The Interview: Renaissance Time

I spoke with three leaders in venture capital finance to discuss the sector's current status and outlook. Joining me were Jay Spencer, partner and the Americas director of Cleantech for Ernst & Young LLP; Nancy Floyd, managing director, Nth Power and Ira Ehrenpreis, general partner, Technology Partners.

Q. How did the recession affect venture capital investing?

Ira Ehrenrpeis (left): Having invested in this area for as long as we have, I don't look at it myopically as quarter to quarter or even compared to the last year or two, but rather try to put this in the context of how this compares with where we first were when we started investing in this space in the early '90s. And compared to a decade ago this is a renaissance time for cleantech investing. We see corporate interest in this area like never before, we see it from a policy perspective, and I'm broadening it beyond just U.S. policy. Of course, in the U.S. we've seen tremendous support from the ARRA (American Recovery and Reinvestment Act), ARPA-E (Advanced Research Projects Agency-Energy) and a number of other U.S. government initiatives. But that's even been trumped by the international initiatives in the sector and support we've seen.

Nancy Floyd: The venture industry as a whole is going through a contraction. We certainly view that as a good thing because there were just too many firms and too much money chasing too few good deals. In part the recession contributed to that, but there were other factors and the industry will continue to contract. But, on the other hand, cleantech is one of the two or three largest areas of interest for the venture community.

Ehrenpreis: Nancy, to your point, great deals are still getting funded. When you've pruned the tree it gets healthier. We're seeing the best and the brightest come to the cleantech sector in an unprecedented way.

Floyd: There's no lack of capital.

Jay Spencer: To put this in context, just some numbers we've looked at from an analysis perspective: during the third quarter 2010 we're at about $3.8 billion globally invested in cleantech. The good deals are getting done. Just go back to the significance of energy and natural resources and everything we do. It's such a big market opportunity that we're seeing capital continue to go in and we expect additional growth.

Q. Does the Solyndra episode weigh at all in the psyche of investors? Are there any cautions or red flags as a result of its withdrawn initial public offering and decisions related to its manufacturing line?

Ehrenpreis: I'd point to a number of successes during the same period of time. We saw Abound Solar get $400 million from the Department of Energy loan guarantee program; we see that company growing during that same period of time. So the fact that there may be some companies experiencing speed bumps and contraction doesn't take away from all the growth and opportunity we see in other companies. Moreover, the fact that even Solyndra may be going through a speed-bump period doesn't necessarily suggest what the outcome will be. In fact, some of the best venture-backed companies historically have gone through a period of difficulty and contraction. That's the time when the outside world so often looks in and sees that difficulty and presumes an ending. I think it's a bit premature.

Floyd (left): This is the venture business, after all. I don't think there's a single company-and we're even talking about the most successful companies across all venture sectors-that hasn't had to deal with speed bumps.

There are some investors who say in order to have a meaningful impact on the global energy industry you need to invest hundreds of millions of dollars. That's really swinging for the fences. There are other investors-and we're in that category-that see game-changing opportunities that don't require more than $50 million of equity all-in.

Ehrenpreis: People misunderstand when they talk about capital intensity and equate that with venture capital equity dollars. Where there's been a historic lack of funding in the energy and cleantech ecosystem is in true energy innovation. And historically there has been a lack of capital that targets that real early stage; that risk stage of innovation. There has never been a lack of capital for growth and scale-proven technologies. Venture dollars target the early stage when you prove in the lab and in a pilot and, ultimately, in a full-scale facility, which can then access different parts of the capital markets. It's a misunderstanding to presume that one step has been accomplished: it's either all equity or venture capital dollars. It is not.

Floyd: One of the changes over the last maybe five years is that you do have the full financing spectrum come into play here where you can access debt, project finance-although, of course, project finance was hurt in 2008 and 2009-grants, other sources of capital that can complement equity dollars. So I would agree with Ira on that respect.

Ehrenpreis: I would refer to this as a renaissance time. It's true from a human capital perspective, it's true from the kinds of real innovation that we're seeing coming out of these venture-backed startups; this is an incredibly exciting time.

There are areas of concern. And those areas of concern have less to do with a single company or even what the capital markets happen to be doing this day or this week or even this quarter and have to do with-at least from a patriotic perspective-the lack of having a long-term, comprehensive energy policy here in the United States. And the implication of that is perhaps less to us as investors and more to us as citizens of this country.

What's happened now is you see enormous support from other areas of the world for our portfolio companies, most notably China. We've seen since late September almost $50 billion of support that has gone into the solar and the wind industry at a time when this country has been trying to figure out how to get to a smaller government footprint. And therefore it will be challenging in the near-term to figure out how we actually get U.S. support for a lot of these companies.

The implication of that is we are going to be seeing U.S. innovation and deployment internationally. And that should be concerning to us as citizens. But as investors and entrepreneurs it means we've got a global opportunity in front of us and we've got to navigate the global footprint of where we're going to deploy.

Floyd: We're seeing a record number of patents being filed in cleantech; we're seeing more innovation coming out of the labs, out of universities. But because of a lack of predictable, stable policy in this country at the federal level, once these companies gain market traction, they're going elsewhere. So the innovation is happening here and then the manufacturing and the jobs are going elsewhere.

Spencer: One of the things that we see from an investment perspective is the interest of corporate players. So as companies are developing and their technology is getting to scale we're clearly seeing interest from large corporate companies in helping companies prove the scale and getting the product to market. It's a trend we've seen and a trend we expect to continue to see.

Ehrenpreis: This is not a social networking Internet company, which gets fully funded just from venture capitalists. In fact, the way we scale our companies-maybe initially with VC equity dollars to fund the high-risk, innovative technology stage-but then we've seen plenty of examples where corporates and governments come in at that next stage to help with deployment and growth.

There are a number of examples we've seen in 2010 of great corporate partnerships in the cleantech sector. I contrast that with the early days when the corporates were largely doing greenwashing and not paying attention to clean and green.

Q. What role does the Valley of Death play both positively and negatively in moving from development to commercial scale?

Ehrenpreis: That was one of the things I was just trying to address: how do you deal with the Valley of Death, how do you deal with this growth phase when you may need more capital and it's beyond the venture checkbook? You see plenty of examples of corporates and the government-not the U.S. government but plenty of international governments-stepping in to help bridge that valley.

Floyd: I'd also say that not all of these deals are capital intensive. Of course they do take dollars to get to scale and Ira's absolutely right: the corporates are stepping in and helping these companies. Not just providing capital, but their channels to the market. They really can help these companies execute on a global scale.

Q. The Valley of Death serves a useful purpose, doesn't it, in weeding out companies that might not make it to commercial scale?

Spencer (left): It's another step in the process. You bring technology or some kind of innovation to market and there are critical steps: you have to prove the concept, you have to prove you can manufacture it and ultimately you have to prove that you can scale it. So it's a step in an overall process for a company to get to market in a big way.

Floyd: And they could fall out at any step along that process.

Ehrenpreis: It is a misunderstanding that all cleantech companies are capital intensive and experience a Valley of Death. It is absolutely the case that there are some companies that have that profile and plenty of other companies which do not have that capital-intensity profile. Instead, they have a classic venture profile in terms of the amount of capital required.

It's probably important to offer readers an analogy to other areas of venture-type investments historically to illustrate that cleantech isn't alone in great ideas needing capital to scale. If you look at the biotech industry, it's presumed that getting from idea to direct-to-market is $1 billion and historically it's been large investments. What is also true is the necessity of partnerships and the importance of understanding the business model in order to get to success.

Spencer: This jumps a little bit away from the renewable side, but it's also important to talk about vehicle electrification. What you're seeing there is a great example of partnerships that are beginning to develop; partnerships that are really cross-industry. You're seeing automotive suppliers, automotive manufacturers and utility companies talking to one another and figuring out how to make electrification a reality. The belief is it's going to be done in a large way and be accelerated through partnerships and collaborations.

Ehrenpreis: It's a very good example. I'm on the board of Tesla Motors and Tesla is a great example of both points I was trying to make earlier around the necessity for both corporate and government partnership. The company has very strong partnerships with both Daimler and Toyota, both of which have invested capital and developed business development partnerships with the company. In addition, the company has a partnership with the DOE and has accessed $465 million as part of the DOE loan guarantee program.

Q. Let's talk a bit about primary exits for cleantech: how are they different than other sectors and how are they similar?

Floyd: Across all venture sectors, everyone thinks IPO is the correct exit for most ventures-backed companies and that's simply not the case. It's 75 percent M&A, 25 percent IPO. I think we're going to see a very robust M&A market in the next few years in cleantech.

Spencer: I agree with that principle. It's not an either-or; it's a situation where it's going to be a mix. It's historically been a mix and it's going to be a mix.

Ehrenpreis: There were over 100 M&A deals for venture backed companies in Q3. That represented almost $4 billion of M&A value. It's been a time where we've seen robust M&A activity. We also have seen some venture-backed IPOs (in 2010); Tesla leading the charge, pardon the pun. And more important we see a robust IPO pipeline in the cleantech sector. Companies which have either filed their S-1s (a registration statement filed with the Securities and Exchange Commission) or likely will be filing here in 2011.

Q. It's a healthy mix of IPO and M&A?

Ehrenpreis: If you look at the last 30 years of venture statistics you will find it's always been disproportionally M&A and a smaller subset of companies that go public. That is the venture model.

Floyd: An M&A transaction can generate a great return for a venture investor.

Q. How much do venture capital companies go back to companies they've worked with in the past?

Floyd: Believe it or not we are patient capital and we're going to support our companies, assuming they're continuing to make progress. Again, that's the nature of venture capital. We really are patient capital.

Ehrenpreis: The National Venture Capital Association in Q3 saw a silver lining in the story of first-time fundings. The amount of money that went into first-time fundings of technology companies exceeded follow-on, but it was very high in Q3. What that suggests is there is no shortage of new and innovative companies and venture capitalists are continuing to see plenty of new opportunities to invest their money.

Spencer: On the question of IPO or M&A we don't think it's an either/or question. It's going to be: what's the opportunity what companies are in development? The good opportunities are going to get the funding, whether they're initial rounds or they're follow-on rounds.

Q. What do you see as the next "solar?" What's hot?

Floyd: Energy efficiency is certainly getting a lot of attention. It's an area we've been investing in since the mid-90s, though I think the environment for energy efficiency products is stronger, there are more defined channels to the market. There's a lot of attention on energy efficiency and green buildings.

Spencer: In reference to some of our analysis around solar, it's a different type of solar investing these days. Investments are now focusing on optimization, whether it's optimization of materials, storage, integration into manufacturing sites. We're seeing a new generation of types of companies in a particular vertical. We would expect to continue to see that as the space develops.

Floyd: Well that's true, Jay, the industry is now, what, a $40 billion industry; it's not monolithic. You're seeing segmentation by application. You're seeing opportunities to really optimize what's a very large industry that continues to grow at double-digit growth rates.

Ehrenpreis: Until recently, people mistakenly thought of cleantech as the narrow opportunity of solar and then they narrowly thought of it as solar and biofuels. Now we think of cleantech as a transportation play with the growth of the EV opportunity, we think of it as a whole set of sector areas to invest in; Technology Partner's portfolio is in many ways a microcosm of that breadth and diversity. We have invested in solar, biofuels and transportation. We also have investments in battery storage, water, fuel cells, coal technology, the environmental registry side, advanced materials. Our newest investment is a wind investment. And perhaps more importantly, in the existing portfolio every day we're looking beyond these opportunities for ones that weren't even mentioned: in efficiency, in building materials, in smart grid.

It's this breadth and diversity of opportunity that in many ways has been one of the drivers of clean tech in the sector because it's not just a single problem with a single solution.

Nancy said it and she's right: this isn't monolithic, it's really the breadth of innovative solutions targeting the breadth of issues and opportunities we have in the energy ecosystem.

There's one important point that's perhaps the most important thing if you're sitting inside a venture capital firm. It's to see how we think about the future.

The single factor, which is the best barometer of success, is the human capital side. When you try to predict the future and measure where we are as a sector, the most talented people today are dedicating their lives and their resources to cleantech. Cleantech really has been a magnet for the best and the brightest.

The kinds of people Nancy and I funded a decade ago were disproportionately the scientists and the technologists with a great idea. And now we're able to match those people with some of the best entrepreneurs and some of the best executives who are coming from traditional energy and who want to get into the cleantech sector.

It's the marriage of those great technologists and the great executives and entrepreneurs that is really leading to the cleantech opportunity today.