Capital intensity and cost of capital for ‘big idea’ startups

By Bilal Zuberi

My firm Lux Capital frequently invests in entrepreneurs that aim to change the world with bold, daring, big ideas. We are investors in 3D printing (Shapeways,Sols), flying robots/drones (CyPhy Works) and satellite technologies (Planet Labs,Kymeta) to nuclear waste management (Kurion), drugs & vaccines (Genocea,Visterra, Cerulean), power electronics (Transphorm) and digitization of the electric grid (GridCo). A few characteristics are common to such “big idea” startups:

• There is often some R and then some D involved in the productization process. i.e. such companies typically tend to spend 1-2 years in product development mode before any product leaves door to be in customers’ hands.
• Any product changes and/or pivots are expensive
• Only having one shot at the goal can some times be too risky, esp if regulatory hurdles are involved. But diversification of products on top of a technology platform earlier in the life of a company can be costly and potentially distracting
• Markets can be slower to develop, have regulatory hurdles, or competition from well-heeled incumbents can slow things down
• Hardware space is fraught with large incumbents whose defensive strategy is to sue competition. Startups frequently get sued as well and it costs a ton of money to even prove you are right
• Markets may be global, but distribution and sales are costly and complex
• Hardware products tend to need working capital to continue to grow

Net of the above usually is that such companies tend to take a bit longer and a bit more money all-in than what we have come to expect of startups in the internet/mobile era. However, they represent the very kind of startups that venture capital should be investing in — big ideas that impact large markets and if successful, ultimately generate large returns for its investors.

Before investing in such companies we always ask ourselves if these companies may be too capital intensive to fit the venture capital model. Would they make good VC bets or not? We want to back world-changing ideas and technologies, but not all big ideas are necessarily good venture capital bets. We don’t look for capital intensive companies — we want to back capital efficient companies, but we don’t believe in just writing off an idea just because it might take $50m or $100m to be fully realized. So how to pick?

There is no easy answer.

1. Should we not invest in companies that might need significant capital? Even if the potential returns can be outsized?
2. Should we invest and spend all our time trying to find shortcuts to limit capital needs, even if that might mean risking the upside?
3. Are there companies that may end up taking in more aggregate capital but reward early investors by reaching value-adding inflection points early?

IMHO, one question to consider in regards to such companies is not just how much money in aggregate would they require to reach the end goal (i.e. a successful exit in the form of an IPO or an M&A transaction) but also what could the company do along the way to reduce their cost of capital, and would early investors be rewarded for taking the risk and continuing to invest along the way. That is, it might be OK for a company to need more money in later fundraising rounds to grow and expand if it is able to raise that money at a higher price because it is increasing its enterprise value at a rate significantly higher than its burn. Of course, the inverse is also true that it sucks to be a company that needs money to continue to exist or slowly inch forward if its valuation is not keeping up, and subsequent financing rounds become painful for the insiders (including the entrepreneurs).

Reducing a startups cost of capital is something I have noticed many entrepreneurs not paying enough attention to. They generally understand that higher valuation in a financing round is a good thing (up to a limit) but that is not all there is to it. Cost of capital also has to do with the source of money you are talking to, their expected return (financial or otherwise), and how you make the financing process work in your favor. There are so many things that contribute to how a company’s valuation grows and how its cost of capital can come down for the entrepreneurs and early investors. For example:

• Clarity of vision and mission for the company. Visionary team/founder/CEO and investors who can convince future investors that the sky is the limit for this company’s ultimate worth.
• General investor interest in the space that the company is operating in. Is this the right time for this idea?
• Being seen as the category-defining company in the space. Have you generated buzz around your company?
• Ideally always beating and exceeding expectations/milestones. Are you firing on all cylinders?
• Early revenue, customer validation and upwards trajectory on revenue/customer traction. Investors look for both social and financial proof.
• Intellectual property and know-how, including the quality of team that is brought together by the founders

If you look at companies like Tesla or Nest, this is among the things they did well compared to their competitors. Yes they needed significant capital to grow (hundreds of millions of dollars) but they also created the conditions to be able to raise that capital at increasingly lower costs. In fact they used their relative capital needs and fundraising prowess to their advantage, and by raising large rounds at large valuations, starved their competition of capital. I remember a conversation with the CEO of SunRun a few years ago who listed his ability to raise significant amounts of capital at increasingly lower costs as a key tactic in winning over the competition.

Companies like Tesla, Nest or SunRun reduce their cost of capital by not only raising capital from VCs, but by being creative, and at the right time approaching PE funds, non-traditional funds, via non-dilutive grants, loans (in Tesla’s case from the government), strategic partners, and other methods including IPOs. In the fundraising sense Tesla and Nest are not too dissimilar to Twitter, Facebook, Uber etc. Fundraising prowess is certainly not enough to guarantee success (eg.BetterPlace), but its a much needed skill in capital intensive companies. And it is certainly something we consider in investment decision-making.

Critically analyzing all the risks involved (including financing ones) and taking early bets on big ideas of great entrepreneurs is what VCs get paid to do. Good VCs can, and should, help reduce the risks by providing help on strategy, recruiting, marketing, fundraising. At Lux Capital, we actively work on this front because so many of our companies benefit from that. But at the end of the day, it is the entrepreneurs who truly carry the burden and help shape their ‘big ideas’ into successful enterprises. They could help themselves by thinking about fundraising and reducing their cost of capital more than many currently do.