Solving the FOAK puzzle — Addressing Capex financing for first-of-a-kind plants in the green transition
Climate tech companies requiring Capex often find themselves in an investment allocation gap
The green transition requires massive capital deployment into new technologies. This is well understood and climate-related investments far outpaced the broader market in 2022, as measured by deal activity, capital deployed, and capital flows into dedicated funds. As a consequence, climate tech investments have grown despite the economic downturn and are now at 12% of total VC/PE funding, doubling the share from only three years ago (McKinsey).
In the VC segment we observe a strong increase in climate tech activity, but we see different sectors growing at very different paces. A majority of funding goes into the mobility and energy sectors, while other large emitters like industry and the built environment are still under-financed (PWC).
More specifically, funding for software companies is growing at a much higher pace than for hardware companies (Net Zero insights), although it is widely understood that the climate crisis can only be addressed by replacing atoms with other atoms, not solely relying on electrons.
The data shows a severe funding gap for climate tech startups in sectors that are hardware focused — like those in the “industry” bucket noted above. In our opinion there are several reasons for this under-allocation of VC capital:
- Experience: Most VCs have long been focused solely on software businesses (writ large) and are loath to change focus with all that entails.
- Knowledge: Most VCs lack expertise in operational and financial scaling of hardware businesses.
- Networks: Most VCs don’t have strong networks in relevant stakeholder groups, especially to the corporations dominating the industrial sectors.
- Timelines: Development times across TRLs are longer and harder to predict than in software focused market segments — and revenues also tend to be further out.
The effect is that hardware oriented startups struggle to raise VC funding. This is especially true for startups facing a Capex hurdle to move forward, e.g. to build a first-of-a-kind (FOAK) production plant. This is because it requires financial engineering right off the bat, of a sort that is unfamiliar to most VCs given the past 20+ years of focus on “software eating the world”. The irony here is that startups that successfully pass this particular chasm are well positioned for exponential growth, with an ability to generate highly attractive VC returns.
On the funding journey of many climate tech companies, the FOAK plant is a critical inflection point
Let’s take a look at the typical fundraising journey for a hardware oriented company. As indicated in the illustration below, they are usually able to access public money and small pre-seed & angel investments up to a stage where the technology works at lab scale. The next is to build up the first demonstrators and generate interest from strategic partners and customers. These pilot and demo plants can usually find funding from larger grants, strategic CVCs, and specialized VC funds.
So far so good, but building the FOAK plant that effectively demonstrates economies of scale and has sufficient output to meet a specific corporate customer demand, is a very different ball game… A few key reasons for this:
- VCs usually don’t have the financial power to finance €20–100 million Capex needs
- Corporates are often proactive on offtake agreements, but they often have limited risk-willing capital and their internal decision-making processes can be complex & slow.
- Private Equity and Infrastructure players prioritize capital preservation and have little tolerance for outright failures in their portfolios. Furthermore, their technology assessment capabilities are limited, making even modest technology risks associated with scaling up from pilot/demo to commercial-scale first-of-a-kind (FOAK) plants too significant for them to accept.
- Debt providers are similarly risk averse, but their risk mitigation checklists encompass a wider range of areas, which cannot be fully addressed by FOAK plants.
- Public grants play an important part, but are usually too small or too conditional, tied to other funding (all of the above), creating a chicken-and-egg situation
“The green transition requires Infrastructure-like ticket sizes with a VC-like risk appetite“ as one of our friends in the investor space put it. As such tickets are unlikely to emerge as a significant financial product in the ecosystem, we need to find creative ways to overcome the challenge with the existing ecosystem players.
After FOAK a new world of financing options opens up
Private Equity and infrastructure investors are clear on the potential of climate tech and are rapidly building up vehicles focusing on that. This is motivated by some strong trends, including:
- Many of their investors have set climate-related targets, incl. more than 450 financial institutions belonging to the Glasgow Financial Alliance for Net Zero, collectively pledging >$130 trillion toward net-zero goals
- Many of their corporate partners have set climate-related targets for 2030, requiring them to scale green operations already in the second half of this decade
- Given the above, the end of the decade will most likely be an ideal time for many exit strategies, pushing to achieve targets via M&A
In addition, PE and infrastructure investors show a clear appetite for investing at earlier stages than they have historically, to make sure that they don’t miss the train (and simultaneously building up more technical competencies to mitigate the associated risks). Clear indicator for this trend are the multiples in PE for climate related assets, which have tripled in recent years (McKinsey) — outpacing VC, where multiples are yet to double.
Promising as this sounds, it does not solve the FOAK dilemma. Going “earlier-stage” mostly means that they are interested in the NOAK (next-of-a-kind) plants. This is an important step in the right direction, but before that, founders are often left with a complex financing puzzle to solve, with little in the way of guidelines or case studies to help them.
With a combination of increased risk mitigation from the companies and a modest increase in risk willingness from the investors, we could see great positive change in the industrial landscape. Overcoming the FOAK dilemma would bring many companies past an important inflection point, opening up for strong commercial demand and much easier financing. So let’s dig a bit deeper to understand what founders and investors need to change in order to ease FOAK plant funding and increase the speed of the green transition.
The role of founders in solving the FOAK puzzle
Preparation is crucial. To finance a FOAK plant, founders need to answer different types of questions from different types of investors. While VC funds invest in visions, Infrastructure and PE funds focus on facts and risks. Across industries and geographies, we have gathered five key learnings that every founder should keep in mind when trying to solve the FOAK plant financing puzzle:
- Secure sufficient project and infrastructure financing know-how: The founding team needs to ensure that they have a comprehensive understanding of the needs of project and infrastructure investors. The structure of these financing projects is not yet standardized and involves grants, debt, guarantees and different types of equity. It is important to understand the differences and be able to compare diverse corporate structures in different financing scenarios. This know-how can be acquired through a competent CFO or external advisors that speak the same language and open the right doors.
- Get as many technical proof-points as possible: The technology needs to be proven to qualify for a large funding round. The R&D phase needs to be over and a TRL of 6 or 7 needs to be achieved. While a fully functional demo plant is the most compelling demonstration, it can also be the most time-consuming option. To go around that, technology can sometimes be demonstrated through alternative means,, e.g. through partnerships with universities, machinery suppliers or customers.
- Ensure high granularity in your planning and documentation: Project financiers and debt providers demand a much higher level of granularity on all elements of the business and the market projections than other investors. This includes patents, plant designs, regulatory approvals, as well as supplier and off-taker contracts and downside protection for all scenarios. If in doubt, you probably don’t have enough details ironed out.
- Split the overall FOAK plant programme into smaller projects to optimize funding-project fit: Different parts of the FOAK plant programme may be fundable with different mechanisms. Some of these smaller projects may be covered by grants. Others may allow for Capex delays through smart leasing or renting structures. Others may be eligible for debt mechanisms (e.g. machinery). These disparate funding sources will usually be mutually dependent (each triggered by the others being successful). Consequently, fundraising efforts will need to be coordinated extensively and run in parallel.
- Build an alliance of strong partners: Be vigilant in building and maintaining relationships across all key stakeholder groups, including local community players, technology partners, suppliers, and off-takers. Form consortia and Joint Ventures to develop creative ways to share risk and increase the likelihood of success.
The role of investors in solving the FOAK puzzle
While the to-do list for founders may seem extensive, investors also have to do better if we are to accelerate the green transition.
- Early stage investors need to build up Capex financing capabilities: Similar to providing support for growth management, talent acquisition, and preparing the next VC-led financing round, VCs must establish a support model for founders to raise Capex funds. VCs should help founders with playbooks on solving the FOAK puzzle, access to relevant funders, and assistance in developing sustainability documentation to unlock funding.
- Climate tech VC and PE/Infrastructure players need to come closer together: As a climate tech VC we clearly see that downstream PE and Infrastructure investors are often too far away from us. We speak different languages (visions vs. facts), we wear different clothes (suits vs. vests), and we attend different events. While the edges are blurring, there is still a way to go before transactions become more common, fast, and frictionless.
- We need to bring more engineers into the investment process: Investing has traditionally been carried out by financially savvy individuals. Particularly in the PE and infrastructure world they have impressive capabilities in financial modeling. However, investing in technologies that have yet to operate at full commercial scale necessitates a better understanding of the technology implying a need for more engineers (mechanical, chemical, biological, and electrical) to help evaluate the technical potential of a solution.
- We need to form more and stronger multi-stakeholder alliances: Given the different roles that different parties can play in solving the FOAK puzzle, we need to form more alliances across these stakeholder groups. This includes founders, VCs, PE and Infrastructure investors, corporates, banks, foundations, government entities, and universities/institutes. New ecosystems are emerging, specific to every region and industry, and we need to accelerate this trend. A strong consortium is an important risk mitigation strategy for any FOAK plant to become a reality and it requires collective efforts from all stakeholders involved.
