Last time, we explored how the venture capital world came to dislike hardware and prefer software. Modern technology companies with hard assets continuously face difficulty finding funding and often receive heavily discounted valuations because of increased competition for VC capital with similar-stage asset-light businesses. Multiple aspects of an asset-light business align it better with the VC model: the shorter time to return, the more straight-forward (and frequently less technical) value proposition, the perceived lighter capital intensity, and the nimbler business model.
Add to that, the VC world has grown significantly since its inception, which has only increased the compounding effect of the “club mentality” that concentrates venture interest in popular investment areas. The more widely-attractive investment areas receive the majority of the interest because VCs often have to rely on the investment’s ability to attract other investor capital in the same round or subsequent rounds. As a consequence, the less popular and more niche investment areas struggle to attract attention.
Is it unfair for asset-heavy innovation to lack in capital funding because of characteristics inherent to their technology? Or a better question: is it unwise for asset-heavy innovation to lack in capital funding because of characteristics inherent to their technology?
As we are constantly reminded in this time of energy transition, investment in new infrastructure and hard assets is what is needed to bring about the necessary change. When we are putting together our innovation priorities to leave asset-heavy businesses at the bottom of the list, are we being mindful of what is or isn’t productive innovation? One could argue that the current VC model that optimizes for largest economic return with the least amount of capital in the shortest time possible does not equally optimize for largest benefit to society (or at least, to global productivity) with the least amount of capital in the shortest time possible. So, in many ways, the problem of funding asset-heavy businesses mirrors the problem of funding ESG investments. But that’s another article.
The goal of this article is to discuss the current and potential funding models for incentivizing asset-heavy innovation. Certain funds already are structurally more amenable to funding asset-heavy businesses. These include:
Corporate Venture Capital (CVC) Arms of Asset-Heavy Companies – CVCs have the benefit of a sole corporate LP whose strategic priorities are considered alongside economic return, so their “total return” is potentially greater than that received by a strict financial investor. CVCs also have the benefit of having access to larger company resources to evaluate new investments and should theoretically be better positioned to evaluate more engineering-heavy, niche technologies.
Internal Innovation in Asset-Heavy Companies – Sometimes the best innovation in asset-heavy industries is sourced from the incumbents themselves. Developing strong corporate innovation programs by establishing things like an internal pitch competition, innovation fund, incubator, or even a separate innovation / R&D group entirely can incentivize innovation in niche industries and allow whatever technologies come out of that process the wherewithal to scale in being part of a large corporate budget.
Similar to this concept is the idea of “funding” via time investment. The widely publicized 20% Rule at Google and the 15% Rule at 3M are examples of this. In each of those companies, employees are encouraged to devote 15-20% of their time during the workweek to innovation projects that could result in new products for the company.
Family Offices / Sovereign Wealth Funds – Family offices and sovereign wealth funds (SWFs), much like CVCs, have single LPs with often non-financial strategic goals. For family offices, this may be as simple as the family / individuals’ personal interest. For SWFs, this may include a country’s reputational and political impact or job creation. Both of these types of investors tend to look longer-term when evaluating investments, which allows room for certain asset-heavy investments that take longer to scale.
Government Agencies – Government agencies like DARPA have long since funded asset-heavy innovation, especially in the defense industry. With the goal to spur innovation within their home countries, they have similar incentives to SWFs but typically focus even less on financial return. Many of these agencies choose to fund via grants.
Theoretically, the overwhelming interest in asset-light investments and limited interest in asset-heavy investments from institutional VC investors should divert the overlooked asset-heavy investments into the capital above, and these capital providers should naturally increase their exposure to asset-heavy investments because of their lesser competition. Like in any free market scenario, the arb should get priced away. Problem solved, right?
Not so much. Overall funding in venture capital from the above institutions remains just a fraction of all VC capital while asset-heavy investment opportunities continue to grow in breadth and number, especially as heavy industries (like energy) look to focus on innovation. Moreover, corporate R&D budgets continue to decrease, and asset-light businesses like software continue to garner attention from these funds. So where will the new capital that’s needed for asset-heavy businesses come from?
As alluded to in Part 1, I believe there is an entirely new class of institutional VC funds that can emerge to strictly to invest in hard asset technologies. This is and will be necessary to balance out the equation.
What could that look like? Some suggestions:
Large Advisory Boards – Hard asset technologies often require significant engineering and technical expertise. The advantage that CVCs have in accessing a pool of technical resources could be replicated by an institutional fund having access to its own set of SMEs gathered solely for this purpose. The downside is, of course, potential cost of such a construct, and a reliance on third parties for evaluation of a technology.
Builder-led funds – This downside can be eliminated by just having the entire team composed of individuals with technical backgrounds and experience in building / scaling hard asset technologies. Builder-led funds are better able to understand the challenges and opportunities with hard asset technologies, offer meaningful support to their entrepreneurs, and attract like-minded LP capital.
Corporate Partnerships and LPs– Having corporate partners is somewhat like being the CVC for multiple corporates. In addition to having a built-in advisory board, this structure also lends itself to more flexible financial criteria as strategic fit with corporate partners can help drive an earlier exit or accelerate validation of the technology. In some cases, corporate partners pay a fee to the fund to essentially scout out new technologies for them. This offsets some of the required return.
Permanent Capital Funds – Non-traditional VC structures will be necessary to accommodate investments with longer time to maturity. Permanent capital funds are an example of one such structure. In a permanent capital fund, investments are held much like a mutual fund. The fund’s goal is to increase the collective value of all of the holdings. Periodic valuations by third parties establish the worth of each share or unit. Investors in permanent capital funds can buy / sell their stock to each other on a public or private exchange and the fund can periodically sell more stock for liquidity. In removing the requirement of an exit to generate return, permanent capital funds are able to accommodate longer term investments.
The point is: for funds that have the capital structure and mandate to support asset-heavy innovation, there should be an increased preference for asset-heavy investments. For institutional VC funds that may struggle to fit asset-heavy investments in their existing structure, there are plenty of ways to adapt.
To incentivize asset-heavy innovation, we will need to innovate the way we innovate.