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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.
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.