Bridging the Valley of Death

June / July 2004 By: Lawrence Murphy and Peter Edwards Volume 2 Number 3

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Technology innovation has been strongly stimulated by federal financing for more than 50 years. In fact, public investment often guides or directs private sector investment to areas of the public good—€”such as clean energy technologies.
The Department of Energy, along with its National Renewable Energy Laboratory (NREL), have made remarkable technological advancements, efficiency improvements and cost reductions in a spectrum of clean energy technologies, with the expectation that industry would move emerging technologies into the marketplace and that the resulting public benefits of energy diversity, security and environmental protection would also accrue.

These achievements notwithstanding, the new generation of clean energy entrepreneurial firms is finding it very difficult to make the leap from public sector financing to private sector funding for their innovations. Without new capital, many of our nation's most promising energy entrepreneurs will fail.
According to a recent study by Gompers and Lerner, "—€¦. 90 percent of new entrepreneurial ventures that don't attract venture capital will fail within the first three years." In reality, ventures fail to obtain funding because there are significant gaps between what the ventures are offering to investors and what the potential investors are seeking.

Clean energy entrepreneurs are regularly in a position where they must simultaneously satisfy divergent criteria, goals and values of the public and private sectors to obtain financing. It is extremely difficult to conduct high-risk early stage research to satisfy the public sector, while simultaneously prioritizing market and product development to obtain private sector financing. Neither group believes it is within their purview to finance the transition stage of commercialization. This presents a significant challenge.

For their part, DOE and NREL are often constrained, by public policy and legal mandates, to treat commercialization as the responsibility of the private sector. Rather, the public sector sees its role as funding high-risk, long-term research and occasionally funding cost-shared demonstration projects. They hope that the private sector will exercise its option to further invest in entrepreneurial ventures based on these technologies.

Private sector investors, on the other hand, must pursue return on investments and profits for the companies in which they invest. Private sector profits result from developing effective businesses with market driven products and robust markets and not just technology.

These two groups have only a vague understanding of what drives each other—€”thus creating a chasm between the two worlds and a formidable gulf that entrepreneurs must navigate. Particularly striking is the need for entrepreneurial firms to evolve from a technology focus to a market and customer focus, which is primarily due to the requirement that the private sector make a profit. The public sector does not have this requirement. Thus, it is not surprising that many promising entrepreneurial firms that have had significant public sector technology investments are unable to raise private sector capital.

The Cash Flow Valley Of Death

While the values and goals of the financiers are one piece of the equation, it is equally important to analyze what is happening to the entrepreneur's cash flow during this transition from public to private sector financing. Getting a venture to the position where it is successful and can produce a commercial product is an arduous task usually requiring a trek through the "cash flow valley of death." Here entrepreneurs face the dangerous convergence of high cash demands and low ability to raise it. The "cash flow valley of death" and the corresponding financing context is illustrated schematically in the table (previous page), where we have plotted normalized cash flow, and the normalized risk related discount rate for a typical entrepreneurial energy venture, versus time, along with typical investors for each corresponding stage.

Focusing first on the cash flow curve, note three broad stages of development where investment is needed to keep the venture solvent: 1) the technology creation stage where the public sector focuses its investment, 2) the cash flow valley of death where there is typically a dearth of funding, and 3) the early commercialization stage —€“ typically the earliest point at which private sector investors like to invest. Venture capitalists typically prefer to finance the venture when solid initial sales have been established.

Moreover, the availability of public sector funds decreases abruptly after the technology is created because the public sector views subsequent investment as the purview of the private sector. This drop-off of public investment occurs at the same time that the investment needs of the venture are actually growing. Hence, the entrepreneurial venture must often turn to equity financing for at least part of the resources needed. Further, adequate levels of angel and seed investor resources are often not available as a precursor to venture capital, especially for high technology. This is why we call the region between the technology creation stage and the early commercialization stage the cash flow valley of death.

Private Sector Risk Perspectives

The public sector contributes significantly to the reduction of technical risks through its investments, and the private sector highly values the technology certification value that these early investments provide. However, there are numerous other risks. And while clean energy investments can be very profitable, they are still perceived as high-risk, large-dollar investments by much of the investment community. The amount of money needed and the time to recover those resources are especially large relative to other technical investments. These differences and higher risks occur because of:

—€ Information asymmetries resulting from an entrepreneur knowing more about his technology and his company's prospects than investors or strategic partners
—€ Lack of real products. The need to transform the new technology into market driven, market ready products and "whole product" solutions
—€ The markets for these technologies are often immature and need to be developed
—€ Multiple and costly prototypes are often necessary for initial markets
—€ Energy is generally perceived as a commodity market with low margins and high volatility
—€ Emerging energy companies often have management teams heavily weighted with researchers and very little business experience —€“ increasing the private sector's perception of risk

While the biggest of these perceived risks is usually information gaps or asymmetries, most risks are interrelated, and we can correlate the overall risk profile with the development stage of the business. Venture investors typically discount the value of a business to compensate for the inherent risks they perceive. This is illustrated in the table where a typical risk adjusted discount curve is shown. Hence it is seen why private sector investors typically want to invest only after most risks are reduced to acceptable levels.

By better understanding the nature of these risks, there is much one can do to position public sector investments such that the private sector is more inclined to exercise its option to invest.

By examining the entrepreneur's funding situation several common themes emerge.
There are powerful tools, which the public and private sectors can exploit to close the gap between the two investment sectors to accelerate the commercialization process. We propose three strategies and tools for fostering more effective public and private co-investment:

—€ Reducing information gaps or asymmetries between the two sectors by providing appropriate access to data, knowledge, and insights critical to making sound investments by both sectors
—€ Fostering an accelerated shift from a technology focus to a market focus
—€ Exploring and developing novel co-investment partnerships with the private sector to help address significant funding gaps. This may include experimenting with approaches such as those already underway with the U.S. intelligence and defense communities.

Building the Needed Bridges

DOE and NREL have already embarked down this road through NREL's Enterprise Development Programs, which act as catalysts in bridging these gaps by fostering linkages and partnerships between investors, entrerpeneurs and other key players in the commercialization process. These partnerships can help reduce risk to further investment, while speeding up the the commercialization process and increasing the yield on DOE/NREL investments. These programs are relatively early in their development, but the corresponding linkages and partnerships are already expanding rapidly. The four key elements of this program are:

—€ NREL Industry Growth "Venture" Forums—€”Learning intensive venture investment forums that provide clean energy entrepreneurs opportunities to present their business cases to an expert panel of investors and energy executives
—€ The National Alliance of Clean Energy Business Incubators—€”An alliance of the nation's top incubators committed to incubating and providing business services to clean energy entrepreneurs
—€ The Clean Energy Network & Investor Directory—€” A directory containing contact and profile information for more than 90 investors that are currently interested in making quality clean energy investments
—€ NREL Growth Link—€”A web-based market place for linking clean energy companies with other strategic financing partners

Lawrence Murphy is manager of enterprise development programs at the National Renewable Energy Laboratory. Peter Edwards is a partner at Altira Group, a venture capital firm in Denver. This article was adapted from Murphy and Edwards's report, Bridging the Valley of Death: Transitioning from Public to Private Sector Financing. NREL/MP-720-34036. NREL, 2003.