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Show Them the Money: Why Restructuring US Investing Mechanisms Is a Necessity for Clean Technology Innovation

11/10/2010 03:07 pm ET | Updated May 25, 2011

Two things all entrepreneurs will agree with: Capital is good and more capital is better. Healthy levels of capital have been critical for enabling the biotech and digital revolutions in the US. The clean technology (cleantech) innovation system is different. It also consumes capital differently. The US significantly risks missing out on critical opportunities (primarily to China) if the special needs of cleantech are not recognized by institutions that have traditionally funded innovation.

In the US, these are the 5 financing mechanisms that have historically funded innovation:

Profit-seeking capital sources:

1. Venture Capital Funds & Angels
2. Corporations

Goals-focused capital sources:

3. Governments

4. Foundations

5. Universities

These 5 mechanisms have evolved practices and systems through which to assess, evaluate, and invest in innovative initiatives based on their experience with biotech and digital technologies. These practices now need to adapt to enable clean technologies. The critical differences between cleantech, biotech, and digital technologies are outlined below. These differences need to be taken into account as these 5 mechanisms adapt to the needs of the cleantech industry.

Time to market for clean technologies is longer. Companies like Facebook or Google could open their portals to the public in months if not weeks. In contrast, as Navin Chaddha (Mayfield Fund) recently stated at VentureBeat's GreenBeat conference, "[Cleantech] is a marathon. This is not a sprint." The time it takes to develop a clean technology, refine it, and bring it to market is significantly longer than digital technologies for most sectors within cleantech. VCs and angels, who typically like to invest in companies with a viable exit strategy spanning 3-5 years, find longer time horizons discomforting.

Externalities, though valuable, don't generate returns. Unless cleantech companies are able to translate their large positive externalities into positive returns, they will remain unattractive for profit-seeking capital sources. VCs and corporations are legally mandated to maximize returns for their investors and shareholders respectively. Neither biotech nor digital technologies were externality-focused to the extent cleantech is (see graph).

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For the first time we are faced with a necessary innovation need which generates much of its value in the form of externalities. There needs to be a way for investors to realize returns based on these externalities, and market mechanisms and regulations need to be crafted to achieve this.

Cleantech companies need a lot of money to make money. To manufacture photovoltaic cells, setup wind farms or install geothermal equipment, takes a significant amount of capital. Further, marginal costs remain significant even as these installations scale. In sharp contrast, once Genentech made a drug, to replicate it for thousands of patients is relatively cheap. Once Amazon.com had established its platform, to load in new SKUs and start to sell them was relatively straightforward. This difference in scalability combined with the capital intensity of cleantech businesses (with exceptions such as EnerNOC) makes these ventures unattractive to VCs and angels.

No student discounts for cleantech entrepreneurs. Cleantech substitutes in exact shapes and forms what consumers have already. Wind farms, for example, will generate the exact same electricity flowing through the same plugs in our houses that coal currently generates. In comparison, when Hotmail launched, it was fundamentally new and offered advantages that far exceeded mere substitution of snail mail. Hence came widespread consumer adoption. Further, the Pentium could evolve from the 286 machine because consumers were willing to buy 286, 386, and 486 processors and help Intel scale up, learn, and lower costs of manufacturing these chips. This was like a "student discount" for Intel - as consumers were paying for Intel to learn. This consumer-based assistance is not going to be available for cleantech - as these products are mere substitutes as opposed to the 286 which offered something fundamentally new that customers were willing to pay for.

Deeper into the madding crowd. Today VCs, angels and corporations have the possibility of investing in businesses in India, Israel, and China and continued innovations in biotech and digital technologies. The landscape for raising capital is much more competitive than it was just 10 years ago and cleantech is a relatively newer and riskier asset class for most investment firms - making it very competitive for cleantech entrepreneurs to raise money. Entrepreneurs in biotech and digital technologies faced lesser competition when these sectors were emerging 10-20 years ago.

So, what's the solution? Basically, there's a China model where the government is pouring money where it deems fit. That model is just not a good fit for the fundamentals of how innovation works in the US. What you really want is a regulatory framework that encourages and incentivizes profit-seeking capital to flow into cleantech. This could take the form of targets and quotas for corporations and VCs to allocate funds to clean technology ventures, or tax breaks and subsidies for investments made in clean technologies by such funds and companies. What one must also try and avoid is a scenario in which the government allocates capital and picks winners. Whichever form the solution takes, it is clear that the 5 existing mechanisms for financing innovation in the US need substantial prodding to take on the challenges that face cleantech innovation. In the absence of such adjustments, a country such as China, that is able to orchestrate a large quantum of financial resources from a central autocratic regime, might gain an unmatched edge in this critical industry.

Dinkar Jain holds a Bachelors in Computer Science Engineering from University of Michigan, Ann Arbor and an MBA from Harvard Business School.