Does Venture Capital Work in Energy?
The crash, leaving my great job for a dot-bomb, and losing significant capital must have burned any irrational exuberance out of me. I created multiple startups afterward; however, the past, as well as savvier and pissed-off investors, tempered my desire to pitch the unicorn scenarios. Damn GenX'er! No wonder they call us the disappointed generation. Kurt Cobain's All Apologies live version on MTV's Unplugged recorded a few months before his last breath became one of the cornerstones of our generation's disposition.
Fast forward just a few years later. A new bubble appeared called cleantech. Startups in the energy sector, particularly cleantech, were anticipated to bust out, generating tons of interest in the venture capital industry. This 2012 account of the good ole days of Al Gore's Oscar, Solyndra, and Silicon Valley VC's saving the world is one of those WTF were you thinking reads.
So this got me thinking...is it possible that energy startups are not a good fit for the venture capital model? Or was the previous bust a consequence of unfortunate market conditions?
I'm confident the answer lies somewhere in between, and after I share my thoughts, I'd love to hear your feedback and war stories.
The Venture Capital Model
The concept of venture capital emerged in the 1940s when new technology companies were forming but couldn't get traditional funding from banks. That was because they had no track records the banks could use to determine risk. And they couldn't find traditional investors because there was no way to determine the expected future free cash flows nor the opportunity cost of capital for something so new and risky.
Instead, these new technology companies had to seek out wealthy investors who were willing to take a risk for an ownership share in the company and some control over how the company operated.
Harvard Business School professor Georges Doriot created the first self-proclaimed venture capital firm in 1946, the American Research & Development Corporation. ARDC hit on the first "unicorn" when it invested $70,000, and leveraged $2 million in loans, for a 70 percent ownership stake in Digital Equipment Corporation. That investment paid off 11 years later when the company's IPO netted ARDC a cool $355 million.
This high-stakes, high-reward industry continued to grow steadily into the late 1990s, but then exploded, and nearly imploded, in the dot-com era of the early 2000s. 2000 was the first, and last, year venture capital investments in the U.S. topped $100 billion, until 2018. Pitchbook found that venture capital investments, spurred by large late-stage investments, soared to $130 billion in 2018. The market continues to be hot in 2019 as Statista shows the pace through the first two quarters is ahead of 2018. Oh boy, here we go again.
Generally, venture capitalists have claimed to operate on the one-third model, where one-third of their investments were losers, one-third broke even or made a small return and one-third scored the big return that provided the reward.
However, an analysis by Correlation Ventures of more than 21,000 venture financings from 2004 to 2013 showed 64 percent either lost money or broke even. Another 25 percent provided a return of between 1 and 5 times the initial investment, but only 4 percent returned 10 times or more, those unicorns the VCs are looking for.
These kinds of numbers also were reported in 2011 by Santé Ventures in a report titled, "Why Venture Capital Does Not Scale." At that time, no venture capital fund larger than $750 million had ever provided a return of greater than 2.0X to its limited partner investors. And only about a dozen larger than $300 million had returned more than 2.0X.
Santé posited the example that a $100 million fund making 10 investments at $10 million each would require two of those investments to hit a 15.0X return to create a 3.0X return for limited partner investors (this does not take into account management fees; however, the math is easier to understand). On the other hand, a $1 billion fund would need to hit on twenty such startups to return the same 3.0X. Given the limited number of such great returns, it would be nearly impossible for a fund to find that many unicorns.
This leads to two outcomes: investors shift to smaller funds that can provide the greater return, or the larger firms chase the one giant unicorn with greater investments to try to dominate a market and get the giant 30.0X or 50.0X return. The strategy of portfolio concentration is something that even the best investors of our period tend to follow. However, unlike later stage investing, this pattern of portfolio concentration to back the winner takes all unicorn has set into motion a disturbing trend that is leading to new valuation methodologies moving away from the long-held standard of measuring value: the expected future free cash flows discounted at the opportunity cost of capital.
The latter is the trend we saw in 2018 as the number of deals dropped by more than 500 while the dollars jumped nearly $50 billion, including a whopping $12.8 billion invested in Juul's late-stage funding round. Juul, really? Let's see what the WeWork disaster will do to this trend/bubble. And let's remember that this is not the first time the market has moved away from demand-side valuation strategies as explained above to supply-side (if a tech startup raises $1B, it must be worth a lot more than $1B. Despite the expected future free cash flows being unknown, the market puts a valuation on a firm due to how much cash the firm has raised, not generated).
How This Impacts Energy Startups
The chase to find or create the biggest monster to dominate an industry and milk the greatest return is not a strategy that will play well for startups in the energy sector. You're just not going to get a dominant player in the energy field like a Facebook in social media or a Juul in e-cigarettes. But what about RigUp? I sure hope so. Let's watch and see if this unicorn starts a new trend.
Back in the mid-2000s, startups in cleantech looked like they were set to disrupt the long-established energy market, and VC funders took notice and took their chances. But reality quickly set in, and cleantech ended up looking like a mini-dot-com bubble that burst. Being early is equivalent to being wrong.
As they analyzed Series A funding beginning in 2006, the MIT Energy Initiative found cleantech funding was nearly equivalent to medical technology and software technology. They found VC companies poured $25 billion into the industry between 2006 and 2011, but by 2016 had lost more than half their investment. Of the 150 startups founded in Silicon Valley over the previous decade, nearly all had shuttered or were on their last legs.
Was venture capital a bad model for cleantech? Or was this bubble just bad luck? Probably a little of both. First, the 2008 recession hammered economies across the globe and sent oil and natural gas prices plunging. At the same time, hydraulic fracturing (or fracking) had been introduced into horizontal drilling in the late 1990s. It greatly increased oil and natural gas output across the United States, ensuring prices would not skyrocket back to their 2006 levels.
With lower oil and natural gas prices, energy providers had little incentive to proceed with adopting clean technologies (and consumers had not yet shown their willingness to pay more for sustainability), putting all of these startups at a distinct disadvantage.
The other piece of the equation — whether cleantech fits with the current VC model — also became evident during this bubble "experiment." The MIT report showed the cleantech startups which focused on software solutions were the only type to enjoy any success. "In particular, clean-tech companies developing new materials, hardware, chemicals, or processes were poorly suited for VC investments because they required significant capital, had long development timelines, were uncompetitive in commodity markets, and were unable to attract corporate acquirers," the report states. And just a few days ago, a new article was written about the Business Development Bank of Canada's (BDC) $600M cleantech fund and its struggles.
Because venture capital firms operate on a 10-year cycle, they are designed ideally to exit their investment within four to seven years, a timeline that is too short for energy startups. These startups also are not likely to yield the massive returns VC investors need to cover the high percentage of losses they will experience.
Where Does This Leave Energy Startups?
If energy startups are left out in the wilderness dependent upon bootstrap funding, the entire industry and even the U.S. economy will face a bleaker future. The industry needs entrepreneurs to innovate. Institutional capital reduces the risk of customers to work with a startup.
The industry is not innovating fast enough out of its own decision to reduce investment. Corporate research and development have been in decline for several decades. Research from the National Bureau of Economic Research released earlier this year shows that by 2015, the business share of research funding had fallen to 20 percent, down from 30 percent in 1985. In the oil & gas industry specifically, R&D spending has been trending down by both operators and service companies.
As the research emphasis has shifted to the university setting, the translation of research to product development has lagged. In the giant corporate labs like those founded by AT&T and IBM, researchers not only had the financial muscle behind them, they also had the challenge to develop a product to meet a specific need.
More emphasis now has shifted to those startups leveraging university research to develop products for the market. Venture capital has made that possible by providing the cash to allow startups to span the fiscal desert from concept to ROI.
This has been a successful model for many industries. However, it appears not to be viable for energy startups because of the longer timeframe necessary and the smaller ROI. Taking an idea from the lab to liquidation from acquisition or IPO is well beyond 10 years in energy. We've previously discussed why Failing Fast doesn't apply to the energy tech industry.
But there is a growing area of hope for these startups. First, we are seeing the rise of digital startups attacking energy due to industry prioritization and technology access. Startups are starting to make significant progress as many customers have started to adopt cloud and mobile platforms. This opens the door for a startup to be able to land and expand quickly on a global basis. Second, corporations are sitting on a vast mountain of cash ($1.7 trillion in cash held by U.S. corporations, at last count) while watching other investors putting money to work backing a startup that may invest more are creating corporate venture capital programs to put that cash to work including energy companies.
Who Can You Turn To For Funding?
Despite the past painting a grim view towards energy venture capital working, there are new and a few old investors in the game with fresh capital convinced that new track records can be established showing value creation for the associated risk. Time will reveal whether the era of energy venture capital is upon us. I break down the investors into a few important categories and list the most active firms:
- Traditional Energy Venture Capital: defined as VC's that focus almost exclusively on oil & gas investments.
- New Energy (Cleantech) Venture Capital: defined as VC's whose charter is focused on clean, sustainable and new energy investments.
- Hybrid Energy Venture Capital Firms: defined as VC's who invest across the energy value chain from oil & gas to cleantech and in between.
- Corporate Venture Capital (CVC): energy companies that have a dedicated venture capital arm.
I am listing the most active firms that I come across and work with often. Send me others that you think deserve a shout out!
Traditional Energy Venture Capital
The tradition energy venture capitalists have both legacy investors as well as new entrants. If you are an oil & gas focused startup, you should know these investors:
- Altira Group: like EPVE below, Altira is one of the more seasoned VC's. Based in Denver, Altira is a firm whose LP's are made up primarily of the top US Independent oil and gas companies. This is good news if this also happens to be your primary customer.
- Cottonwood Venture Partners (CVP): CVP is a Houston based fund that focuses on oil & gas technologies especially digital. This young team has just invested most of its first fund (with an exit already!) and are working on fund 2.
- CSL Ventures: Taking a page out of SCF Partners, CSL is a Houston-based classic oilfield service private equity firm that sees how important technology will play in oil & gas moving forward. They just announced a VC fund to complement their PE fund. Packed with oilfield services industry titans and senior executives, this model is something to take seriously especially because they have larger investments into potential customers for your startup.
- Energy Innovation Capital (EIC): Founded by former GE Ventures and ConocoPhilips Ventures veterans, EIC is a firm focused primarily on investments that service the US onshore oil & gas industry. They are based in both Silicon Valley and Houston.
- Energy Ventures Private Equity (EVPE): having been around since 2002, EVPE is one of the veteran firms. Based in Norway, with offices in the US and UK, EVPE is an oil & gas focused VC and PE firm that has moved to more growth capital and investments between Series B - Growth Equity. They invest in both the US and Europe.
- Houston Ventures: Is a Houston-based fund that focuses on oil & gas software. The founder is a well-respected investor with one of the best track records in a difficult industry. This firm will not invest in you unless they truly understand it. And if they do and invest, you are probably going to be one of the lucky ones.
- SCF Ventures: SCF Ventures is a Houston-based venture fund that is part of the famous oilfield service private equity fund, SCF Partners. SCF Partners is the iconic and legendary firm founded by L.E. Simmons who built one of the best performing private equity funds across industries. SCF recognized that technology is upon us and hired a well-known and respected entrepreneur and investor to lead the venture fund.
New Energy (Cleantech) Venture Capital
Like traditional, there are both investors that have been around since the cleantech 1.0 and those that have recently raised funding.
- Breakthrough Energy Ventures (BEV): Founded by Bill Gates, BEV is a Boston-based firm that is part of the Breakthrough Energy Coalition. The team is very talented and willing to look at the long game. I am very interested to see how they perform as more years and investments come to light.
- DBL Partners (Double Botton Line Partners): Having been around since 2002/2003, DBL Partners is probably the most famous clean and new energy-focused VC firms due to their close relationship with Elon Musk and backing Tesla, Solar City, and SpaceX. They are not a pure-play since their mission is focusing on double bottom line companies. My favorite investment of theirs is The Real Real.
- Energy Impact Partners (EIP): EIP is a New York-based venture capital / PE firm whose LP's include many of the larger utilities in the US. This is another interesting model due to their ability to tap into existing investors as customers.
- G2VP: Based in Silicon Valley, G2VP is the former team from Kleiner Perkins’ Green Growth Fund. This is a new fund that has been around for a few years and is focused on the new energy space. As we have seen with many "new" funds, it is easier to raise money as an existing GP even if your track record is still to be revealed. G2VP will be an important example of whether silicon valley can conquer new energy.
- Khosla Ventures: Founded in 2004 and based in Silicon Valley, Khosla is the posted child of cleantech 1.0. Having over $5B+ under management, Khosla is still in the game.
- Oil & Gas Climate Initiative (OGCI): OGCI is an oil & gas consortium that includes CEO support from the largest oil & gas companies whose purpose is to focus on climate investments. It will be interesting to compare their impact and results to other firms like BEV and EIP.
Hybrid Energy Venture Capital Firms
- Blue Bear Capital: Blue Bear is a Los Angeles and Houston-based venture fund focused on data solutions across the energy value chain both oil & gas and new energies. The founder spent his time in larger energy private equity before leaving to build an impressive fund. Like Cottonwood, Blue Bear is a few years old that is working on its 2nd fund.
- Evok Innovations: Evok is a Silicon Valley-based fund whose LP's include 2 of the Canadian oil & gas companies. Evok makes investments in both oil & gas and new energies due to their interest in finding sustainable solutions for energy.
- PIVA: The newest fund in energy, PIVA is a Silicon-Valley based firm founded by a former GE Ventures executive. PIVA has an interesting model since it has a single LP from the Malaysian oil & gas company known as PETRONAS, short for Petroliam Nasional Berhad (National Petroleum Limited).
Corporate Venture Capital Firms in Energy
Corporate venture capital (CVC) offers advantages for the energy sector because it doesn't face the time constraints of a typical VC. There are a few other advantages and levers that can be pulled:
- If a technology can be deployed internally and it achieves realized cost savings, there is more value to the investment and a greater payback than simple cash alone.
- CVC's are not dependent upon pleasing multiple investors with their own investment horizons.
- Cash on Cash return from venture investments is not the primary source of income for the corporation.
As the Santé report noted, creating a smaller venture capital investment strategy also has a greater chance of succeeding, so CVCs don't need to chase the winner-take-all strategy. Rather they can adopt a more targeted strategy instead of relying on the high-risk, high-return model.
The CVC model also frees the startup to focus on its core purpose, developing its product or service, rather than chasing the next funding series, acquisition, or IPO.
Top energy CVC's include: BP Ventures, Centrica, Chevron, E.On, Enel, ExxonMobil, Equinor Technology Ventures, Occidental, Orsted, Saudi Aramco Energy Ventures, Repsol Ventures, Shell Ventures, Sumitomo, Total Energy Ventures.
In a future post, we'll talk more about my investment thesis, what has changed, and is now the time to jump in.
As I mentioned above, I'm not interested in having the last word on how energy startups can find funding and success without squeezing into the traditional model of venture capital. I'd prefer this post to be the opening of a conversation. My hope is you'll share this post with your friends and those that you enjoy punishing. Leave a comment. Tweet at me. Message me on LinkedIn.
"The worst crime is faking it." Kurt Cobain