Robert W. Shaw JR. IS A BETTING MAN. Shaw's Aretê Corp. venture capital fund has invested $100 million in energy technology. This year the Center Harbor, N.H., fund set aside $30 million to invest in micro-generation technologies. Already the fund has pumped hundreds of thousands of dollars into more than a half-dozen companies trying to develop microturbines, fuel cells and other promising small-scale generation.
"This is a hot corner," Shaw says.
Shaw bucks naysayers like Ralph Selvig of VentureOne Corp., a San Francisco firm that tracks the venture capital industry. Selvig insists the regulation-intensive utility environment simply doesn't draw investors.
"Realize [that] we had almost $6 billion get invested in the first half [of 1998], in venture-backed deals," Selvig says. "All industries, all stages, all regions of the U.S. And that's by venture firms managing a minimum of $25 million and up. The fact is, you've got 657 venture firms out there and you can count, probably on one hand, the guys that are doing the utilities' deals."
But those developing distributed power applications and the venture capitalists who believe in them point out that most of the business plans they're financing fall outside regulated power.
In fact, that's exactly what's creating opportunity for energy's subset of small generation systems - photovoltaics, microturbines and fuel cells, to name a few technologies. Furthermore, it's the utilities, from the U.S. and Europe, who are backing the venture capital firms. Utilities like Cinergy Corp., PacificCorp and Electricité de France.
To put the venture capital industry's new interest in small-scale power in perspective, one needs to look at what's happening with central station fossil and nuclear plants. Today, those plants supply 87 percent of the electricity used in the United States. Fuel cells and microturbines promise to play a greater role, helped by a growing track record of overseas installations where there are few central plants and many remote villages in need of power. Some 70 percent of the products and equipment produced in the U.S. for "off grid" power generation is exported for use in foreign countries. Experts predict 20 percent or more of all new generating capacity built in the U.S. over the next 10 to 12 years could be for distributed applications, representing a potential market of several tens of gigawatts.
However rosy the picture is painted by true believers, the reality is that Selvig is right: Maybe a handful of VC firms are investing solely in energy technology. A few more have moved outside their high-tech specialties to fund promising energy technology.
Not Quite the Right Time?
"It's changing," says Nancy Floyd, a principal in Nth Power Technologies Inc., which manages a $55-million fund in San Francisco. "You do have an increasing number of funds that are specifically focused on energy and I'd say environmental technologies because many of these energy technologies have environmental benefits." Floyd adds that most of Nth Power's investments in energy have been co-investments with top-tier, traditional VC firms, "people who are very interested in investing ¼ but only want to invest with somebody who's smart in this area."
Floyd pegs venture capital investment in energy at about $50 million annually.
But according to Venture Economics Information Services, a research firm that has tracked venture capital and the private equity industry for 35 years, alternative energy sources - including solar, photovoltaic, wind and nuclear - have received spotty VC funding since 1980 (see Figure 1). Over 17 years, 37 companies received $73.2 million in funding.
Floyd likes to point out that prior to AT&T's divestiture, almost nothing was invested in communications technology. Yet just years after divestiture, telecom drew $800 million in venture capital (see Figure 2).
"We think the same thing is going to happen in energy," she says.
Much can be learned about what's happening with distributed power and venture capital by speaking to executives at VC firms and startups. Many roads lead to Shaw's backyard. In fact, he sits on the boards of companies he funds, as a director, chairman, or even, in the case of Northern Power Systems Inc., as full owner - the result of a debt-for-equities swap.
From most venture capitalists' perspective, however, there's a shortage of solid ideas and top-notch managerial talent. In some cases, hurting the startups' chances is the fact that "leading" distributed power companies aren't meeting their growth targets.
On the flip side, the companies say VCs are followers who don't dare invest without industry-wise partners.
Jito Coleman, president of Northern Power Systems of Waitsfield, Vt., says from looking at business plans and from talking to venture capitalists, several companies are behind on their schedules - companies such as AlliedSignal Inc. and Capstone Turbine Corp.
"In distributed generation itself, the venture guys have been burnt a number of times because things have not matured on the pace and the plan they thought they would," he says. "AlliedSignal is behind. Capstone is behind ¼ behind on the projections they made to the investors, to say, 'Here's what's going to happen: We're going to do this, this and this and you're going to get your money back.'
"So a lot of the investors are a little disappointed in how those technology-driven solutions have made it in the marketplace. Whether it's the market that isn't ready or it's the equipment that isn't ready, it doesn't really matter."
Growth targets are crucial to VCs. They typically require an increase in equity over three to five years of 10 times or more by the time the startup goes public.
Lance W. Schneier of Capital Technology Group LLC of Dublin, Ohio, makes another crucial point: Distributed power's use is either for self generation or reliability. If it's to lower costs, it's a tough sell. The efficiencies of microturbines have yet to be lowered to where the investment is recouped through operation. If the technology is offered as a cut-the-wires solution, it has to be reliable and redundant, and it often fails on those counts as well, Schneier says.
"From the market point of view, it's an idea whose time may not have yet come," he says. "They don't seem to have a unit yet that they're confident in ¼ and that sort of raises the specter - at least on the microturbine side - whether they've gotten enough bugs out of it to merit its application and drive the cost down.
"We've looked at distributed generation and we've put it on the back burner for now. Overall, as a technology."
But the skepticism of some won't stop others from investing.
David F. Lincoln, managing director at EnerTech Capital Partners LP, a Wayne, Pa., VC, says it invested $1.5 million in Capstone Turbine, of Tarzana, Calif., in hopes of getting microturbines' price down to $350 per kilowatt, installed, with less than a 6-cent-per-kWh generating cost. (By way of comparison, reciprocating engine generator sets now cost more than $400 per kW installed, with per kWh costs as high as 15 cents.)
Looking for Something to Value
Lincoln says that what may be hurting distributed generation companies on the venture capital side is the fact that their valuations are high, due to their capital-intensive nature. VCs like to own a good chunk of the company they're investing in, and high valuations prevent that.
Lincoln's fund is worth about $50 million and it's raising $150 million.
He says once companies have met rigorous review of their technology and management team, his fund wants to be sure the market the company targets is sizeable. "We, ideally, are looking at investing in companies that we believe can be $100 million in sales or better." And that's a seven-year goal.
Besides its Capstone Turbine investment, Shaw has put money into Evergreen Solar Inc. of Waltham, Mass., and Proton Energy Systems Inc. of Rocky Hill, Conn. Shaw says he knows of no fund other than his own Micro-Generation Technology Fund that invests solely in distributed technology.
One of Aretê's success stories is Ballard Power Systems Inc., which started as a six-person operation. Now valued in the billions, it manufactures fuel cells that use a proton exchange membrane technology. When it went public, shares sold for $10 apiece, until they split. In August, Ballard stock was trading at $70 per share. The same month, Capstone was on the threshold of an IPO. (What effect the Aug. 31 stock market plunge had on the company's direction was uncertain.)
Aretê has almost 70 deals, and six funds.
Shaw says the reason his fund has been successful is because it has always stuck to demanding standards. Potential for high growth is what makes a good deal, but there also has to "be a sustainable competitive advantage. Either a technology or market presence, expertise. Something that somebody would place value on. And good management. The most important thing is the good management."
He says the small-scale generation units hold the most opportunity because they can be mass produced and sold like an appliance. "The price will go down and down and down and central station generation will never be able to compete in the long run," Shaw says.
He says if the utilities disclosed the true, delivered cost of power - 30 cents per kWh recently in the Washington, D.C., area, for example - distributed power rates would look more attractive. "If the true price signal was being sent by PEPCO, then photovoltaics would get very interesting for people in the 703 and 301 area code," he says.
What could be one of Shaw's most potent investments is Evergreen Solar Inc. of Waltham, Mass. The company makes photovoltaic modules, the heart of solar electric systems. The company's String Ribbon manufacturing process produces twice as many solar cells per pound of silicon as conventional manufacturing methods, says Richard G. Chleboski, one of the company's three co-founders. It's a technology that promises a 25-percent cost advantage over leading crystalline silicon competitors.
The company was started in the fall of 1994 with $500,000 in funding from Shaw. It also received $500,000 from Zero Stage Capital, a small business investment company. Other investors followed, including Calvert Social Investments and Rockefeller and Co. So far the company has raised more than $13 million in venture capital dollars in three rounds of financing. Other investors include Solstice Capital and Venture Investment Management Co.
Evergreen is now in "pilot scale" manufacturing. This follows its April 1997 shipment of a set of solar panels to a rural Bolivian village. The panels provide power for the first time to 130 families, enough for each home to operate two light bulbs and a radio. The company will bring in $500,000 in product revenue this year. It employs 40.
Luring Investors Into the Fray
Chleboski says that convincing investors to believe in PV technology can prove challenging. But if costs can be reduced, the size of the market is in the billions of dollars a year - and that is enticing for investors.
"Getting the first investor is key," he says. "PV as a whole doesn't have a great reputation. It's known as the place where oil companies lose a lot of money and then eventually get out of the business."
Fortunately for Evergreen, it won a first investor's attention. "After getting Bob Shaw, it sort of opened up doors to have us be able to present to other venture capital companies," Chleboski says. "You never know you're going to get the money until you actually have it. Each round, getting the first guy to say 'yes' is always challenging."
Chleboski advises startups to "make sure you have a reasonable market project, market plan, and if there is a way to establish a market outside the utility business, then I would recommend doing it.
"The basic sort of rub on utilities is they're conservative. They're slow to change, as a whole - that's not true of all utilities ¼ if you can come in with a new technology in a different area, then you have a chance of being successful with the venture community."
Proton Energy Systems may fit the description of technology applied to a new area. The company hopes to offer industrial gas companies and utilities a water electrolyzer, the HOGENTM. The product uses electricity to separate water into hydrogen and oxygen gas. Walter "Chip" Shroeder, CEO, calls it "hydrogen by wire." HOGEN uses cheap off-peak electricity to make hydrogen. In development is the UNIGENTM, which will then use the hydrogen for a fuel cell that will generate power to be sold back onto the grid at on-peak prices.
Electrolysis isn't a new technology, having been used in military and aerospace applications for 30 years.
Schroeder joined Proton Energy from AES Corp. His four co-founders had come from United Technologies Corp. Soon after the CEO's arrival, the company received $500,000 from Aretê and $200,000 from AES. Then, the business operated as a paper company for about eight months trying to attract other VCs.
"We learned there are a lot of people who claim to be in the venture capital business and who are not," says Schroeder of the company's early days. "There are mostly followers in the business. There are mostly people who - they wait for the first round. They're the last stage [of funding] before the IPO."
"One of the things that separated us from the pack," he says, "is most of the alternative energy companies ¼ are hurt by the falling prices of oil and electricity. We are actually helped, in the near-term plan, because we use electricity."
He notes that the microturbine market suffers from the low electricity prices caused by the marketer-pushed deregulation movement. "And it is really undermining some of the market potential of distributed technology, for good economic reasons."
In the near term, Proton Energy hopes to sell its electrolyzer products to industrial gas companies, to help lower their costs, which again, is difficult because no venture capitalist has invested in the industrial gas business, Schroeder says. Hydrogen by wire, rather than by truck, however, is an intriguing concept to industrial gas companies as a way of lowering their business costs.
Proton Energy is in its third round of funding, having raised about $7.5 million over three rounds. Investors include Solstice Capital and Connecticut Innovations.
Although the company is a full-scale manufacturer, it is testing its hardware and won't log revenues until 1999. It is discussing with industrial gas companies to sell through them, not take away their customers. The electrolyzer product, which uses 50 kilowatts, sells for about $200,000 and is expected to be sold for half that in two years. "These are going to be appliances," Schroeder says. "When you look at them, two or three years from now, that's what they're going to look like, very standardized, compact, solid state, very simple devices."
The electrolyzer-fuel cell unit that operates on 50 kW or 30 kW to make hydrogen and produce electricity might cost about $300,000, Schroeder says.
"Let's say it takes $300,000 to make 30 kW," he says. "That's $1,000 a kW. That's interesting. That's not spectacular. That's installed. It costs almost nothing to operate. And all you need to do is give us potable water."
It's the kind of thinking that's luring investors like Shaw and Floyd.
And it may be the kind of thinking that catapults energy to the forefront of private investors' portfolios.
Joseph F. Schuler Jr. is senior associate editor of Public Utilities Fortnightly.
1 See Taylor Moore, "Emerging Markets for Distributed Resources," EPRI Journal, March/April 1998 .
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