By Timothy L. Faley, Ph.D., M.B.A.
July 1, 2010
Innovations in the clean technology (deriving new energy sources, creating advanced practices to clean and distribute potable water, or developing new renewable-based materials), or cleantech, arena have the potential to change the way we live. All of us. Cleantech innovations hold out the promise for everyone in the world to raise their current standard of living without depleting the planet or triggering wars over diminishing resources.
But there is a problem in the cleantech world. That problem is the uncertainty of the exits for cleantech investors. The transformation of new technologies into new businesses requires capital investments. Investors are willing to take on these risky investments if they see an opportunity to recoup their investment plus a return commensurate with that risk. The issue for cleantech investors today is that those financial exits are not at all clear. The result is many potentially transformational breakthroughs are simply not being developed for lack of financing.
Over a decade ago, the same issue threatened the then-nascent biotechnology sector. Like cleantech, building a biotechnology company requires considerable amount of time and money. Guiding a new drug application through the FDA’s phased approval process can take seven or more years; well beyond the three to five year investment-to-exit timeframe that most venture capitalists need to make their ten-year investment funds viable. As a result, early investments in the biotech sector often focused on companies whose products did not have to go through the long and expensive FDA process. While these companies certainly impacted the field, by far the largest impact from biotechnology came from the development of — and thereby investment in — new therapeutics. However, significant therapeutic investment did not occur until the exit path for these therapeutic companies became clear.
Over time, with a few exceptions such as AMGen and Genzyme, most therapeutic-orientated companies would develop their new therapeutic through Phase II of the FDA’s evaluation process, and then be acquired by a large pharmaceutical company. The acquiring large pharma company would complete the process–assuming all went well–by taking the new drug through the remaining clinical stages and ultimately to the commercial market. The emergence of this exit “norm” increased the viability of therapeutic investments and ultimately increased biotechnology’s impact on human health.
The cleantech investment parallel is apparent. Investments in cleantech today tend to be focused on energy and other resource savings opportunities (so-called “demand side” investments) that require shorter development times and investments. Similar to biotech-based therapeutics, the ultimate opportunity for cleantech lies in the longer-developing supply-side — those new energy sources, creating advanced practices to clean and distribute potable water, or developing new renewable-based materials.
As was the case for biotech, cleantech needs to find a financing equilibrium that allows all its investors to succeed in order for the public to ultimately benefit. The obvious parallel for cleantech would be for large companies to acquire cleantech startup companies before their development is complete. Generally this will not be feasible since many potential acquirers, electricity generation companies for example, are primarily operation-oriented companies and are therefore not proficient at developing new businesses. Private equity firms, on the other hand, have the necessary skill-set to develop, aggregate, and scale these early-stage cleantech startup companies. PE firms also have the necessary financial investment acumen necessary to do just that.
An intermediate acquisition by private equity firms will have a significant financial impact. Take two typical cleantech firms, each requiring identical investments and identical development times. One firm is developed to the point of acquisition entirely by VC firms. The second is developed to an identical point through the intermediate purchase from the VCs by a PE firm. In the second case, the acquisition price the PE firm would ultimately have to receive in order for all investors to receive rates of return commensurate with their risks is half what it would be for the case where the VC firms go it alone. The significant reduction is primarily due to the fact that the intermediate acquisition ends the compounding of the high-return rates of the early investors.
The additional benefit of this sequential financing method is that it also lowers the size of the venture capital fund necessary to invest in cleantech. Instead of the mega-funds that have been formed in the space, like Khosla’s billion-plus dollar fund, a VC firm with a more typical $200 million fund will now be able to easily invest in a portfolio of cleantech firms. Both of these benefits of the sequential-funding model increases the number of transformational cleantech breakthroughs that will potentially be developed.
The success of the cleantech segment is key to raising the standard of living of people across the globe without jeopardizing the planet’s resources. Private equity firms investing in succession after venture capital firms holds out the promise to be an investment model that can unlock the potential of this segment.
Dr. Faley is the managing director of the Samuel Zell and Robert H. Lurie Institute for Entrepreneurial Studies and the Center for Venture Capital and Private Equity at the University of Michigan. He is also an adjunct professor of Entrepreneurship at the Ross School of Business at the University of Michigan. Dr. Faley came to the University from The Dow Chemical Company where his career extended from research and new business development, to venture capital and technology licensing. Dr. Faley holds a Ph.D. in chemical engineering in addition to his MBA.