Climate Tech Is Not A Sector (it's a goal)
It's pretty hard to raise money for a venture fund in choppy economic times… unless you want to invest in Climate Tech where you can still close large “continuity funds” and VCs are tripping over each other to sign on to a $60B Climate Tech alliance.
The problem is, most of these funds are pitching and approaching Climate Tech as if it's a sector but it's not. So taking a sector fund strategy and using sector fund is just not going to work the way they expect it to. Fortunately there is a better model to work off of.
Who The Hell Are You Anyway?
I get it. There are a lot of so-called experts spewing out advice of questionable value. Here's where I'm coming from so you can consider the source.
I founded two companies and have been investing in early stage startups for 15 years. I started as an angel before taking over Dreamit’s NYC based program. At the time, Dreamit was the archetypical, pre-seed, generalist accelerator. In 2016 Dreamit made the strategic decision to go after later stage, post revenue, pre series A startups and to specialize exclusively by vertical. I built the Edtech vertical from scratch and came up with the new accelerator model to service these later stage startups. A little over a year later, I then built the Urbantech (proptech and construction tech) vertical. Right now, I'm a strategic advisor to, and Head of REACH Labs for, Second Century Ventures, a fund that invests in Realtor focused technology. So I am keenly familiar with the pros and cons of both generalist and sector specific investing.
OK Genius, So What's So Great About Sector Focused Investing?
As a generalist, I got to experience a near endless variety of ventures but I struggled with two things: assessing product market fit and the competitive space. I would often meet what I thought were very interesting startups only to find during due diligence that their potential customers did not value the solution or that there were several other startups that were far ahead. At best I wasted a lot of time; at worst I made bad investments.
As a specialist, I have a strong instinctual feel for what the end customers need and a solid understanding of the competitive landscape. I can often tell before the elevator pitch is done whether I want to dig into or pass on a particular startup. Furthermore, I have both deep and broad ties to potential customers and I can deliver a lot of value to my portfolio companies, making me a much more desired addition to their cap table than I was as a generalist running a cohort of 12 startups in 12 entirely unrelated industries.
So Why is Climate Tech not a Sector?
"He spent 10 years in commercial banking before getting into venture" is (arguably) a good pedigree for a fintech VC. "He spent 10 years in climate" makes no sense. What we think of as Climate Tech is actually parts of several industries like energy, mobility, agtech, fintech, etc etc. It's probably not too much of a stretch to say that there is not a single industry in which you cannot find startups that meet a Climate Tech mandate.
So would-be Climate Tech VCs don't get any of the usual benefits that they would get from a sector focused strategy. At best they can be strongly connected to just one or two industries with that gut level instinct for what the customer wants and the up-to-the-moment understanding of the competitive landscape. While they no doubt will know a few potential customers in any industry, they simply don't have the depth of network to call on that a true sector specialist has.
In other words, they look a lot like a generalist fund in that respect.
Exception: a few funds with a very deep tech focus in emergent technologies (e.g., carbon capture, new materials, production processes) are specialized enough to potentially qualify as a sector focus. But deep tech can be incredibly capital intensive and there are not a lot of funds willing to write a $50M check into a seed round.
So if Climate Tech is not a Sector, What is it?
I'll give you a hint: these funds talk a lot about having a positive impact on the environment. That's right. Climate Tech funds are essentially social impact funds aimed at environmental goals.
While running Dreamit Edtech (and while helping out with Dreamit Health), I worked with a fair number of social impact funds and they talked a lot about their goals: cutting dropout rates, increasing employability, reducing mortality rates, etc. Some went so far as to actively pitching themselves as “double bottom line” investors where improving social outcomes was as important as maximizing ROI. So I got to know a lot about what makes a social impact fund succeed or fail.
So What’s Wrong with Climate Tech as a Social Impact Fund?
Most double bottom line funds fail. Badly. Not all of them, of course, but the overwhelming majority of them. Why? Because double bottom line has an inherent flaw: there’s no explicit exchange rate between 1% of ROI and a 10% increase in math competency. And there’s no way to stack up a 10% increase in math competency against a 5% reduction in high school dropouts. Even if you can quantify the value of a life saved, how do you measure improvements in quality of life? If a Climate Tech investor has one investment left and has to choose between two roughly equally promising startups where one reduces carbon emissions by X and the other improves the resiliency of a power distribution system by Y, how does it choose?
If you cannot measure the tradeoff precisely enough to answer these questions, what happens in practice is that the investors fall in love with specific startups’ social potential and convince themselves that the returns will be ‘good enough.’ Which they rarely are. So the startup fails... ironically leaving the double bottom line investor with neither the returns nor the social benefits.
Social Impact Investing that Works (and What that Means for Climate Tech)
So how do you make social impact investing work? By using impact as a constraint rather than as a trade off; decide what the minimum measure of expected impact is for a startup to be eligible for consideration and then make the investment decision solely based on expected returns. For example, if the startup that lowers carbon emissions reduces it ‘enough’ for the fund mandate but the one that improves the resiliency of a power distribution system doesn’t make the cut, the decision is simple. If they both make the cut, the choice is made strictly on the (non-environmental) numbers.
The good news is that few of the Climate Tech funds I see claim to be double bottom line investors. Most do use their mission as a filter, not a variable to be maximized. So I don't think they will slide down this particular slippery slope.
But they are still generalists when push comes to shove.
The Best of Both Worlds
As Dreamit, we didn’t have an explicit social impact goal. Our promise to our investors was strictly financial and a Healthtech startup didn’t get a leg up on a Proptech startup regardless of how many lives might be saved. But we had a lot of impact nonetheless. Why? Because it is essentially impossible to invest in Edtech or Healthtech without having an impact.
If only that were true in Climate Tech. Well, it can be. What if you were to pick a sector to invest in where most of the startups you look at just happen to have an impact on the climate?
For example, if your fund were to focus on transportation you might come across some startups with negative climate impact. For example, I find it hard to believe that an air taxi could have a smaller carbon footprint than a ground taxi but who knows? But there overwhelming majority of your investment options would move the needle in the right direction and you could likely simply screen out the outliers without limiting your investment options meaningfully.
Construction Tech Focused Climate Tech
Transportation was an easy one but there are other, less obvious, sectors that also qualify.
Let's take construction. The oft quoted statistic is that the building sector is responsible for 39% of global CO2 emissions, 11% from materials and construction and 28% from building operations. Not coincidentally, without even focusing on it, most of the last 10 construction tech startups I invested in have meaningful direct or indirect impact on climate.
As many of you know, unlike virtually every other industry, productivity has actually declined in production over the past 70 years.
Even without investing in new materials or startups overtly targeted at reducing energy consumption or carbon output, anything that simply reduces the time it takes to build, eliminates wasted material, makes it easier to find and use greener components, simplifies procurement logistics, et. al. can have a meaningful impact on the environment. By starting as a construction tech focused fund and then adding a Y/N filter for broadly measured climate impact, you get a fund that can deliver on the impact side while still reaping the benefits of sector focus.
Other Sector-lad Climate Tech Strategies?
So how do you know if a particular sector is a good fit for Climate Tech? The calculus is actually pretty simple: how many startups are there in that sector at the stages that you want to invest times the percentage of those startups that meet your environmental threshold. It does not matter if it's a very large sector with relatively few startups that have environmental impact or a smaller sector where proportionally much more of them qualify, as long as the net number of investable startups is a 'large enough' (however you personally define that) pond for you to fish in.
Which other sectors do you think would work? Let me know in the comments below.
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