For VCs in green tech, it's time for Plan B

CAMBRIDGE, Mass.--Venture capitalists, who once thronged into clean technology, are finding that they need to rethink their strategies in order to succeed, with some of them apparently moving out of the field altogether.

There's often a mismatch between the large amount of money required to commercialize new energy technology and the capital to which a venture fund has access. As a result, venture investors are increasingly seeking to invest in green-tech start-ups that are less capital-hungry, a trend which will accelerate next year, according to experts.

Instead of getting all their money from venture capitalists, budding green-technology companies when starting out will be looking for money from large corporate partners to test out new technology or from alternative sources such as angel investors, families, or government grants.

Overall, investors say that because green-tech investing is very different from other fields, people need a different game plan than what worked in the venture capital-friendly industry of IT.

"The model is not going to work the way it sits right now," David Danielson, a former venture capitalist and program director for energy storage at the ARPA-E clean-energy research agency, said during a panel on venture capital and energy last week at MIT's Sloan school.

Danielson said that venture capitalists have told him they are getting out of green tech because it's taking longer to innovate around energy and materials than they originally expected. Venture capital investor Rob Day also sees more departures from green tech, saying that "generalist" venture capital companies which work in a number of industries are quietly moving on.

Recent data on venture capital investing points to a shift toward energy efficiency, an area which typically requires less money. In terms of number of deals, efficiency beat out solar and transportation in the third quarter. There was also a big drop in the average deal size from $35 million to $8 million. Overall, the third quarter saw a sharp drop in total dollars invested, although the year total for 2010 is expected to higher than in 2009.

Investing in energy efficiency, such as LED lighting, is a big shift from how green-tech companies got started earlier in the last decade. Many investors and entrepreneurs crowded into the solar and biofuels. But often tens or hundreds of millions of dollars is required to build a pilot facility to find out whether a technology works.

That puts clean-energy technologies in a "weird gap" where they are too expensive for venture capitalists to fund all the way through to commercialization and too risky for project financiers who work with tried and tested technologies, Ramana Nanda, assistant professor of business administration at Harvard Business School, said during the panel.

Deep pockets needed
Start-ups themselves are altering their funding plans as well, with more of them seeking out deep pockets of large industrial companies, similar to how biotech start-ups have worked.

Six-year-old Ze-Gen, for example, is seeking to raise more money to build a pilot facility for its waste-to-energy gasification technology. But because building this sort of industrial plant requires a lot of capital, the company is looking for a "strategic partner," which would act as an investor able to bankroll many plants if the technology proves out at scale, said Neal Isaacson, the chief financial officer of Ze-Gen.

"We can't be chasing money from the VCs because the model isn't going to work," Isaacson said. "We need too much money and the payback is too long, it just doesn't fit the model."

An Ernst & Young analysis of DowJones Venture Source data found that 23 percent of the venture green-tech deals in the third quarter involved large corporations, including BASF, General Motors Venture Group, and Intel Capital. General Electric, meanwhile, teamed with four VC companies to launch a contest to attract the best ideas around the smart grid.

To get good returns, a number of venture capital companies have tried to invest in green-tech start-ups at a later stage in their development, Danielson said. Filling the gap for early-stage companies are wealthy individuals called angel investors or family funds, which tend to have a longer time frame for investing than the five or seven years of a venture capitalist.

Green-tech companies also need to be aware of government incentives to build factories or other facilities. Often, companies are using a combination of these sources which works very well, said John Harrington, the founder of Sheffield, which advises venture-capital companies, during the panel. First Solar, the very successful U.S. thin-film solar company, was funded in its early days by the investment arm of the Walton family behind Wal-Mart, he noted.

Venture investing overall has had relatively poor returns in the past 10 years, so the green-technology category is part of an overall trend, investors note. In its analysis of third-quarter data, the Cleantech group said investors are readjusting their expectations to get two to five times their money from successful ventures, rather than 10 times their money.

Bill Aulet, managing director of the MIT Entrepreneurship Center, during the panel said that the venture investors who came into energy early in the decade will most likely not have great "exits," in the form of a public offering or an acquisition. Often, that's because even with a great product, new technology historically does not get adopted quickly in energy.

"Energy is ultimately a commodity, not a value-added service. It's a regulated service because it touches all parts of society. It depends on capital-intensive infrastructure. It has exquisite supply chains," he said. "Those early funds that went in, now that we look back, [we can see] structurally, there's a reason they won't see great exits...and now they're adjusting their strategy."