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Why VC Infatuation with Cleantech Will Hurt Silicon Valley
I’ve always been a bit harsh on VCs and I do feel that my criticism of VCs has been deserved. If you look at the business of venture capital over the past 10 years, it’s pretty clear that VCs aren’t the sharpest tools in the shed.
That said, there is a place for venture capital and VCs have funded some wonderful companies over the years. The reality is that venture capital is not entirely useless; in recent years there have simply been far too many firms with far too much capital chasing too few good startups.
I think VCs have done a great disservice to themselves and to innovation over the past decade by allowing themselves to get caught up in an irrational exuberance that encouraged investment in overhyped startups that never should have received investment in the first place.
But I feel that the current infatuation VCs have with "cleantech" investments may be far more dangerous to Silicon Valley’s future than the irrational exuberance we’ve seen over the past decade for several reasons.
VC Cleantech Investments Are Being Driven by the Broken Economics of Venture Capital
Even though the ongoing global financial crisis has nothing to do with Silicon Valley directly, VCs have been the beneficiaries of capital glut that fueled one of Wall Street’s most impressive ponzi schemes ever.
As The Deal recently observed, "Many of those same [limited partners] that fattened venture funds are the same pension funds, endowments and other institutions that levered up, piled into hedge and private equity funds, and otherwise made a big problem even bigger."
Earlier this year, Paul Kedrosky argued that "venture capital still has too much money under management" and pointed out that if you took "pre-bubble 1994 figures" and adjusted for inflation, the average fund size in 2008 would be $100 million, not the $200 million that it is.
VCs have been put in an unusual position: many have been able to raise oversize funds but there really haven’t been many good markets to put a lot of money to work efficiently. Although a considerable amount of good money has been thrown after bad consumer Internet plays (especially in the Web 2.0 space), VCs weren’t completely clueless as to the changing economics of their business.
Obviously, investing an oversize fund across a larger number of smaller startups in markets like Web 2.0 isn’t viable. The economics of smaller deals don’t make sense and it’s been clear for some time M&A and IPO exits were not viable for the vast majority of these startups.
Cleantech startups, on the other hand, have been a VC’s wet dream.
Unlike most startups that have traditionally appealed to VCs, which target multi-billion dollar markets, cleantech startups target a much bigger market – the multi-trillion dollar global energy market.
But for startups taking on this trillion-dollar market which is already dominated by some of the world’s most powerful companies, a lot of capital is needed. And that’s just what VCs with oversize funds looking to invest large chunks of capital in one fell swoop like to hear.
I’ve seen few VCs actually question whether or not the economics of their business have changed for the better. Obviously, VCs have good reason to like their oversize funds (their management fees are based on committed capital), but I’ve yet to see many VCs consider that raising more money and investing it in more capital- intensive markets (like cleantech) is actually what they’re best positioned and best equipped to do.
VCs Don’t Know What They’re Doing
I would argue that VCs aren’t best positioned and best equipped to invest in this fashion. Although "cleantech" is tech, it’s not tech as VCs know it and I think most have absolutely no idea what they’re doing.
Case in point: Vinod Khosla, the Sun founder who is one of the most prominent Silicon Valley cleantech investors, invested in "an idea for a new sustainable cement" after receiving an email from a man he knew only casually.
Regardless of whether or not his investment in Calera turns out to be his "biggest win ever," Khosla’s approach highlights the new breed of irrational exuberance that cleantech has sparked. But if the recent shakeup at Tesla highlights one thing, it’s this: saving the world and making a fortune one startup at a time is not easy.
The reality is that most cleantech startups will never get off the ground commercially. Developing something that works in the lab is very different than developing something that works in the real world. And while much of the VC money flowing into the cleantech sector is currently being spent on R&D, it’s the scaling (for the technologies that even work) that will kill the VCs.
In short, the model that has worked for "traditional" VC technology investments will not work for cleantech.
Neal Dikeman of Jane Capital Partners explained this perfectly when he wrote:
In energy, there is no disruptive technology, only disruptive policy that makes some technologies look disruptive after the fact. In energy, the risk is in the scale up, not the R&D, and the end application is so massive, so capital intensive, and so utterly dependent on commodity prices, that you can’t invest in it like you invest in IT. It takes longer, 10x as much money, and the ante up to play the game for one project is the size of your largest fund. At scale, there is no capital efficient strategy in energy.
But we are Silicon Valley and we smash open gates with technology, and we know better than those energy dinosaurs in Houston, London, and Abu Dhabi, right? They just don’t get it, right? One game changing technology can force the oil companies and power companies to their knees. The one I’ve found really is new and different. This entrepreneur has discovered something new. And it can be *cheaper* than oil (if you define cheaper right).
Beware Silicon Valley, the great fortunes, wars, and economic crises of the world for 100 years are not technology ones, they were energy made. Half the schools you went to were built by oil money. And the entreprenuerial spirit in this industry was born in the hardscrabble oilfields of Pensylvania and Texas, and grew up in the far reaches of the globe. And the oil companies those entrepreneurs founded have forgotten more about technology in energy than you even know existed.
Be forewarned, you do not have a comparative advantage here. The oil men invented risk taking, AND risk management. The oil men are bigger, faster, smarter, richer, have more scientists and more entreprenuerial spirit than you, AND they know energy.
So while you fight the good fight to develop technology to change the world, don’t forget, be humble, learn what can be learned, build what can be built, and walk softly, because the elephant in this room floats like a butterfly and stings like a bee, and he has yet to take the field.
VCs clearly haven’t quite recognized this, although I think the situation at Telsa demonstrates that they’re finally getting clued in to reality a bit.
The bottom line is that many VCs are betting the farm on cleantech and they’re biting off more than they can chew.
VCs Are Becoming Subsidy-Hungry
So what are VCs supposed to do now that they’re playing in a market where they are really not equipped to compete? Ask for government handouts, of course!
Before I address this, a disclosure: I am not an American citizen and I could care less about who wins the United States presidency. Now that this is out of the way, let’s move on.
The fact that VCs are, by in large, supporting Barack Obama to be the next president of the United States is no secret. They’ve raised millions of dollars for his campaign.
And for good reason: he has called for an investment of $150 billion over the next 10 years "to catalyze private efforts to build a clean energy future." From direct investment to incentives to tax breaks, Obama’s plan appeals to cleantech-infatuated VCs for one simple reason: they expect that it will benefit their investments either directly or indirectly.
While their support is to be expected because of this, I think it’s worrisome that VCs are so attached to the outcome of a presidential election. If VCs are investing in companies that they feel can only thrive with a president who will provide investment, incentives and tax breaks that happen to support their portfolio companies, haven’t they lost their way? Are they not supposed to be investing in companies with the potential to do great things on their own?
In a 2005 post, Kedrosky wrote:
Too many people are trying to boil the ocean in clean power investments that require the world to change for them to be successful. Much better is finding opportunities where you can succeed nicely even if the world doesn’t oblige, and where you succeed wonderfully if the planet plays along.
Unfortunately, VCs know that the world isn’t going to change and are hoping that the not-so-invisible hand of government is going to change it for them.
Even one of my least favorite Silicon Valley movers and shakers, Carly Fiorina, observed:
Barack Obama believes a big government program is the answer, and I find it interesting that the Valley, which has historically believed that you let entrepreneurs and businesses do as much as possible, supports this: that’s anathema to how the Valley works.
I agree.
About a month and a half ago, I spoke with a hedge fund manager who took the time to tell me about a new cleantech fund he was launching. It was not the virtues of the companies he planned to invest in that he extolled; it was the tax benefits that would exist for the fund because of the nature of the investments.
This highlights a major problem that is created when subsidies come into play: the benefits of the subsidies (some of which may on their own guarantee a return of some sort) distort the normal investment decision-making process. Investments are not necessarily made in companies because those companies can compete in a fundamentally sound manner on their own but because a benefit can be realized from the subsidies that will be available to them.
For VCs who typically make their money from "home run" exits, investing in markets manipulated by government handouts is problematic for obvious reasons – most of these markets will not miraculously become self-sustaining at some point in the future. Instead, these markets will remain attached to the teat of government.
In the United States, for instance, it’s established that corn ethanol is not all that it was cracked up to be. Not only has it not benefitted the environment, it has made gas costlier. Yet in an effort to "level the playing field," billions of dollars in corn ethanol subsidies have created a powerful special interest group that it looks like Americans won’t be able to get rid of.
From my perspective, technologies that are commercially viable don’t need subsidies and if VCs are calling for them, it means they think they’ve invested in technologies that aren’t viable.
So Why Does Any of this Matter?
By now, you’re probably asking: why does any of this matter? Why should I care about VCs and their cleantech investments?
The answer is simple: while I don’t believe most startups need it and I think it is glamorized, venture capital has played an important role in Silicon Valley. Venture capital does have a place in the market and it has contributed to the development of some of the most successful technology companies ever built.
But the economics of venture capital are out of whack and that in turn has forced VCs into markets where they really have business being. VCs now find themselves in a position where they’re investing in companies that they really shouldn’t be investing in, many of which will need government handouts to even have a chance at surviving in the market.
In short, VCs have gone in the wrong direction and I would argue that their investments in the cleantech space represent a misallocation of their capital.
None of this is good news for the type of technology entrepreneurs who VCs have traditionally backed (and I’m not talking about the Kevin Roses and Mark Zuckerbergs of the world).
Over the long term, this will likely change the face of Silicon Valley in negative ways.
In the simplest analysis, some firms are not looking to create the next Intel, Microsoft or Google. They’re looking to create the next Exxon Mobil and we can expect this trend to continue if the next president of the United States moves ahead with a cleantech welfare program.
But just as one probably wouldn’t find it sensible to appoint Exxon Mobil CEO Rex Tillerson the CEO of Google, it’s not sensible for Silicon Valley VCs who know more about software and semiconductors to think themselves modern day John D. Rockefellers.
Rockefeller’s biographer wrote that the rise of Standard Oil "was not meteor-like, but accomplished over a quarter of a century by courageous venturing in a field so risky that most large capitalists avoided it, by arduous labors, and by more sagacious and farsighted planning than had been applied to any other American industry."
VCs should not dream of finding the cleantech version of Standard Oil. It’s likely a search for El Dorado.
VCs should instead downsize and get back to the basics. VCs do play a role in fostering innovation in Silicon Valley and judging by their investments over the past decade, there’s a lot of room for improvement.
Silicon Valley as we know it may depend on that improvement.
This post was contributed by Drama 2.0.
Anonymous7: you should check your politics at the door. If you use petroleum-based products on a daily basis, don’t preach. I’d also love to see photos of your electric car and the wind turbine that powers your home.
If you can’t look at the physical properties of oil and understand why it has been so widely-used, that’s your problem.
The bottom line is I don’t care about your political beliefs – I care about money and markets. The latter work better when the former minds its own business.
All of this said, contrary to the direction this discussion has taken, I’m not opposed to any technology on ideological grounds.
Solar is not a panacea (there is no panacea) but great strides have been made with solar, as you point out. Let private industry pay for these advances and let them compete in the marketplace on their own merit, reaping the rewards when they succeed. In that situation, the interests of all parties, including taxpayers, are aligned.
As for Oracle: don’t be disingenuous. There’s nothing wrong with government contracts. Government buys products and services like any other business. It wasn’t as if the government was buying Oracle to subsidize the database market – it was buying from Oracle because it had a need for Oracle’s products.
Drama von 2.0:
You make my point for me. The energy issue is so big and all-encompassing that politics is a central part of the discussion. The politics of America’s energy policy have been overwhelmingly tipped in oil’s favor for decades (while renewables have been buffeted with remarkably sporadic support – thus ensuring they’re limited success).
Back to my original point – the role of government. Energy policy is central to our economic health and our national security. If there is a viable path to achieving economic growth while making us less vulnerable to the vagaries of international threats (militarily and economically), the government should do what it can to promote same.
If that means outlining incentives to speed a transition to renewables I think that’s the right thing to do. Essentially it’s a way to accelerate the time line.
We can argue whether that’s appropriate or not (Adam Smith and all that). But I think because of the massive implications of finding a solution to this problem, the use of incentives is well justified – and effective.
On Oracle – it’s all a shade of gray – tax incentive, buying some software – it’s still money from taxpayers being used to subsidize a business in one form or another. Oracle was the beneficiary of massive gov’t contracts early in it’s growth. The same will happen when the gov’t buys fleets of new electric cars for their use (ensuring enough demand to justify continued production until organic demand is in place.)…
Anyway – good back and forth. Have a sunny day…
Anonymous7: I will make one final point. You state:
“Energy policy is central to our economic health and our national security.”
I hate to tell you (as an objective outsider) that you have no economic health and no national security.
The United States of America is effectively bankrupt. When you throw in entitlement programs like Social Security and Medicare, it’s possible that the total US debt exceeds 2007’s global GDP, which was about $54 trillion. Mathematically, it is impossible for you to pay off your debt. You are making over $400 billion in interest payments every year.
As for national security, I’d point out that this cannot exist in the absence of economic security. Additionally, your borders are about as porous as Jessica Simpson’s face. Not pretty.
Apologies in advance for challenging your illusions. Have a sunny day. Should be a good one for your solar panels.
Well there’s something we can agree on. America is bankrupt.
So while we’re printing money and the rest of the world is willing (for now) to accept that confetti, we might as well use it to promote the right energy policy. Less oil, more clean, local energy.
Cheers.
[...] and the products it has lost much of its relevance in the marketplace. And before you think that cleantech is the answer, consider that a shockingly large percentage of the Silicon Valley eco-entrepreneurs [...]
This is a bunch of baloney. Good Greif.
In 1978 Congress for once did the sensible thing and slashed capital gains taxes: This resulted in the supply of venture capital exploding. By the start of 1979 a massive commitment to venture capital funds had taken place, rising from a pathetic $39 million in 1977 to a staggering $570 million at the end of 1978. Tax collections on long-term capital gains, despite the dire predictions of Keynesian big-spending critics of tax cuts, leapt from $8.5 billion in 1978 to $10.6 billion in 1979, $16.5 billion in 1983, and $23.7 billion in 1985. By 1981 venture capital outlays had soared to $1.4 billion, and the total amount of venture capital had risen to $5.8 billion. In 1981 the maximum tax rate on long-term capital gains was cut to 20 percent. This resulted in the venture capital pool surging to $11.5 billion. Astonishingly enough—to conventional economists, that is—venture capital outlays rose to $1.8 billion in the midst of the 1982 depression. This was about 400 percent more than had been out-laid during the 1970s slump. In 1983 these outlays rose to nearly $3 billion….In 1982 the U.S. General Accounting Office sampled 72 companies that had been launched with venture capital since the 1978 capital-gains tax cut. The results were startling. Starting with $209 million dollars in funds, these companies had paid $350 million in federal taxes, generated $900 million in export income, and directly created 135,000 jobs.
Anonymous: you seem quite capable of copying and pasting numbers but you failed to address any of the points made in my post and your grasp of economics seems to be lacking.
Let me preface my response with this: I have an affinity for the work of Ludwig von Mises and while I don’t agree with all of the theories held by the Austrian School of economics, there’s a lot to like, especially in times like these.
As a fan of von Mises, you probably wouldn’t be surprised to learn that I am not a fan of capital gains taxes (assuming you are generally familiar with his philosophies on taxation).
Yet you seem to miss that there’s a distinction between taxation and subsidies.
Taxation that inhibits capital formation and entrepreneurship is bad. Government subsidies (of all kinds) that are designed to support certain types of companies that likely cannot compete on their own in the marketplace are equally bad.
When the government inhibits capital formation and entrepreneurship through taxation and when the government intervenes in marketplaces, the outcome is the same – capital is not allocated as it would be in a truly free market.
When Congress lowered capital gains taxes in 1978 (which, incidentally, was a decade and a half before venture capital started becoming an overfunded “asset class”), capital flowed in to VC coffers and VCs put it to use. They invested in the companies that they felt presented the best opportunities to create value (and thus a return). Many did an excellent job.
I have no problem with the reduction in capital gains as excessive capital gains taxes are inappropriate in the first place.
But let’s move on to cleantech.
In the case of cleantech, a significant amount of capital is being invested in companies that cannot compete in the marketplace. Many of these companies have technologies that won’t work, many have technologies that won’t scale and many have technologies that won’t be competitive at scale.
The VCs who have invested in these companies are now eager for the government to step in and provide subsidies (in a variety of forms) that they hope will make these technologies viable in marketplaces where they are not naturally viable. Additionally, they are hoping that government will act punitively to blunt certain companies that are “too successful” (after all, they’re supposedly destroying the planet and stealing our money!).
The bottom line: being able to invest your money to create wealth without having to pay hommage to government is a good thing. Asking the government, on the other hand, to “help” your specific investments, is a bad thing.
As has been said, “A government big enough to give you everything you want is a government big enough to take from you everything you have.”
If VCs believe that cleantech is going to save the world and make a lot of money in the process, they should invest their capital in cleantech and let cleantech kick ass in the marketplace. The fact, however, that they want a little help from Uncle Sam tells you all you need to know about the viability of these companies.
If you still don’t get this, I’d suggest you take a refresher course in economics.
Can you point out an industry group that doesn’t “want a little help from Uncle Sam”? I’m not sure this means the industry or the company is not viable, just that everyone wants a hand out if they can get it. Why not cleantech? The government would be better off putting money into a sector that provides job creation and stimulates the economy without rooting the world instead of propping up sectors like car manufacturing. More to the point, the need for ‘handouts’ to cleantech companies is about correcting market failures. IF everyone paid the true cost of their environmental impacts then there would be no need to prop up clean companies.
Garth: ironic question. Last time I checked, Microsoft had never asked the government to subsidize Windows. Oracle was started without a government subsidy for databases. And I’m pretty sure that Google has never asked the government to chip in for advertisers who use AdWords.
While it’s true that most industries lobby government in some fashion, oftentimes it’s done in an attempt to protect those industries from overzealous government involvement – not to lobby for massive handouts.
The bottom line is that there’s no benefit to taxpayers when their money is used to prop up companies that are not viable on their own. Period.
I think if you were to look more closely at your financial meltdown or the collapse of the American auto industry, you’d see that welfare statism played a key role and has not served your country well. More welfare statism is not the answer.
As for your belief that handouts to cleantech companies are necessary because consumers aren’t paying for the true cost of their impact on the environment, I’d have to point out that there would be better methods to address this on the consumption side of the equation.
I’d also have to point out that I believe “global warming” is, in large part, a scam that is being leveraged to increase government involvement in all aspects of our lives and to enrich certain special interests.
I’m all for treating the planet nicely (it’s never a good idea to shit where you sleep) but while I won’t argue that our climate isn’t changing, I’d observe that the climate has been changing for 4.5 billion years and we haven’t been here for most of them. Dismissing the dynamic and cyclical nature of the earth’s climate and other factors (such as solar activity) is quite foolish and frankly, I believe we think ourselves more important in the overall scheme of things than we really are.
Bottom line: if the world’s headed toward disaster, I can’t imagine that the average person is going to feel comforted knowing that khaki-wearing VCs along with their government subsidies are going to save us. Frankly, that’s one pot luck dinner I don’t want to attend. I’d prefer to spend my final years enjoying life (and enjoying my money).
When the herd get infatuated with anything it’s bad… for them and their investors. Watching the VC community operate (in general) is like watching 6-year olds play soccer, they just swarm to wherever the ball happens to be.
The point of the government offering tax incentives is to jump-start a technology area that has broad implications for our economy and national security. If there is a role for government, that is it.
If VC are reacting to a less-than-pristine market environment by investing in technologies that can lift the US out of it’s energy stupor, the incentives are working. What’s the worst thing that happens? We distort the “free” market and come up with a solution or two for our problems.
Clearly, oil has been the beneficiary of a distorted market – unfortunately the “technology” of oil leaves a wretched corpse. We know what we need to do – and we know we can do it – it just takes time and money.
Anonymous7: this goes beyond tax “incentives.” As you know, there will be direct subsidies and additionally, there is talk of punitive taxes on companies that are apparently far too successful at producing the energy that consumers demand.
If private industry is capable of developing alternative sources of energy that can compete in the marketplace, we will all benefit. If they cannot and taxpayers are forced to subsidize products that are not viable, taxpayers will, without end, end up footing the bill for companies that are not naturally viable. You need look no further than other industries that survive and thrive only with subsidy to see this.
I can tell you have no exposure to the energy industry because you seem to believe that government is simply going to provide a “jump-start.” It doesn’t work this way. As Neal Dikeman pointed out, “at scale, there is no capital efficient strategy in energy.” Billions will be wasted in R&D for technologies that can’t scale and billions more will be wasted trying to scale technologies that aren’t competitive at scale.
As for oil, it has been used by civilization for thousands of years in various forms. The reason is simple: it has significant energy density per unit of volume, it’s easily transported, it’s abundant (I won’t get into “peak oil” theory here) and notwithstanding the recent spike which we now know was precipitated by hedge fund speculation, it’s cheap.
In other words, it’s a superior product and there’s good reason that, without the incentive of government handouts, men like John D. Rockefeller and the legions of wildcatters who made their fortunes (both large and small) in the frontiers of oil country risked their own capital (and in many cases, lives) trying to supply the demand for oil.
If VCs think they can help develop better sources of energy, they should do so without the expectation that government will be there to help guarantee their “success” at the expense of taxpayers.
Apparently lots of people (you included) think that your inept and bankrupt government knows the right strategy and all it requires is time and money.
I’ll conclude by pointing out that, in my experience, anyone who tells you he knows exactly what needs to be done but that he needs a lot of time and a lot of money is someone you should run (not walk) away from. He wants more time and money than you have.
Well, aren’t you the energy maven.
“it’s a superior product” Right.
IRAQ, the Gulf War, OPEC, climate change, need I go on?
Get your head out of your rump and realize something needs to be radically altered.
the “jump start” I refer to is “creating” a market for solutions in various technologies in order for them to scale and bring price down. Solar is a perfect example – prices are expected to fall 20% next year. The growth of “net metering”, allowing the excess power to flow back to the grid and be bought back by the power companies is spurring adoption of solar and wind.
These energy sources are clean, local, and distributed. They’re as American as apple pie. Can’t argue with self-reliance – independence from the oil nipple.
BTW – Oracle’s early success was bolstered by huge government contracts.