Funding Smart City Startups

Challenges, stories and hacks discussed at the first Smart City Startups event. 

The first Smart City Startups explored challenges unique to startups that work on city problems. These startups create solutions for problems low energy buildings, mobility, service delivery and governance. During the event, participants shared stories and hacks related to funding challenges. Here are some of my favorites.

The Hmmmm

Challenge: though software is eating the world, it often requires help from hardware. And this can mean more capital and more risk.

Observing the world requires sensors and then acting on what can be learned from sensors increasingly requires an actuator — something (versus someone) that can make a change to the physical world when a person is not well suited to the task. Despite some signs that hardware might be the new software, response to startups that create hardware is often Hmmmm (Hardware Means Much More Money).

Hardware might even be seen as anti-lean. After all, bug fixes or pivots are much scarier in the context of working capital and inventory, an issue captured very well in Elon Musk’s 60 Minutes interview when he is confronted by a garage full of undeliverable Tesla Roadsters. So Hmmmm is an understandable reaction from investors, built on years of experience delivering great returns to investors. So hardware often necessities additional types of funding not usually found in the cap tables of software startups.

But it’s not just hardware that results in pushback from investors — sometimes is the customer that causes fear.

The FOG

Challenge: in some cases, helping cities requires selling to local governments. And for most investors, this creates an undesirable level of uncertainty about sales.

City problems can be solved through multiple different business models. We’re already used to purchasing private security solutions or bypassing our municipal water system when we choose to drink bottled water. But traffic management is usually seen as a core responsibility for those in charge of managing our cities. Yet citizens have chosen to use Waze, sorting out their own routing through traffic.

So it’s true that there are multiple distributions paths for smart city startups, but sometimes it might be necessary to sell to the local government. Presenting this type of business model to prospective investors will almost certainly reveal FOG (Fear of Government). Some of the smartest investors, routinely dismiss businesses simply because their experience has taught them to fear government procurement. In fact firms like Citymart have documented the increased cost of acquiring customers (in time and money) for small companies that sell to government, so the fear is quite warranted.

Alex Pandel provided a good overview of the procurement challenge and it’s not clear that we’ve identified an approach that would make prospective angel of venture investors more comfortable. Among other things, it might be necessary to explore distribution more fully and do things like selling to those who have already secured contracts, but more on that in another post.

With Hmmmm and FOG in mind, our conversations quickly turned to exploration of different types of investors and capital. While most entrepreneurs have become familiar with angels and venture funds found on angel.co or Crunchbase, there is a larger universe of investors interested in the Smart City Space.

A Layered Cap Table

Take a look at a typical early stage cap table like this one from Fred Wilson. Now to be clear, this example is from 2011, so platforms like Angel.co was not a major part of a fundraising. In 2014 AVC, BVC, CVC, etc would likely be joined by ASyndicate, BSyndicate, etc. But from our discussions, it is clear that many more sources of capital have been found by startups that work with cities. The layers look something like:

• equity (angels, venture capital funds, corporate venture capital funds and foundations)
• debt (banks, contract manufacturers, suppliers and distributors)
• sales (reward crowdfunding and pre-purchases)
• magic (grants and prizes)

So lets take a look at each of the layers.

Beyond Financial Returns

Angels and venture firms in Fred Wlison’s cap table might also be joined by ACorporateVC or BCorporateVC as more corporates look to work with early stage firms. And they might also include AFoundation or BFoundation, who used to be focused on grants, but are increasingly investing alongside traditional investors as they seek more sustainable approaches to foster civic innovation.

Corporate Venture firms and Foundations have motivations beyond pure financial returns. For venture firms, there may be any number of strategic fits. For example, mobile carriers have been actively organizing for a world in which more devices than people need data connections. So they might be motivated as much by the potential of a business as the ability to stimulate demand for more data or resell solutions. In general, Corporate Venture’s interest in early stage startups, particularly those involved with internet of things, is becoming more evident.

Similarly Foundations may have any number of motivations beyond pure financial returns. They might wish to foster citizen engagement or resilience or reduce emissions. As an example The Knight Foundation’s Civic Tech Report documents angels, venture funds, corporate venture as well as foundations that have invested in Civic Tech. It also highlights the different interests by business model — foundations tend to provide a larger percentage of funding for companies selling to government, for example.

While the number of equity investors is expanding, other types of funding are also growing. One is most often associated with more mature companies — debt.

Getting Credit

So far we’ve talked about an expanded universe of equity investors. It’s usually the case that early on, debt is simply not an option because risk of failure is still too high — after all, what assets might be used to back debt when offerings are still in the process of being validated?

But credit can come from other places. Contract manufacturers like PCH International can help with payment terms and so can distributors like Home Depot. All this means that hardware startups need not require much more equity investment than their software counterparts, if they can manage cash via different credit options.

Which brings us to other sources of cash which don’t show up in the cap table, because they come with different types of obligations.

Pre-Orders

Cash from customers has long been considered one of the best source of funding. And reward-based crowdfunding platforms like Kickstarter and Indiegogo have been leading the way in making it possible to receive cash (long) before products are shipped. Interesting in crowdfunding appears to be continuing with Kickstarter showing over 6,000,000 backers (with almost 2,000,000 of them backing more than one project). So we have created a new category of retail, where backers understand that there is some risk, but now have enough transactions to feel very good about their chances.

But there is one final category of funds that has perhaps the lowest risk and some additional rewards — prizes and grants.

Magic Money

Incentive prizes have been pioneered by organizations ranging from GE (Ecomagination Challenge) to the US Government (Challenge.gov). The best provide cash prizes, but even more important, a public endorsement that services as a strong positive signal to prospective customers, investors and partners. And an increasing number of contests and challenges exist, including:

• City Organized — examples NYC BigApps, Fast Fwd, Open BCN
• University Supported — examples MIT Cleantech Prize, CU Cleantech New Venture Challenge
• Corporate Sponsored — examples GE Ecomagination, Ford App Challenge

And add to these initiatives from not-for-profits or accelerators like Challenge Cup and Next Step City. Beyond these public challenges are more traditional grants. They might have less visibility, but often enable companies to reference well known government agencies or other institutions.

Hacking Complexity

The funding stories and strategies revealed good news — despite some uncertainly from traditional early stage funding sources, there are other options. But founders now have to navigate a more complex fundraising process because of those options. In response to this complexity, participants proposed a number of hacks.

Proposed Hack: Civic Social Proof

Cowdfunding is already playing an important role as a source of funding. But it also acts as a strong signal to other investors. For example, raising one million dollars or more is becoming an important source of social proof or market validation for consumer hardware projects. Could the same types of commitments from citizens be used to signal needs to local government? Could this reduce the impact of procurement? If this approach works, it can speed sales cycles and reduce FOG and also provide an additional source of funding to change the cashflow and risk profile of firms that interact with local government.

Proposed Hack: Smart City Startup or Civic Investor Award

Identifying the best investors that are focused on civic or smart city startups. First, it can help to highlight investors that are interested in this area so that founders have a more targeted list of potential investors. Looking at the Knight Foundation data for example, reveals names like Ashton Kutcher, Sean Parker, Esther Dyson and Alexis Ohanian.

But deal activity would likely be just one signal in the selection. Other factors might relate to faciliation like advocacy, syndication of deals or participation in advisory roles. In addition to helping founders, it is a way for the community to thank and recognize investors who might be thinking differently about risks like Hmmmm and FOG and focusing more on potential public benefits even while they look at financial returns.

Proposed Hack: Stack Exchange for Funding

Stack Exchange has already proved to be a great model for requesting and sharing expertise from it’s early beginnings in software development (Stack Overflow) to more recent applications in patent reviews (Ask Patents). Given the number of options and associated people and processes, it might be helpful to post and respond to questions about investors and funding specifically. But given the other Smart City Startup themes like Procurement and Partnerships, certainly seems like this would be valuable beyond funding, too.

If you are interested in working on any of these hacks, please get in touch.

Additional notes: An overview of the Smart City Startups panels and workshops. @sahuguet’s notes from Smart City Startups. The list of Smart City Startups participants, who shared their stories and hacks and picked the very best ones that made this post possible.