<aside> 💡 Key Take-Aways

• Cleantech 1.0 or first climate hardware investing wave left deep scars and VCs lost a lot of money;
• Climate Hardware Solutions face structural challenges such as longer margins, longer development timelines and lower exit multiples;
• In Germany alone, there is a massive >6.6bn Euro funding gap;
• According to founders, lack of growth funding and difficulties in fundraising are some of the biggest roadblocks. </aside>

There is considerable excitement about the necessity and prospects of climate hardware solutions. Before diving deeper into this, we should remind ourselves that things are not all that easy. Venture capitalists look for outsized returns and certainly over the past 25 years the traditional venture capital model was tailored towards a very specific type of company: software companies. With the promise of zero marginal costs and fast & capital efficient scaling, ‘software was eating the world’. Yet there were exceptions to this. Cleantech 1.0 set out to disrupt the energy industry and save the climate by investing in new technologies, such as solar panels or biofuels. Half of that money was lost (MIT Energy Initiative), leading to perhaps the biggest VC bankruptcy to date. Hardware is hard. But why?

1. Throwback to Cleantech 1.0

The first big wave of cleantech (or climate tech) investments happened between 2006 to 2011, often also referred to as “cleantech 1.0”. In the wake of Al Gore’s "An Inconvenient Truth" in 2006 as well as rising gasoline and natural gas prices, many cleantech companies emerged around the globe. With VC funding for cleantech skyrocketing to $1.75bn in 2006 the new boom began (MIT Energy Initiative). Cleantech companies profited from the earlier, successful commercialization of scientific innovations in the semiconductor and biomedical sector. In 2007, John Doerr, partner at Kleiner Perkins said in a TED talk that “Green technologies - going green - is bigger than the Internet. It could be the biggest economic opportunity of the 21st century”. Funding reached its peak in 2008 with over $5bn invested into the cleantech space. However, 5 years later investments plunged back to $2bn, as did the number of new cleantech companies founded (MIT Energy Initiative). Next to the US, Germany also experienced a significant emigration of its once most promising new industry. The number of jobs in the solar industry in Germany dropped from over 110,000 in 2011 to 32,000 in 2015 (No Trick Zone). Overall, in cleantech 1.0, VC investors invested over $25bn - and lost half of it. The reasons for this crash and burn were plentiful.

1. First, there was the global credit crunch in 2008 as well as a following decline in oil and gas prices. This led to government subsidies declining sharply.
2. Second, China built up significant solar panel manufacturing capacity that obliterated the margins of European and US competitors.
3. Third, many of the technologies being commercialised in the early 2010s couldn’t reach the promised economies of scale and never became price competitive. Especially hardware innovations such as material and process innovations returned only a fraction of the initial investment. Software investments, however, were the exception and (aggregated) became profitable.
4. And fourth, many corporations shied away from acquiring new, high-risk ventures (especially hardware) which made the overall exit environment quite challenging for cleantech companies. For example, BP left the solar industry in 2011 and Shell already in 2009.

Approximately 90% of all cleantech companies funded after 2007, ultimately failed to return their initial investment. Normally only 75% of all venture-backed companies fail to return the invested money to investors (Louisa Zhou. This financial trauma caused investors to shy away from cleantech in the years to come.

2. Structural Challenges of Hardware Investing

In recent years we’ve seen a new boom in climate tech investing. Regulatory changes and decreasing cost curves are attracting funding to hardware solutions again. Yet on a higher level, some of the challenges remain the same. Climate Hardware Solutions are nascent technologies, in most cases not de-risked enough to qualify for commercial investments other than venture capital and oftentimes it's hard to fit into VC frameworks. We ran data on recent hardware vs software IPOs to illustrate those challenges:

Margins

While software companies might see margins of 80-90%, hardware companies will inevitably have higher COGS, as they have physical inputs, therefore much lower margins. This really makes organic growth more difficult as their free cash flows are lower.

Timelines

Hardware typically comes with longer scaling cycles and slower iterations. This means that timelines are different from software development where it's much easier to pivot and adapt to customer needs. Because of that, time-to-revenue is longer and exponential growth is difficult since production capacity grows more or less linearly as a function of CAPEX investments.

Capital Efficiency

In simple terms, taking a software company from 1m to 10m Euros in ARR ‘just’ takes increased spending on customer acquisition. For a company operating physical plants reaching the same revenues likely takes 30m Euros in CAPEX spending. As one investor puts it, licensing is unlikely in most cases and you will not get around enormous CAPEX investments. Thus, scaling is costly. In our sample, climate tech hardware companies tend to perform worse on all capital efficiency ratios.