Energy-Tech Venture Capital
The Next
Disruptive
Technology
New ideas that may transform the utilities industry.
April 2005
By Rodrigo Prudencio
Venture capital investments have tended in the past to focus on advances in computing, software, biotechnology, and semiconductors. Small investments led by venture capital firms hatched companies such as Apple, Google, Ebay, Amazon, Genentech, and Advanced Micro Devices-plus several others that never became household names.
But the growth and earnings potential when disrupting long-established industries or creating new economic sectors forms a key part of the excitement and appeal of the high-risk investment strategy at the heart of venture capital. As energy technology venture capital emerges, it is causing investors and entrepreneurs alike to sit up and take notice-and take action.
Defining Energy Technology
Energy technology encompasses a variety of inventions, innovations, and applications that serve a widely diverse set of energy consumers, producers, and specialized service providers. To better understand the markets, it is useful to divide energy technologies into four distinct categories. Each represents a segment with existing markets, established channel participants and customers, and opportunities to create significant investor value.
Energy Intelligence: Data are vital to the efficient and optimal use of energy. Ironically, the information-gathering systems that connect to critical energy assets, such as meters, transformers, and generators, are well behind the times. New metering technologies, the collection of interval data, and complicated billing processes for power customers of all classes are among the reasons why the modern energy marketplace needs new energy solutions. Frost & Sullivan estimates the market for serving end-customer energy use at $25 billion in the United States and Canada alone. The Meta Group pegs software for customer information, trading, and workflow management at $5.3 billion worldwide. And, the research group, Chartwell, estimates the annual market for advanced metering is at $1 billion and growing.
Distributed Energy: For years, distributed energy systems have worked in commercial and industrial facilities. But as the increasing cost of power for many users encourages consideration of small-scale generation in smaller facilities-even in homes-technologies such as solar panels, clean diesel generators, Stirling engines, micro-turbines, and fuel cells are emerging. As a result, Navigant, a leading energy-consulting firm, believes that today's distributed energy market, currently sized at over $13 billion, is at an early stage of widespread adoption.
Power Reliability: Demand for high quality, uninterruptible power systems continues to rise, driven by the proliferation of digital equipment in processing facilities, online commercial transactions, and data centers, and in distributed telephony by the increase in cable and satellite infrastructure. The mission-critical nature of electrically powered equipment makes such short-term storage systems a significant market. New uninterruptible power technologies and services have the potential to grab a valuable share of what Frost & Sullivan expects to be an $8 billion market by 2008.
Related Services: Many other industries aggressively pursue outside services during times that compel operational efficiency and cost cutting. The energy industry is following a similar pattern as it begins to outsource business services that historically have been conducted in-house. Venture capital backed "related services" companies address "core" activities such as call centers, engineering, asset monitoring, billing services, and workforce automation.
By no means are these four categories exhaustive of the energy technology opportunities. For example, advances in material sciences are leading to companies that develop flexible batteries, membranes for miniature fuel cells, and catalysts for low-temperature reformation of natural gas. Also, laser technologies used in telecommunications applications are now serving as sensors in gas and water pipeline monitoring. These kinds of crossover technologies further expand the energy technology opportunity.
Energy Tech Investment Origins
How did all this happen? From the early 1990s through 1995, venture capital investments in energy technology were practically non-existent, barely totaling about $90 million over five years. Those funds came from a small group of venture capitalists and some corporate investors primarily focused on a narrow set of applications for electric utilities.
By 1995, Europe and Japan began to take steps to make power and energy markets more competitive in their respective countries. New Zealand and major markets in the United States soon followed. Suddenly, utilities became quite focused on the possibility that competition would require investments in new billing systems, customer management software, advanced metering, and new service offerings.
Entrepreneurs responded with new business plans and technology ideas, and investors began to understand the burgeoning opportunity in advanced energy solutions. In 1996 alone, investors poured $122 million into companies developing new energy technologies and services. And while the average deal size was small, only $5.8 million per company, the venture capital community's interest in energy technology began to grow.
The Rise and Rise
By the time new companies were formed to respond to rapidly restructuring energy markets, several specialized venture capital funds responded by raising targeted funds. Arête, Enertech, Kinetic Ventures, and Nth Power became the earliest and most visible venture capital funds dedicated to the energy niche, although a few generalist funds also explored energy-related deals.
The arrival of specialized and generalist investors in this next phase meant that from 1997-2001, more than 266 investment rounds were closed, resulting in investments totaling more than $3.3 billion, according to Nth Power, which has gathered and analyzed such data since 1994. The most prolific of these years was 2000, when energy technology investment totaled more than $1.5 billion and the average amount raised by each company surpassed $20 million.
Remarkably, the growing investment in energy technology companies made only a small impression on the overall venture capital community. Rising investments in energy technologies mirrored the hyperactive levels of investment in the general venture capital markets and thus were lost in the swell of the market. Total venture capital investments in U.S.-based companies totaled $245 billion from 1997-2001, with more than $100 billion invested in 2001 alone. The venture capital industry had never seen such levels of investment activity.
During this same period, several venture-capital-backed energy technology companies completed successful initial public offerings, including Capstone, Proton Energy Systems (now known as Distributed Energy Systems Corp.), Evergreen Solar, Plug Power, and Active Power. The public valuations of some of these companies climbed to remarkable but unsustainable heights, although they did briefly create strong returns for some investors.
After the Bubble and Beyond: 2002-2004
Just as energy technology investments rose with the tide of overall venture capital activity, they also fell as public investors fled the tech bubble. Investments in energy technology companies in 2002 dropped by 45 percent as California's energy markets calmed. Investors stepped back to assess the impact on energy technology demand and some posited that energy technology might be a short-lived investment segment.
The pessimists were wrong, however, as the data showed energy technology growing as a percentage of overall venture capital activity. Even as investors tightened their belts and grew pickier about the deals they would support, they actually dedicated more of their tightly held capital to energy deals. As a result, energy deals, which represented about 1 percent of overall venture capital investments in 1998, by 2003 rose to nearly 2.7 percent.
More information emerges from the data collected by Nth Power; venture capital investors continually adjusted their investment approach in the wake of the 2001 market crash. At first, investors became more discerning. From 2001 to 2002, the number of energy technology deals completed went from 77 to 55. In 2003, however, the deal count climbed right back up to 75.
And while venture capitalists dramatically reduced the size of their average energy technology deal, in 2004 they nevertheless dedicated just over $8 million to each deal. This was up from the 2003 average of $6.8 million. In sum, venture capitalists continue to demonstrate a high degree of selectivity in the deals they will back, but they are making larger commitments to energy technology companies.
Energy Technology's Promise
Two important forces drive today's sustained interest in energy technology. The first is the establishment of experienced investors who understand the subtle dynamics of technology development and adoption in the energy markets. The second is the power of perspective brought by more seasoned investors that keeps capital working toward new innovations and solutions. Rather than retreat, these investors continue to seek companies that promise to create new value in the energy sector.
The continued commitment suggests a fair amount of visionary thought and action by long-time energy venture capitalists. Once focused on a narrow set of power utility advancements, venture capitalists today see energy technologies much more broadly, incorporating technologies from material sciences, wireless communications, and advanced sensors to create solutions that address nearly every aspect of the energy sector and every way in which energy touches our lives. As governments, businesses, and individuals around the world continue to search for improved energy products and solutions-from power that can be generated with less greenhouse gas emissions to batteries that can power laptops and other mobile devices for days at a time-energy innovation is making energy technology an increasingly important segment of venture capital investing.
Rodrigo Prudencio is a principal at Nth Power LLC. Contact him at rprudencio@nthpower.com.
Venture Capital Basics:
A Primer
Simply put, venture capital is an investment strategy that seeks out, funds, and guides early-stage technology companies with significant growth potential. Because these companies are typically very young in their development cycle, a high degree of risk accompanies the investments. Generally speaking, a portfolio of 10 such companies may yield only one or two successes-companies whose value appreciates sufficiently to make up for the low returns or losses in value from the rest of the portfolio.
Venture capital also must be patient capital. The gestation period of many venture capital investments can range three to six years from initial investment to a successful liquidity event, such as a public offering or acquisition. As a result, venture capitalists add value in the interim. In addition to serving as a funding source, venture capitalists coach and guide their portfolio companies and help pull them through the difficulties that many startup ventures encounter.
Yet, despite the mercurial nature of venture capital returns and the accompanying levels of risk and long-term commitment, venture capital makes unmistakable contributions to technology. According to Professor Joshua Lerner of the Harvard Business School, venture capital is much more successful than corporate research and development (R&D) in leveraging small amounts of capital into technology innovation.
Lerner's research shows that each dollar of venture capital delivers about three times the patented innovation of traditional corporate R&D programs.1 This innovation multiplier is significant at a time when corporate R&D spending by energy companies, particularly utilities, is generally on the decline. And even though broader market opportunities for energy technologies are developing, the emergence of a defined energy technology niche as a significant venture capital category is apparent, and with it the establishment of specialized investment firms.-R.P.
Endnotes
- "Assessing the Contribution of Venture Capital to Innovation." Joshua Lerner and Samuel Korum. Rand Journal of Economics, 31 (Winter 2000) 674-692.
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