In recent years, climate tech has been top of mind for almost all industry players across the real estate ecosystem. That attention combined with an unprecedented period of low interest rates and a favorable regulatory environment led to an influx of institutional capital and startups aimed at curbing ESG problems. However, this isn’t the first time climate tech has drawn the attention of the tech community, so we think it’s important to discuss the history of climate tech and what could be expected going forward.
In the 2000s, the first wave of climate tech was known as ‘cleantech’, and startups like Aquion, SolarCity, Solyndra, Sunrun, and Tesla were founded and capitalized. Prominent firms like Kleiner Perkins raised large, dedicated pools of capital to quickly deploy into promising new startups across wind, solar, desalination, and other nascent verticals.[1] Investors were drawn to the massive, global industries that were previously untouched by technology and thought to be less competitive, overlooked, and primed for adoption.
Many investors learned quick lessons after this:
- Too many businesses turned out to be lower margin, capital intensive, less scalable services (e.g. solar installers) or hardware (e.g. membranes for desalination) businesses.
- These industries were more competitive than initially thought. US-based startups quickly attracted international copy-cats located in geographies with cheaper labor and commodity materials that put foreign companies at a cost advantage over their US counterparts, making it challenging to compete efficiently. The competition was so fierce that some fast followers even went as far as stealing IP from their American competitors.[2]
- US government regulation was in the early innings of being written, so credits, subsidies, and incentives weren’t in place yet to drive more meaningful, broader adoption.
- Few, if any, startups had reached the scale necessary to realize the cost structure benefits of economies of scale. That put increased pressure on venture capital to fund and support fledgling businesses with unit economics that hadn’t been fully baked.
Unscalable business models, highly competitive markets, undifferentiated commodity products, nascent regulatory policies, and a lack of economies of scale created a recipe for disaster for most. While many startups in the first cleantech wave were building much-needed technologies, the majority unfortunately went out of business and returns for investors never materialized.
Fast forward to today, and things have changed. Markets have matured and government incentives have evolved. Customer purchasing behaviors and economies of scale combined with newer, larger subsidy programs allow startups to grow and compete more efficiently relative to their international competitors. New regulations like Boston’s Emissions Reduction and Disclosure Ordinance will require large existing buildings to reduce their greenhouse gas emissions as soon as 2025[3], which increases demand for startup solutions. Although these industry dynamics support faster growth and lower cost structures, which has attracted a flurry of venture capital in the past few years, we recognize 1) that different sources of funding may be required to help these next-gen ESG companies scale, and 2) the best use of VC dollars is usually at the earliest stages of ESG and used to develop fledgling technologies.
While markets have matured and new regulations put incentives in place, most second-wave climate tech startups still rely on the same lower-margin, capital-intensive business models used in the first cleantech wave. Hardware is often required to bridge the gap between the physical and digital worlds. Software requires data inputs to make an impact on built-world customers, often in real-time, that is frequently produced by hardware. For example, smart temperature control and leak detection require hardware to generate real-time data that software interprets, displays, and processes to make decisions autonomously. To have an AC system or a valve turn on/off, it needs a signal that only hardware can provide.
Hardware requires working capital for manufacturing and is subject to delicate supply chains. Production is directly correlated to cash because inputs have meaningful costs, whereas software scales via 0s and 1s and along digital rails that make distribution costs essentially zero. Where hardware companies must manage cash and balance growth and profitability, software – and the scalability that VCs love – is free from these burdens. Hardware also has a useful life (call it five years) that then requires replacement, and the cycle starts over again. Hardware manufacturing therefore provides little margin for error. These intricacies can impact startup unit economics, margins, growth, and subsequent outcomes, resulting in a change in the return potential of investments in the sector, pointing to a different evolution of capital sources for a business.
VCs require returns that compress multiples meaningfully, so venture capital could be a good fit to finance the development of software that interprets, displays, and processes data generated from hardware. The manufacturing of hardware on the other hand can and should probably be financed with working capital lines. This separates equity use of proceeds to more scalable software and debt use of proceeds to more capital-intensive hardware. After initial software and hardware have been financed, PE could be used to generate cash flow assuming the right operational and capitalization strategy.
As discussed in our 2024 PropTech Trends, punitive (although needed!) regulations combined with an increasingly challenging operating environment are putting owners and managers between a rock and a hard place. Owners and managers who are frequent purchasers of many climate technologies are experiencing lower rents, more vacancies, and higher delinquencies which are putting strain on technology budgets. Every dollar spent is being heavily scrutinized by finance teams as firms fight for survival. If an ESG company requires meaningful upfront cash and/or doesn’t clear ROI hurdles by a healthy margin, we’re observing owners foregoing these investments as they stem the bleeding elsewhere. Higher interest rates to finance hardware development and/or purchases aren’t helping either. This is what may have contributed to three large institutional investors (JP Morgan, BlackRock, and State Street) recently pulling back from the space.[4]
Hardware and hybrid (hardware + software) startups can still be great companies and are critical to fight climate change. They just need to be operated, capitalized, and valued appropriately. Some climate tech companies such as Icon[5] and TurnTide[6] quickly reached unicorn status by being valued as higher margin, more scalable software companies but could be facing steep valuation overhangs. Their modular housing products and electrification components are needed and innovative, but they could very likely have outcomes commensurate with lower margin, more capital-intensive hardware, and value-added services models. Although climate change is a timely problem that’s impacting massive markets, it is critical to match appropriate capital with the right models, use cases, and outcomes to ensure success.
Disclaimer:
This content is provided for informational purposes only, and should not be relied upon as legal, business, investment, or tax advice. You should consult your own advisers as to those matters. References to any securities or digital assets are for illustrative purposes only, and do not constitute an investment recommendation or offer to provide investment advisory services. Furthermore, this content is not directed at nor intended for use by any investors or prospective investors, and may not under any circumstances be relied upon when making a decision to invest in any fund managed by Nine Four Ventures. All views expressed herein are the opinions of Nine Four Ventures employees and are not the views of our affiliates or investors.
[1] TechCrunch: Kleiner Perkins Goes Green With $1.2 Billion In Two New Funds, May 2008
[2] CNN: Chinese wind turbine firm found guilty of stealing U.S. secrets, January 2008
[3] City of Boston: Building Emissions Reduction and Disclosure, December 2024
[4] WSJ: An ESG Asset Manager Exodus, February 2024.
[5] 3DPrint.com: Construction 3D Printing Startup ICON Lays Off 20% of Staff, January 23, 2023.
[6] Business Insider: Bill Gates-backed climate startup Turntide laid off almost 20% of staff a month after raising $80 million, Jul 28 2022.
