The ‘valley of death’ for climate lies between early-stage funding and scaling up
Jonathan Strimling found himself at a crossroads. After nine years of development, his company had successfully engineered a process to transform old cardboard into premium-quality building insulation. CleanFiber’s innovation boasted superior performance, with fewer contaminants and less dust compared to traditional cellulose insulation made from newspapers. The product garnered praise from insulation installers, presenting a promising opportunity for growth.
However, the challenge lay in scaling production to meet the rising demand. While many CEOs would envy such a dilemma, transitioning from a research project to a fully operational commercial venture posed significant hurdles.
“It’s challenging to establish your first-of-a-kind production facility,” remarked Strimling, CEO of CleanFiber. “The process was costlier and more time-consuming than anticipated, which is quite common in such endeavors.”
Every startup inherently carries a degree of risk. Early-stage ventures often grapple with uncertainties surrounding technology feasibility and market reception. Yet, investors are generally more accepting of these risks, recognizing the inherent gamble but also the relatively modest investment required to launch a fledgling company. However, as startups mature, particularly those dealing with physical products rather than digital ones, the dynamics shift.
“There’s still considerable reluctance towards investing in hardware, hard tech, and infrastructure,” noted Matt Rogers, co-founder of Nest and Mill. This sentiment is amplified in the climate startup sector, which predominantly comprises hardware-focused companies. The intermediary stages of growth pose significant challenges, requiring substantial capital and navigating complex operational processes.
“Solving climate issues requires more than just software as a service (SaaS),” Rogers emphasized. The intersection of finance and climate change has become a focal point of discussion, particularly as a surge of startups aims to revolutionize sectors like home electrification, industrial pollution reduction, and carbon removal from the atmosphere. However, as these ventures transition from conceptualization to commercialization, they encounter significant challenges in securing the necessary funding to implement their first large-scale projects.
Navigating this transition proves immensely challenging, as noted by Lara Pierpoint, managing director of Trellis Climate at Prime Coalition. The existing venture capital (VC) framework and institutional infrastructure investment models are ill-equipped to address the unique risks associated with these ventures.
Referred to as the “first-of-a-kind” problem or the “missing middle,” this issue highlights the substantial gap between early-stage venture funding and infrastructure investment. However, these terms fail to capture the gravity of the situation. Ashwin Shashindranath, a partner at Energy Impact Partners, aptly describes it as “the commercial valley of death.”
Sean Sandbach, principal at Spring Lane Capital, offers a more straightforward assessment, deeming it “the single greatest threat to climate companies.” This succinctly underscores the magnitude of the challenge facing climate-focused startups as they navigate the transition from concept to commercial reality.
Financing hardware is hard
The “valley of death” phenomenon isn’t exclusive to climate tech companies, but it presents a particularly formidable obstacle for those dedicated to decarbonizing industries or buildings. As Matt Rogers pointed out, ventures involved in hardware or infrastructure face distinct capital requirements compared to software-based startups.
To illustrate this point, let’s consider two hypothetical climate tech companies: one is a SaaS startup generating revenue, having recently secured a $2 million funding round and seeking an additional $5 million. Abe Yokell, co-founder and managing partner at Congruent Ventures, notes that this scenario is appealing to traditional venture firms.
In contrast, imagine a deep tech company without revenue, aiming to raise a substantial $50 million Series B to fund a pioneering project. Yokell acknowledges that this narrative is considerably more challenging to sell.
Consequently, a significant portion of the effort for investors like Yokell is dedicated to supporting portfolio companies in securing the next stage of capital. However, the process is arduous, often requiring outreach to hundreds of potential investors to bridge the funding gap.
The difficulty in raising funds extends beyond just the dollar amounts involved. Part of the issue lies in the evolution of startup financing over the years. While venture capitalists historically tackled hardware challenges, the current landscape predominantly favors digital innovation.
Saloni Multani, co-head of venture and growth at Galvanize Climate Solutions, highlights this shift, stating that our economic capital stack was primarily designed to support digital innovation rather than hardware advancements. This mismatch exacerbates the challenges faced by startups focusing on hardware or infrastructure solutions.
How startups die in the middle
The “commercial valley of death” has claimed its share of casualties, illustrating the challenges faced by startups in transitioning from concept to commercial viability. A decade ago, battery manufacturer A123 Systems expended considerable effort to establish its own factories and supply chain, only to be sold at a fraction of its value to a Chinese auto parts company.
More recently, Sunfolding, specializing in actuators for solar panel tracking, ceased operations in December due to manufacturing obstacles. Similarly, electric bus manufacturer Proterra filed for bankruptcy in August, partly due to unprofitable contracts that led to higher-than-anticipated costs.
Proterra’s situation was further complicated by its expansion into additional business lines, including battery systems for heavy-duty vehicles and charging infrastructure. This tendency to diversify prematurely is a common pitfall among startups, as noted by Adam Sharkawy, co-founder and managing partner at Material Impact.
“As they experience early success, startups often seek to expand their ecosystem and pave the path for scalability,” Sharkawy explained. “However, they may lose sight of their core value proposition, neglecting essential execution priorities before attempting to scale other aspects of their business.” This can ultimately undermine their ability to achieve sustained growth and success.
Finding talent to bridge the gap
Navigating the complexities of prioritization is a crucial aspect of startup management. While maintaining focus is essential, determining what to prioritize and when often requires firsthand experience, which is frequently lacking in early-stage ventures.
Recognizing this gap, many investors are advising startups to onboard professionals with expertise in manufacturing, construction, and project management earlier in their development journey. Mario Fernandez, head of Breakthrough Energy Catalyst, emphasizes the importance of hiring key roles such as project managers, engineering leads, and construction heads at an early stage.
Addressing this “team gap” is a priority for investors like Ashwin Shashindranath, a partner at Energy Impact Partners (EIP). He highlights that most startups lack experience in executing large-scale projects, necessitating strategic hiring to fill critical skill gaps.
However, even with the right team in place, the viability of a startup ultimately hinges on its financial sustainability. Investors must be prepared to allocate sufficient resources or explore alternative funding avenues to ensure the company’s continued operation and growth.
Money matters
One approach that many investment firms pursue is writing larger checks and establishing opportunity or continuity funds specifically earmarked for the most promising portfolio companies. These funds provide startups with the financial resources needed to navigate the challenging “valley of death” period. Not only does this strategy bolster startups’ war chests, but it also enhances their credibility with debt financiers, opening doors to additional sources of capital.
For startups involved in building manufacturing facilities, asset-backed equipment loans offer another avenue of financial support. Tom Chi, founding partner at At One Ventures, highlights the option to sell equipment back at 70% of its value in the worst-case scenario, mitigating debt exposure.
However, for ventures operating at the cutting edge, such as fusion startups, conventional financing strategies may fall short. Some projects require significant upfront investment before generating substantial revenue, presenting a barrier for many investors.
Francis O’Sullivan, managing director at S2G Ventures, explains that early-stage investors face challenges in supporting hardware-focused climate tech startups due to fund size limitations and the difficulty of achieving traditional venture-like returns. He suggests that a more realistic return expectation of 2x to 3x may be appropriate for these ventures, facilitating follow-on investment from growth equity funds and eventually infrastructure investors.
Despite the potential for collaboration, O’Sullivan notes that investors often lack incentives to work together, hindering the development of cohesive funding strategies. Additionally, there’s a scarcity of climate-focused venture capital firms equipped to provide funding during the middle stages of startup growth, as Abe Yokell points out. He emphasizes the importance of traditional venture firms stepping in, although recent market challenges have impacted their willingness to invest.
Bringing in more capital
One reason traditional venture firms have been hesitant to engage with climate tech investments is a lack of understanding regarding the associated risks.
Shomik Dutta, co-founder and managing partner of Overture, highlights the nuanced nature of risk in hardware investments. Some ventures may appear to have technology risk but are actually relatively low-risk opportunities, presenting a significant opportunity for investment differentiation.
Spring Lane, which recently invested in CleanFiber, has adopted a hybrid approach blending elements of venture capital and private equity. The firm conducts rigorous due diligence comparable to large infrastructure funds, ensuring that startups have navigated scientific and technical challenges effectively. Following investment, Spring Lane provides support through a combination of equity and debt, leveraging a team of experts to assist portfolio companies in scaling up.
Prime Coalition, led by Lara Pierpoint, advocates for catalytic capital, which encompasses various sources such as government grants and philanthropic funds. This approach helps absorb risks that traditional investors may be reluctant to bear. Over time, as investors gain a deeper understanding of middle-stage climate tech investing, they may become more comfortable taking on these risks independently.
Saloni Multani emphasizes the importance of broadening investors’ knowledge base, noting that generalist firms’ interest in climate tech signifies a growing appreciation of the sector’s potential.
Regardless of the approach, addressing climate challenges through technology is imperative. With global efforts aimed at eliminating carbon pollution within the next 25 years, the urgency is clear. However, achieving this goal requires significant investment, especially considering the time and resources required to build new factories.
Despite the challenges, success stories like CleanFiber demonstrate the potential impact of innovative solutions. As Jonathan Strimling reflects on CleanFiber’s journey, he acknowledges the unexpected obstacles encountered along the way, including the impact of the COVID-19 pandemic.
Looking ahead, optimism persists among investors, driven by the recognition that the future must diverge from the past to address pressing climate concerns.