The Lost Category Capital

Below is the ‘Tip of the Week’ transcript from the Podcast Ep39: Cleantech (Rob Day):

In this episode we discussed the opportunities within project finance. And in previous installments we have covered early-stage businesses that are deemed “lifestyle businesses” and may not be investment-grade. In this week’s tip I want to talk about a couple instances that I’ve come across that aren’t venture back-able and aren’t of interest to PE.

The first was a startup that had developed an efficient energy distribution product for the heavy machinery and defense vehicle sector. Their solution reduced assembly time, increased energy efficiency and decreased long-term maintenance and overhaul. It was a really neat, elegant sub-system. Yet, the business had been operating for multiple years and there clearly was no prospect for exponential scale or a $100M+ exit.

Yet, it was a sound, profitable business with an innovative approach that was not your typical SMB. The issue arose when they had their biggest win-to-date. They were able to sign a very large OEM on a new defense vehicle platform. If you are familiar with the industry, you are aware that getting your component or system on a new air or vehicle platform is a huge win, b/c often these vehicles are built over long, forecastable time horizons. If you were to get your product on the F-35 fighter jet, for example, they may build 600 F-35’s over the next 10 years. So, this company won a big contract on a major vehicle platform, but they did not have the resources on staff to complete the design spec and fulfill the orders. And they were unable to borrow money from a bank b/c the banks all viewed them as a risky small, startup w/ limited collateral, despite this huge purchase order that was going to triple their business. So the founder of the business ended up raising money from Angels. And, in the absence of large upside, it was not venture-investable in the traditional sense. But it was investable. And ultimately the business was able to retain funding via a debt instrument w/ liquidation preferences so that the Angel investors recieved a reasonable interest return on their money and also had some upside in the event that a strategic acquirer made an offer.

Another situation I encountered, was even more unusual. I was talking with a friend who was complaining about his condo association. The high-rise building was undergoing major roof repairs which had increased the assessments significantly for the condo owners. This was causing the owners to vote-down any initiative that increased their short-term assessments. The problem was that when the building was built, the builder installed cheap, non-programmable thermostats. So, in the hot and humid summer of Chicago, you could set your central A/C to On or Off… there was no temperature setting. And this became an issue for the association because the meter utility was not setup to track individual condo energy usage. There was one meter and a bill that was charged to the building and spread across all the condo owners. As you can imagine, these factors caused owners to be very inefficient with their A/C and many would leave the thermostat in the On position for the entire day they were at work, so that they would not return to a sauna after work. And proposals to the condo board had been submitted multiple times to replace the thermostats with a Nest or, at the least, a programmable thermostat, only to meet rejection due to high-cost of purchasing the new units and installing them in the building. One can imagine that in a 42 floor building, this was not a modest cost. Yet, I couldn’t believe that they would continue with a significant overspend on their monthly utility bills b/c of an upfront amount. But, I’ve come to realize that this is the case, not only in this random instance, but even with many large businesses that will avoid upfront capex in favor of getting gouged on a recurring basis. In this instance, I was able to connect with the association leader and agree to a split of the monthly savings in the building’s energy spend, in exchange for incurring the upfront cost and procuring the product and installation services. It resulted in a big win for me and significant savings for the building that otherwise would’ve been wasteful, continual spending.

So, we should acknowledge that this does not fit within the existing venture capital model and actually has more similarities to private equity. But, unfortunately, w/ regard to traditional PE, these opportunities either never hit their radar or, if they do, are far too small to move the needle on large funds. And while this clearly is not technological innovation, it certainly fits into the category of business model innovation. For the later example, it is reasonable to think that if an entrepreneur could figure out a way to access a significant number of large building managers or associations, feeling the pain of unnecessary resource spend, yet unable to generate the upfront capital required to mitigate monthly expenses, they could build a business with this focus. And, unfortunately, this category of investment often gets lost in the noise. It’s never going to be a unicorn and it’s just not big enough for PE. So if you’re an entrepreneur, looking for funding, in this area, recognize that the pool of investor-candidates is likely pretty shallow. And if you’re an investor, willing to entertain such opportunities, you may be the only game in town.