A few months ago, the investment team at my private equity firm sat down with a talented management team from an exciting entrepreneur who was trying to raise $50 million of capital to grow their business, which had developed an innovative way to turn trash into electricity. They demonstrated strong commercial revenues and an operational track record, they described their experienced team with strong project development backgrounds. All was quite impressive.
Yet every meeting they’d had with venture capital firms had ended the same way – in disappointment. Their tale was a familiar one that I’d witnessed with increasing frequency over the past several years from worthy companies. The question was why?
It’s no secret that the flow of VC cash to startups finally seems to be ebbing. Since 2014, early stage and seed round investments have decreased 40%, with the total number of VC rounds in technology companies dropping from 19,000 in 2014 to 10,000 in 2017, according to Pitchbook.
But there’s more going on here.
Obscured by the fascination with all things tech and healthcare over the past few years, there is a sector being largely overlooked by traditional VC financing involving a new generation of entrepreneurs and emerging businesses – like the trash to power company, with early track records and compelling economics, which offer tremendous upside for investors.
This new sector is essentially taking a page from the transformative growth of rooftop solar, where demand grew to the tens of billions of dollars virtually overnight.
In the case of rooftop solar, the size of a solar panel installation for a single consumer rooftop (in the tens of thousands of dollars) fell far below the threshold for institutional project finance to invest in on a case-by-case basis, but homeowners were still unwilling and often unable to pay these costs up-front.
To make the economics work, the early financers of rooftop solar hit upon a new model: they pooled their projects, financed multiple projects at once, and then changed the customer model by offering an easy service contract that a homeowner could pay each month, thereby eliminating the need for an upfront capital expenditure.
Further, to de-risk these investments while still allowing them to be deployed more efficiently, the financers pre-identified and removed as much variation as possible, and eliminated any potential downfalls up front, pre-identifying installers and system designs, establishing standards of credit-worthiness for each customer, and requiring consistent contracts, eliminating costly and time-consuming elements of the process.
The results of these actions were transformative – and everyone came out a winner.
Today a range of entrepreneurs, working on a range of resource innovations – in the sectors of energy, water, food and waste — like trash to power, power generation, drinking water treatment and food production are poised to transform the way we manage our natural resources, creating tremendous economic opportunity for investors in the process. The production of these assets, which are capable of generating stable cash flows, should be strong candidates for investment.
Yet, outside of larger scale infrastructure, long the domain of project finance capital, many of the most innovative companies involved in the distribution of these systems have had trouble attracting financing. The problem is that these projects require significant capital deployments that are nonetheless too small or too complex for traditional banks and institutional investors and are ill-suited to the VC model, which wasn’t designed with significant capital amounts and is better suited to things finance things like the latest app rather than physical assets.
Let’s take the trash to power company I’d mentioned: if every plant that they want to deploy costs $4 million each, and you want to sell service contracts to only 12 customers, that’s still $48 million you need to find somewhere. And that’s just a bad use of venture capital. By the simple A+B=C math of venture capital, even if you can raise $48M, unless you’re planning on giving up more than half of your company, you’re going to be sitting on a valuation (at least on paper) for your company of at least $100M. Which may sound great… until you try to find a buyer for your company and discover that the average value for companies like this at acquisition in these industries is actually $85M, according to the NVCA. And if that happens, who lost money on the investment? If typically structured, it wasn’t the VCs. It was the entrepreneurs.
Fortunately, there are emerging solutions to this dilemma, new financial models that can unlock institutional capital. By providing initial “project pool” capital as with the rooftop solar example from above, investors like my firm allow entrepreneurs to build and deploy their assets, enabling them to grow quickly without having to resort entirely to venture capital. If you can build and pool enough projects together, the total capital put to work can be significant. The resulting structure is an investment that is both recognizable to institutional investors and scalable, with predictable yields. And yet, someone needed to have stepped in and structured the first such capital pool for that entrepreneur.
By stepping in at this stage and providing financing for deployment of the assets, this new wave of finance will enable the next stage of growth and position the companies behind these innovations for commercial success. While also unlocking significant “mainstream” capital for these projects down the road.
We’re in the middle of a wave of such financial innovation around sustainability that is capable of providing tremendous scale in ways traditional types of financings like venture capital just can’t do alone. As the fast growth of rooftop solar proved, when this type of capital is introduced to one of these market opportunities, the demand can quickly grow to tens of billions of dollars nearly overnight. And the food, water and waste markets represent in the aggregate trillions in revenues annually, so we’re talking about a lot of investment potential.
In fact, we saw enough investment potential in this trash-to-power company (and they saw enough growth potential in our model), that we did in fact make that investment. But using a smarter, better-fit structure for their needs, rather than their initial mega-venture-round ask.
I’ll be talking more about this in the weeks about how we’re finally starting to build the capital ecosystem that sustainability entrepreneurs need to succeed. It’s an exciting time.