markets as a complementary tool for enabling environmental benefit and as a means of ensuring a sustainable future. Methodology The authors conducted a series of over 60 one-on-one interviews (See Appendix Two) with well- known venture capital investors. They also interviewed entrepreneurs, university professors, corporate executives, and others with experience in the field (See Appendix Three). In order to ensure open dialog in such a closed community, the authors agreed not to personally identify the individual investors nor to personally attribute quotes. Because some of the investors were highly critical of their profession and colleagues at other firms, the quality and honesty of feedback would have been severely compromised without this agreement. For purposes of our research, we define the term "clean technology" as those technologies developed in the physical, chemical, biological, and computational sciences that enable more efficient, productive and valuable use of natural and other scarce resources. The use of clean technology greatly reduces the ecological impact on these resources when compared to what is commercially available today. 10/20/03 The Flow of Venture Capital Into Clean Technology Ventures.doc 3 Copyright 2003 – Jeff Steen, Paul Frankel
  4. 4. The Flow of Venture Capital Into Clean Technology Ventures On the most basic level, the alternative energy category involves one or more technologies that are not commonly used today to produce or deliver energy. These technologies can be classified in a number of ways.1 • Energy and efficiency - high efficiency lighting, climate control, and appliances aimed to reduce the consumption of energy • Energy generation and conversion - solar, wind, bio-fuels, hydrogen and other so-called “renewable” energy technologies, fuel cells, microturbines, etc. • Energy infrastructure, transmission and distribution - decentralized generation technologies • Energy storage and power quality • Key enabling technologies • Energy, information, asset and customer management systems and services For purposes of our research, we define the term “advanced materials” as relating to2: • Metals, advanced ceramics, polymers, biopolymers, metals, metal-, ceramic-, and polymer- based composites, electronic, optical or magnetic materials, catalysts, semiconductors, or other chemicals and materials classes; • Technologies and processes offering more rapid discovery of new materials, better characterization, more direct molecular-level control, more confident simulation, and faster access to prior materials knowledge; • Novel engineering solutions to discovery, processing, and fabrication and the various computation, simulation and informatics domains that support materials development and commercialization; • Improvements in materials with regard to their intrinsic properties, their costs, their creation, processing and fabrication, and their recyclability; and • More efficient, productive and valuable use of, and greatly reduced ecological impact on natural and other scarce resources applications as compared to what is commercially available today. We use the categorical definitions of software, semiconductors and industrial / energy as defined by the 2003 PWC/Thomson Venture Economics/NVCA MoneyTree Survey.3 Findings According to Thomson Venture Economics, the overhang (uninvested capital - the amount of committed capital remaining in the hands of limited partners) in 2001 stood at $97 billion.4 The total fell to $84 billion at the end of 2002 after accounting for givebacks, liquidated funds, new committed capital and new takedowns.5 Since venture funds typically earmark anywhere from 25% to 35% of a fund for follow-on rounds, there is actually $50 billion to $60 billion available for new investments.6 1 Arete Corporation, NextWave Energy 2 NGen Partners 3 http://www.pwcmoneytree.com/moneytree/nav.jsp?page=definitions 4 Thomson Venture Economics, The Overhang Shrinks, But Does It Matter?, July 1, 2003 5 Ibid. 6 Ibid. 10/20/03 The Flow of Venture Capital Into Clean Technology Ventures.doc 4 Copyright 2003 – Jeff Steen, Paul Frankel
  5. 5. The Flow of Venture Capital Into Clean Technology Ventures The researchers found that the amount of venture capital flowing into an industry is not correlated with the industry’s size as measured by revenue. For example, the energy industry’s electric and gas sectors totaled over $400 billion/year of revenue in 2001 according to the latest economic census data available from the US Department of Commerce7. These sectors had venture capital inflows of approximately $600 million 2002. 8 On the other hand, semiconductor manufacturing revenues were approximately $140 billion in 20019 while receiving venture capital inflows of $1.3 billion in 200210. This capital inflow rate is six times greater than the annualized rate of investment in the energy industry. By contrast, the software industry revenues totaled approximately $62 billion11, yet received venture capital inflows of $4.6 billion, in 200212. Therefore, the capital inflow rate in software is 50 times greater than the flow into electric and gas. Figure 1 – Cleantech versus overall venture capital investment for 2002 ($ Millions) Source: Cleantech Venture Network If industry size is not the key determinant in the amount of venture capital, then what are the key determinants? The answers fall into five areas. Each of these five areas were cited in the interviews conducted by the authors. The information given by the respondents can be divided into myth and reality. Myth #1 – Money Flows Where Money Knows. Myth – Venture investors only invest in industries and entrepreneurs with which they are intimately familiar. They use this familiarity and expertise as a means of mitigating risk. Without deep knowledge of a particular domain, the risk level of investment would be completely unacceptable. Limited partners (i.e., “LP’s”, the VC fund investors) are putting their money at risk and want to see deep industry experience and expertise before entrusting a VC with their investment dollars. 7 US Department of Commerce, GDP by Industry Report, 2002 8 National Venture Capital Association, www.nvca.org 9 US Department of Commerce, GDP by Industry Report, 2002 10 VentureOne/Ernst&Young, Q42002 Venture Investment Report, www.ventureone.com 11 US Department of Commerce, GDP by Industry Report, 2002 12 VentureOne/Ernst&Young, Q42002 Venture Investment Report, www.ventureone.com 10/20/03 The Flow of Venture Capital Into Clean Technology Ventures.doc 5 Copyright 2003 – Jeff Steen, Paul Frankel
  6. 6. The Flow of Venture Capital Into Clean Technology Ventures A high proportion of general partners and other investment professionals that staff the venture capital funds spend significant portions of their careers in the information technology industry. These professionals often had one of four roles prior to joining the venture capital world: • Entrepreneurs who built, and successfully exited via IPO or acquisition, one or more IT companies, • Senior management of major IT firms like Cisco, Sun, Intel, et al, • Senior engineering talent from major IT firms, or • Investment professionals who brokered deals in the IT industry. Because the primary source of highly regarded investment opportunities, or deal flow, is a partner’s network of contacts, it stands to reason that most of the investment opportunities each partner sees coming from his or her network relates to an IT investment. If an investment comes across a VC’s desk without being referred to him or her, it will typically receive lower priority. The investor also relies heavily on this network during the process of due diligence regarding prospective investments. Reality – It is true that information technology firms receive the lion’s share of venture capital investments. In fact, approximately 65% of all venture capital dollars are placed into information technology investments. If one adds medical and biotechnology to that amount, that figure approaches 90% (see Figure 2). Figure 2 – Venture Capital Dollars Invested by Industry Segment ($ Millions) Source: VentureOne 2001 10/20/03 The Flow of Venture Capital Into Clean Technology Ventures.doc 6 Copyright 2003 – Jeff Steen, Paul Frankel
  7. 7. The Flow of Venture Capital Into Clean Technology Ventures It is also true that investments in areas other than technology will receive ample funding opportunities once venture investors understand the value of a given market opportunity. This conclusion is especially true at present, because as one investor put it, “good investments in software and semiconductors are almost non-existent right now.” Two facts support the conclusion that venture dollars will flow into an industry outside of the VC fund’s traditional areas of interest in IT. First, witness the growth in investment in the medical and biotechnology investment areas over the past three years (see Figure 3). Once considered outside the purview of most established IT venture investors, many VCs have built new practice areas, and many entirely new funds have been raised, around nano-tech, bio-tech, healthcare and related medical investment opportunities. In 2002, 625 venture firms invested $3.06 billion in the biotech and healthcare industries.13 Figure 3 – Source: NVCA The second piece of supporting evidence is the actual growth of investment in clean-tech. According to CleanTech Monitor’s Q1 2003 publication14, investment in clean technologies doubled in Q1 2003 from the same period in 2002. The investment total of $325 million was a 50% quarter-on-quarter increase. Recently, many new funds have been formed to invest only in energy or materials companies, while traditional IT firms such as Kleiner, Perkins, Caufield and Byers; Benchmark Capital; Draper, Fisher, Jurvetson; and others are starting to consider, and even to make, investments in clean-tech (See Appendix Four). These investments are outside the typical scope of these traditional IT venture investors, and clean-tech investments represent a very small fraction of their investment portfolios. They are “dipping their toes in,” as one investor put it. In order to get around the fact that they do not have an extensive network in the clean-tech area, the VC investors are doing three things. First, venture partners and associates are educating themselves in the market and industries as much as possible. Although this does not replace actual operating experience, it can help to mitigate some of the risk of moving into a new area. Second, firms are looking to outsiders such as 13 The Deal, LLC, Venture Capital database, http://vcdeal.com/vc/index.cfm 14 http://cleantechventure.com/documents/pr_20030715.pdf 10/20/03 The Flow of Venture Capital Into Clean Technology Ventures.doc 7 Copyright 2003 – Jeff Steen, Paul Frankel
  8. 8. The Flow of Venture Capital Into Clean Technology Ventures consultants and industry experts to help them examine markets and technologies. Lastly, they are looking for technologies that have potential suppliers and customers in industries that are familiar to them. And so while money does flow to what it knows, investors are willing to learn if they can be shown a good opportunity and compelling value proposition on which they can conduct proper due diligence. According to information from the researchers’ interviews, such potential opportunities should present the venture investor with a minimum of five to ten times cash-on- cash return. Myth #2 – The Returns for Investors in These Industries Are Not Significant. Myth - Venture investors, to a person, cited the lack of ROI potential in the energy and materials science industries. There were three specific reasons cited: • Initial capital requirements are too large. • Time horizons before exiting the investment are too long. • No history of successful exits. Reality – Investors state that there are significantly higher costs involved with bringing an energy or materials product to market than those generally allocated to a semiconductor or software product. Investors cite these high initial costs as one of the major barriers to achieving a strong ROI in energy or materials. Yet this assumption is false. Energy and materials firms tend to receive capital in the same or lower amounts than IT investments. As show in Table 1, investments in energy are typically smaller than either software or semiconductors. Semiconductor firms are especially expensive to launch. For example, Atheros Communications, one of the most highly touted semiconductor start-up in recent years, has raised over $100 million in three funding rounds15 and investors still have not seen an exit. Martix Semiconductor, another recent start-up, has raised $147 million in its first four rounds of funding and still has not shipped its first product.16 These numbers are larger than the amount raised by two materials companies. Catalytic Solutions, Inc., a successful manufacturer of advanced catalytic systems for the automotive and other engine industries, has raised $72 million to date through four rounds of funding. Optiva, a firm developing self-assembling nano-materials for use in optical applications such as flat panel displays, has raised $41 million to date through two rounds of funding. Venture investors who are accustomed to making investments in software or semiconductor companies may be frightened off by their own perception that higher amounts of capital are needed to get an energy or materials technology company launched (seed / startup stage), bring a product to market (early stage), ramp production (expansion stage) or to reach profitability (later stage). In the first quarter of 2003 at least, those fears were irrational. In fact, industrial and 15 Atheros Communications website, http://www.atheros.com 16 Matrix Semiconductor website, http://www.matrixsemi.com 10/20/03 The Flow of Venture Capital Into Clean Technology Ventures.doc 8 Copyright 2003 – Jeff Steen, Paul Frankel
  9. 9. The Flow of Venture Capital Into Clean Technology Ventures energy companies17 were funded by fewer dollars at every stage of company development as compared with software and semiconductor companies during the first quarter of 200318 (see Table 1). INDUSTRIAL / Investment Stage SOFTWARE SEMICONDUCTORS ENERGY TOTALS $ 796.881 $ 278.102 $ 117.600 Number of Deals 166 34 31 Median $ 3.000 $ 4.000 $ 1.000 Mean $ 4.800 $ 8.427 $ 3.794 S/S + EARLY $ 211.106 $ 60.060 $ 179.244 Number of Deals 55 15 10 Median $ 3.000 $ 2.000 $ 1.500 Mean $ 1.351 $ 4.004 $ 5.585 EXPANSION $ 411.636 $ 195.042 $ 61.660 Number of Deals 88 15 19 Median $ 2.500 $ 8.000 $ 2.000 Mean $ 4.678 $ 13.003 $ 3.245 LATE $ 174.139 $ 23.000 $ 0.090 Number of Deals 23 3 2 Median $ 4.000 $ 8.000 $ 0.045 Mean $ 7.571 $ 7.667 $ 0.045 Table 1 – Total dollar investments ($ Millions) by industry and by stage of company development for the first quarter of 2003. Source: PWC/Thomson Venture Economics/NVCA MoneyTree Survey The longer an investor must hold an investment without a liquidity event, the lower the return on that investment. Most investors we interviewed cited time expectations of seven to ten years to see a target exit in energy or materials investments. This fact is especially important to VCs, because most investment funds have a ten-year life span. Considering that most investments are made in years two through five, and that fund managers typically want to start raising another fund three to five years into this process, a few early, successful exits are important. IT investors cite three to five years, with a seven year maximum, for desired optimum exit time frames. The seven to ten years cited by investors as timing for energy and materials investments simply does not match the mechanics of a typical venture fund. For example, Captsone Turbines, a leading micro-turbine manufacturer, received its first VC investment in 1993, and went public in 2000, a seven-year period. Catalytic Solutions, mentioned above, was founded in 1996 and is still privately held by the investors. Evergreen 17 See PWC/Thomson Venture Economics/NVCA MoneyTree Survey’s definitions http://www.pwcmoneytree.com/moneytree/nav.jsp?page=definitions 18 PWC/Thomson Venture Economics/NVCA MoneyTree Survey 10/20/03 The Flow of Venture Capital Into Clean Technology Ventures.doc 9 Copyright 2003 – Jeff Steen, Paul Frankel
  10. 10. The Flow of Venture Capital Into Clean Technology Ventures Solar was founded in 1994 and IPO’d in 2000. In software, Actuate, a leading enterprise reporting firm, is a typical example. It was founded in 1993 and IPO’d in 1998. Investors in energy and materials cited the need to hold energy and materials investments longer than software or semiconductors due to: • Higher marginal costs than marginal utility • Presence of economic and regulatory “perverse incentives”19 / dis-incentives • High power of incumbent companies • Slower purchasing cycles of target customers • Difficulty in developing, engineering and commercializing breakthrough / disruptive technologies Lastly, both IT and non-IT investors cited a dearth of exit opportunities for energy and materials firms. Most exits and purchase prices in the energy and materials areas have typically been lower than similarly sized firms in the software or semiconductor areas. Below is a chart showing exits by energy firms between 1998-2003 (Figure 4). As can be seen, strategic sales hovered around $100 million during the five-year period. Considering the capital requirements and the hold periods, these returns are below VC’s expectations. Figure 4 - Courtesty of ChevronTexaco Ventures As seen in Figure 4, there were a total of twenty-two successful exits for start-up energy firms from 1998 – 2003. On the other hand, in the third quarter of 2002 alone, there were twenty- seven M&A deals in the software sector.20 And in 2001, the mean sales price of fabless semiconductor firms was approximately $170 million.21 Most IT investors stated that software 19 Factor Four: Doubling Wealth, Halving Resource Use, Ernst von Weizsäcker, Amory Lovins, and Hunter Lovins, Rocky Mountain Institute, 1998, Kogan Page 20 Thomson Venture Economics 21 Fabless Semiconductor Association, http://www.fsa.org/ 10/20/03 The Flow of Venture Capital Into Clean Technology Ventures.doc 10 Copyright 2003 – Jeff Steen, Paul Frankel
  11. 11. The Flow of Venture Capital Into Clean Technology Ventures and semiconductor firms should be able to obtain returns of 5x to 10x (some even 20x). According to venture investors, this lack of numerous lucrative exit opportunities is another factor that makes energy and materials companies comparatively unattractive investments. While there are indeed positive returns available to investors in the energy and materials areas, as cited above, they tend to be fewer and smaller than in software and semiconductors. In addition, the exit path through strategic acquisition is more difficult for companies in these areas. This finding is supported by two facts. First, the network of former executives-turned-investors is less developed in energy and materials than in software or semiconductors. Therefore, it is more difficult to identify potential strategic options. Second, in addition to research and development, established IT companies are accustomed to achieving technological advances by acquiring smaller companies. Cisco Systems is known in the IT industry as the archetypal example of such behavior. In general, according to our investor interviews, potential suitors in the energy and materials industries are far less likely to make acquisitions. Even so, there have been and there will continue to be some excellent investment opportunities in the energy and materials industries.22 While they might not come along at the rate of IT investment opportunities, some valuable ideas are available to those investors who actively seek them out. Those few funds that are making the investment of time and energy needed to build their networks in the manner mentioned in Myth #1 are positioning themselves to well to identify these opportunities and to become innovators in the venture investing field. Myth #3 - The Regulatory Structure Makes These Industries Unattractive. Myth – Almost every respondent within the IT venture investing community cited the fact that energy is a highly regulated industry, and therefore undesirable as an investment area. On the other hand, these same respondents consider software, semiconductors and other IT industries to be virtually unregulated. When asked about materials, most investors cited the use of materials in energy technology as one of the main sources of investment opportunities (e.g., materials for photovoltaics) and retreated back to the regulatory argument. Reality – The IT investors are indeed correct; the IT industry itself is mostly self-regulated through standards. Standards are achieved via monopoly (eg – Microsoft’s PC Operating System), by a standards body such as the IEEE (eg - 802.3 Ethernet), or through adoption by a majority of industry players (e.g., Bluetooth). Few investors cited the importance of the regulatory regime governing the industry to which the technology is sold, ie – the target customer market. One of the biggest customers for software is the financial services industry, a very heavily regulated industry. The supplier of wireless spectrum to the telecommunications industry, the Federal Communications Commission (FCC), is itself a regulatory agency. Major IT customers are telecommunications firms themselves, whom are also quite regulated. 22 See some historical examples: NREL Technology Transfer Success Stories, 1999-2001, http://www.nrel.gov/technologytransfer/success_story.html 10/20/03 The Flow of Venture Capital Into Clean Technology Ventures.doc 11 Copyright 2003 – Jeff Steen, Paul Frankel
  12. 12. The Flow of Venture Capital Into Clean Technology Ventures An important source of entrepreneurial opportunity is the application of technology within regulation. The best example of this concept is the software firm Documentum. Documentum’s first application helped pharmaceutical firms automate the US FDA submission process. The American drug trial process is one of the most heavily regulated processes in the world. Documentum used this regulation to gain a foothold in the market by saving drug companies significant time in their document submissions to the FDA. The Documentum solution saved drug firms $1 million for each day the average submission time was reduced. Within the regulated energy industry, two factors have slowed down technology acceptance. First, as regulated monopolies, utilities have government-imposed limits on the prices they can charge, as well as the profits they can earn, thereby limiting their incentive to enhance efficiency via the application of new technology. Second, the useful life of the existing capital equipment is measured in decades. Also, because capital costs to utilities that are associated with the rollout of new technologies are often quite significant, the replacement decision is a slow process. This slow process often creates a multi-year sales cycle for technology vendors. In the materials area, like in the Documentum example, firms are beginning to use regulatory regimes or the threat of them as a source of entrepreneurial activities. One firm, MBA Polymers, has developed a technology process to recycle advanced polymers used in the manufacturing of electronic equipment from laptops to cameras to televisions. Considering the European Union’s and Japan’s strict product life-cycle recycling laws, MBA Polymers is well positioned to provide the closed-loop waste stream envisioned by regulators. Catalytic Solutions is using both the competitive advantage of superior emissions cleansing capabilities coupled with their lower cost product to gain significant market share in the automotive catalytic converter market. Thus, while regulation can create difficult barriers to entry, it can also create opportunities for entrepreneurs to successfully commercialize and apply new technologies. Myth #4 - Clean Technology Is Still Underdeveloped. Myth – With the exception of those investors specializing in energy and/or materials and a few very well respected top-tier IT venture funds, investors surveyed all cited the early stage nature of clean technologies as a reason not to invest. Their opinion was that the technologies were too far away from a commercialization stage to be a viable investment. They stated that these technologies were better suited to government or Fortune 500 R&D departments, rather than VC investors. Of all the myths regarding clean-tech investing, this myth is the one least supported by reality. Reality – There are products in both energy and materials that are already commercially viable, and many others that are quite close to viability. In fact, according to the National Renewable Energy Laboratory, the cost of renewable energy technologies per kilowatt-hour, especially wind and geothermal, are already directly competitive with coal and gas-fired fossil fuels. The same study further predicts price per kilowatt-hour equalization, because the cost of new, cleaner- burning fossil fuel power sources will be higher than previous, more polluting techniques. This 10/20/03 The Flow of Venture Capital Into Clean Technology Ventures.doc 12 Copyright 2003 – Jeff Steen, Paul Frankel
  13. 13. The Flow of Venture Capital Into Clean Technology Ventures fact, coupled with the downward trend in cost per kilowatt-hour for renewables, firmly places these technologies in the realm of commercialization either now or in the near future.23 In the area of materials science, especially nano-technology, perception on the part of investors is that the lack of commercially viable products is more acute than in energy technologies. However, as cited above, there are materials technologies for specific applications that show strong promise as investment opportunities. It is indeed true that venture investors generally do not, and should not, fund primary research. However, there are a number of technologies that are either ready or nearly ready for commercialization. One area that some investors cited as ready for commercialization was PEM, or silicon fuel cells, as a replacement for the battery powered systems now used in applications ranging from back-up power for cell phone towers to installation into military radios. Leading VC’s are beginning to make investments in these areas, leaving their less forward-looking brethren behind (see examples in Table Two). Because there are fewer deal opportunities in the energy and materials areas, the early movers see themselves as able to cream the best deals off the top. KONARKA CLEAN AIR TECHNOLOGIES PARTNERS NANOMIX Total VC $16 million $35 million $15 million Funding Lead Draper Fisher Jurvetson; CIBC Capital Alta Partners; Investors Zero Stage Capital Partners; EnerTech Apax Partners; Capital; Nth Power; EnerTech Capital; RBC Capital Partners Sevin Rosen Funds Technology Replaces silicon with Lets vehicles and Adapts carbon titanium dioxide -- generators run more nanotubes, tiny commonly used as a cleanly and extrusions of pure pigment in paint -- to create efficiently by using carbon, to store flexible solar electric panels. natural gas and a hydrogen safely small amount of and efficiently. diesel. Table 2 – Examples of recent VC investments in cleantech companies Source: Business 2.0, May 2003 Myth #5 - Entrepreneurs In These Areas Are Weak In Business Expertise. Myth – Almost all of the IT venture investors that the authors interviewed stated that, generally, they have found a lack of entrepreneurial talent within the energy and materials sectors. Business plans are often eliminated due to a lack of entrepreneurial experience, even before the investor examines technology, markets or customers. Reality – It is true that a significant number of the entrepreneurs that the authors interviewed focused their business descriptions on how significantly their innovation would benefit the environment. While environmental benefits are noble, almost no venture investor would make an investment for reasons other than economic gain. By using the environmental benefits as part 23 http://www.nrel.gov/analysis/emaa/pubs/ceed/ceed.html#true 10/20/03 The Flow of Venture Capital Into Clean Technology Ventures.doc 13 Copyright 2003 – Jeff Steen, Paul Frankel
  14. 14. The Flow of Venture Capital Into Clean Technology Ventures of the argument in support of funding their enterprise, entrepreneurs take attention away from the only item most investors care about – return. In addition, firms like PG&E, DuPont, FPL, 3M, General Electric and many others have long dominated the fields of energy and materials. Dominance by these major corporations, when coupled with the economic barriers and regulatory disincentives, has resulted in slower and less influential entrepreneurial activity for these industries. Firms with great innovations in these industries have a relatively small talent pool of experienced start-up executives. Because managing a start-up takes a significantly different skill set than managing in a global company, the lack of an entrepreneurial talent pool based on experience is indeed a limiting factor. Strong entrepreneurial talent exists in energy and materials, but it is less common and concentrated than in the high tech industries. The energy and materials entrepreneurial industries are in a situation similar to that of high tech start-ups ten to fifteen years ago, when engineers without much business experience or formal business education were founding new ventures. Conclusions In summary, the myths used by traditional venture investors for declining to invest in clean-tech areas like energy and materials are based on reality, yet at the same time, they are not completely real. These reality gaps need to be addressed from both the investor and entrepreneurial perspectives. Due to structural and economic considerations regarding the industries examined here, it is the authors’ conclusion that there probably will not be a massive influx of venture capital into the alternative energy technology or materials science technology industries anytime soon. The current slow pace of venture investment will increase over time as market forces begin to exert pressure in favor of clean technologies. There are three levers that can be used to speed up the pace of change and to achieve the positive ecological and economic benefits that these technologies have to offer. First, there are public policy issues regarding perverse incentives in favor of existing industry structures. These incentives could be changed by the reduction of externalized costs. The petroleum industries are one example of an industry that would be forced to change rapidly if all the costs they force society to bear for the benefit of their shareholders were borne instead by the firm. Market-friendly approaches, such as the carbon taxes touted by The Economist24, would ensure a freer market, with more accurate representation of costs, than currently exists. Secondly, the next generation of technology entrepreneurs and investors needs to be educated in our leading business schools. Business schools, like most academic institutions, are not well adapted to developing the sort of cross-campus curriculum needed to educate clean-tech entrepreneurs. A successful curriculum would entail faculty from disciplines as diverse as finance and forestry, economics and ecology. By bridging the pure sciences, engineering, law, business and the social sciences, such a curriculum would properly convey the complexity of these solutions. 24 The Economist, April 18, 1998 10/20/03 The Flow of Venture Capital Into Clean Technology Ventures.doc 14 Copyright 2003 – Jeff Steen, Paul Frankel
  15. 15. The Flow of Venture Capital Into Clean Technology Ventures Lastly, unless there are significant changes in the way both investors and entrepreneurs approach each other, clean-tech ventures will continue to receive investments at rates significantly slower than their IT counterparts. However, enough potential opportunities exist that VC’s would be remiss if they did not take the time to learn about current clean-tech initiatives and the potential customer benefits they may offer. Although traditional venture investors would be able to find strong entrepreneurs and technologies in these non-IT fields, their networks of contacts, experience and pre-conceived notions often prevent them from seeing these opportunities. By adding energy and materials investments to their portfolios, venture investors will achieve a number of benefits. First, they will begin to reduce the risk associated with their existing portfolios. Currently, with investments in semiconductor, hardware, software, systems and services IT sectors, venture firms’ funds are made up of a large number of positively correlated investments. By broadening the profile of their portfolio, investors will offer some degree of risk mitigation during a depressed market or recession. Second, by entering these non-IT industries at this point in the market cycle, investors have the chance to obtain favorable valuations. Lastly, early investors will benefit by having access to the best investments, with less competition than in their traditional investment sectors. Entrepreneurs also need to expand their views and skill sets. Most investors we interviewed thought that there was enough deal flow in IT technology to support the existing funds and achieve acceptable, if not stellar, returns. There is little or no incentive, according to the majority of these investors, to invest in areas that are outside the realm of current investment. The path of least resistance, especially when based on past success, is difficult to overcome. In order to affect this bias, entrepreneurs must approach VCs in a manner that educates them on the market opportunities as well as the reasons why a particular venture will win in its chosen addressable market. Entrepreneurs must use the same approach that existing IT entrepreneurs use to secure funding, yet they must work hard to educate potential investors by selling them on the business concept, demonstrating its value proposition, and lining up customers who are ready, willing and able to make purchases. The final conclusion supports a market opportunity for professionals from the energy and materials industries to found their own venture funds. Firms like NGen Partners, with its deep materials expertise, and Nth Power, with its energy focus, can serve as models. These companies have taken the venture capital model used by IT investors and applied it to their respective industries, staffing their firms with industry as well as financial experts. While opportunities in the energy and materials markets are not as viable because of the structural and economic issues present at this time, there is certainly room for firms and funds focusing on opportunities revolving around these often overlooked technologies. 10/20/03 The Flow of Venture Capital Into Clean Technology Ventures.doc 15 Copyright 2003 – Jeff Steen, Paul Frankel
  16. 16. The Flow of Venture Capital Into Clean Technology Ventures APPENDIX ONE Investor Decision Metrics There are six major criteria venture investors use when deciding to invest capital. Different investors place different weights on these areas when making investment decisions. No two investment decisions are alike, however these factors are overwhelmingly the ones cited in the research to date. 1. Economics • Market size o Is the market opportunity for the innovation large enough to bring the type of returns VCs expect on their investments? o Can the product be developed, produced and sold in a manner that will make the firm profitable? • Potential Returns • Appropriate financial instruments and vehicles 2. Management team • Is an experienced team in place, or are there personnel readily available, who are well suited to making this venture a success? • Does this team have the right set of skills and experiences to guide the firm through the growth phase? 3. Quality of the innovation/Uniqueness • How unique is the innovation? • How efficacious is it? • How defensible is it (patents, trade secrets, copyrights, control of resources, etc.)? 4. Exit • What is the exit strategy for this investment (IPO, merger, etc.)? • How likely is this firm to achieve that exit strategy? • Time horizon to exit investment 5. Risk • How will financial, business, operational, technological, political and other risk types impact this business? • Is the business in a position to overcome these risks? 6. Location • Are there sufficient sources of needed inputs such as talent, services, innovations etc. are within close proximity of each other? • Is there sufficient information availability and flow to help with investment decisions? • Is there enough deal flow to ensure the availability of suitable investments? • Are the investment opportunities in close enough proximity to allow the investor proper oversight? 10/20/03 The Flow of Venture Capital Into Clean Technology Ventures.doc 16 Copyright 2003 – Jeff Steen, Paul Frankel
  17. 17. The Flow of Venture Capital Into Clean Technology Ventures APPENDIX TWO Interview Questionnaire Sample Set Each interview utilized a set of typical questions. A sampling of such questions follows: 1. What specific industry characteristics make the software and semiconductor industries attractive as an investment area? 2. What specific industry characteristics make the alternative energy and/or advanced materials industries attractive as an investment area? 3. What is the role of regulation in your investment decisions? 4. At what stage does a technology need to be before you will consider an investment (ie - alpha, beta, clinical trial stages, roll-out, customers using it, etc.)? 5. What types of problems do the technologies you invest in solve (efficiency, revenue enhancement, cost cutting, improve use of existing resources, etc.)? 6. What factors do you examine when trying to understand the barriers to a technology’s acceptance? 7. What proofs do you require to determine if a technology can overcome barriers to acceptance? 8. What is the business background and experience profile of the typical entrepreneur in whom you invest (ie – do you look for engineering and development talent above business skills)? 9. What type and what level of ROI do you expect from your investments? What are the typical ROI’s you have actually received from your investments? 10. Typically, what size market must be evident to make an investment attractive? Please give specific examples. 11. How do you evaluate financial and non-financial risks in your investment? What about in your portfolio? 12. What is your time horizon for a typical investment? 13. What types of competitive advantages do you look for in your investments? How are they graded or scored? 14. How many exits have your portfolio firms gone through? 15. What role does government have in creating and regulating new markets that favor sustainable products and services? 10/20/03 The Flow of Venture Capital Into Clean Technology Ventures.doc 17 Copyright 2003 – Jeff Steen, Paul Frankel
  18. 18. The Flow of Venture Capital Into Clean Technology Ventures APPENDIX THREE Types of Research Participants The following list contains functional classifications of the types of people whom were interviewed for this study. This list is not exhaustive, nor is it prioritized in any particular order. While this study could be successfully conducted by interviewing only the financial community, by adding a breadth of viewpoints the researchers hoped to find additional insights into the issues at hand. 1. Financiers • VCs o Information Technology o “Green” or non-traditional • Corporations • Investment bankers • Angel investors • Foundations • Venture philanthropists 2. Complimentors • Government • NGOs • Academics • Incubators • Thought-leaders • Practitioners • Professional services firms 3. Corporations and Entrepreneurs • Energy • Materials • Information Technology 10/20/03 The Flow of Venture Capital Into Clean Technology Ventures.doc 18 Copyright 2003 – Jeff Steen, Paul Frankel
  19. 19. The Flow of Venture Capital Into Clean Technology Ventures APPENDIX FOUR Partial List of Energy and Materials Venture Investors25, 26 1. Adams, Harkness & Hill 40. Energy and Environmental Ventures, 2. Advanced Materials Partners, Inc. LLC 3. Advent International 41. Energy Capital, LLC 4. Altira Group, LLC 42. Energy Ventures Group 5. Ameren Energy Fuels and Services 43. EnerTech Capital Partners 6. Angels with Attitude I, LLC 44. Entegrity Partners, L.P. 7. ARC Energy Venture Funds 45. Environment Capital Company 8. Ardesta 46. Epsilon Synergy Development 9. Arete Corporation Corporation 10. Asia West Environment Funds 47. Exelon Capital Partners 11. Beacon Group Energy Funds 48. Expansion Capital Partners 12. Bechtel Enterprises, Inc. 49. FA Technology Ventures 13. Black Emerald Group 50. First Analysis Corporation 14. Blue Hill Venture Partners 51. FondElec Group Inc. 15. Brand Equity Ventures 52. Fuel Cells America, LLC 16. BridgeWorks Capital 53. Gaebler Ventures, LLC 17. Cadre International 54. Genesis Park 18. Calvert Funds 55. Geneva Energy Advisors 19. Cartesian Capital Corporation 56. GFI Energy Ventures 20. CEfotech Pte Ltd. 57. Goldman Sachs 21. CEI Community Ventures 58. Green Planet Venture Capital, LLC 22. ChevronTexaco Technology Solutions 59. Haddington Ventures, LLC 23. Chrysalix Energy 60. Harris and Harris 24. CIBC Capital Partners 61. Hydrogen Ventures LLC 25. Cimarron Capital 62. Hydro-Quebec CapiTech Inc. 26. Cinergy Ventures, LLC 63. Jane Capital Partners LLC 27. Commons Capital Management, LLC 64. JP Morgan Partners 28. Conduit Ventures 65. Kinetic Ventures 29. Connecticut Innovations/Clean Energy 66. Laranda Solar Technologies Fund 67. Marathon Capital, LLC 30. D.R. Coven & Associates 68. Meridian Venture Partners 31. DQE Enterprises 69. Merrill Lynch 32. DTE Energy Technologies 70. Moore, Clayton & Co 33. EA Capital, LLC 71. MRI Ventures 34. Easenergy, Inc. 72. New Energy Capital 35. EBARA Corp. 73. New Hampshire Governor's Officeof 36. Ecoelectron Ventures Energy and Community Services 37. Ecology Capital Partners, LLC 74. NextGen Partners 38. Edison Development Corporation 75. Nth Power Technologies 39. El Dorado Investment Company 76. OPG Ventures 77. Pacific Venture Capital, LLC 25 http://www.fse-directory.net/ 26 http://www.nrel.gov/technologytransfer/entrepreneurs/directory.html 10/20/03 The Flow of Venture Capital Into Clean Technology Ventures.doc 19 Copyright 2003 – Jeff Steen, Paul Frankel
  20. 20. The Flow of Venture Capital Into Clean Technology Ventures 78. Parker Venture Management 98. Sun Coast II 79. Partech International 99. Sustainable Development Fund 80. Perseus, L.L.C. 100. Sustainable Energy Fund of Central 81. Prometheus Equity Partners Eastern Pennsylvania 82. Prospect Street Ventures 101. Sustainable Energy Ventures 83. Prospero LLC 102. Taproot Ventures 84. Protech Asset Management 103. Technology Partners 85. RAM Capital Management 104. TechQuest Capital Partners 86. Rockefeller & Co. 105. The Lubrizol Corporation 87. RockPort Capital Partners 106. TransAlta Corporation 88. SAM Equity Partners Ltd. 107. True North Partners, LLC 89. SAS Investors 108. U.S. Global, LLC 90. Saw Mill Capital, LLC 109. U.S. Trust 91. SciVentures, LLC 110. Vcapital/Jesup & Lamont 92. SDTC 111. Vencon Management Inc. 93. Sempra Ventures 112. Ventures West 94. SJF Ventures 113. West Penn Power Sustainable 95. Solar Development Group Energy Fund 96. Stephens, Inc. 114. Zero Stage Capital 97. Summit Energy Ventures 10/20/03 The Flow of Venture Capital Into Clean Technology Ventures.doc 20 Copyright 2003 – Jeff Steen, Paul Frankel
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