Fundraising for Climate Startups
Climate startups are just like other startups in that they usually require outside capital to help them grow. And like other startups, climate startups raise seed capital. But this is where the similarities end, because most climate startups don’t just work with software.
Google is one of the greatest startup stories. They raised money from angels such as Jeff Bezos. And then notable VCs such as Sequoia and Kleiner. Then they went public. This is what most VCs and startup founders aim to replicate. But the early fundraising story for today’s most valuable company, Apple, is likely a better reference.
Apple received an order for 50 Apple I computers and received credit from their main supplier. This allowed them to purchase the parts they needed to build the units, and they were able to repay the loan as soon as they delivered the units to their first customer. Shortly after, Apple received an angel investment and set up a credit line with Bank of America.
Most climate startups make or use hardware and therefore have much more in common with Apple than Google. This is important because, over the last quarter century, the default startup funding advice has evolved almost entirely for funding software companies, especially in North America. Second, it’s notable that right from the start Apple was using two types of funding — equity and debt (first, credit from a supplier, then credit from a lender).
Climate startups also benefit from government incentives that reduce the cost to customers or reduce risk for investors. Grants are also available from national and local governments, as well as private foundations. There are tax credits and rebates to further encourage customers and investors. This is not new. In fact, if you wander through Tesla’s funding history, you’ll find a grant from the California Energy Commission as well as debt from the US Department of Energy.
There are lots of great resources for equity fundraising, but climate startups also need to understand grants, credit, partnerships, and incentives to ensure they can maximize their access to funding and increase their probability of success.
Equity Funding for Climate Tech
“I would say Silicon Valley by and large is built to fund software companies and the further away you get from that software core, the less reliable it is as a funding mechanism.”
— — Michael Seibel, YC CEO YC, Lessons from Thousands of Startups.
Over the last nearly two decades, YC has built the most successful early-stage investment platform in history. They’ve figured out exactly what it takes to build and raise funds for early-stage teams from over 3,500 hundred YC companies. But they’ve also identified an important gap in the current VC ecosystem.
The goal of this chapter is to explore how different sources of capital can be combined to arrive at a more reliable source of funding for climate startups.
“Learning to tell a story is critically important because that’s how the money works. The money flows as a function of the story.”
— Don Valentine, founder of Sequoia and one of the first investors in Apple, Atari, Cisco, Oracle, and EA
It’s hard to overstate how important storytelling is for everything from early-stage VC to receiving payment terms from partners. No matter what kind of funding you’re raising, investors need to believe your story (we’ll discuss this another time, but so do prospective customers and employees).
A lot of people can describe what “happily ever after” looks like — the climate impact and financial returns that are possible in a decade or two. And investors ultimately invest in a shared ideal vision of what your company might accomplish. However, it’s much harder to explain how you get there.
When raising equity, the plan for the next 18 months is usually a story about how to convert new equity investment into at least 3x growth in enterprise value. It’s a story about what needs to happen now and what can wait. Mostly this tends to involve a hiring plan, but for climate tech startups, the story also needs additional answers to questions like:
How will you purchase inventory to make your first products?
How will you fund your first production plant?
Can you increase sales by enabling customers to lease or rent your product?
Customers are always a central part of the story. If customers aren’t buying or committing to buy your offerings, there isn’t going to be any planetary impact or return for investors. In some cases, investors might be prospective customers and can assess for themselves the potential value, but in many cases, investors will need to see some signal from customers to confirm that you’re making something they want.
For equity investors, customers provide the signal that there is a clear path to growing the value of the enterprise and, therefore, their equity. But for other types of investors, customers are essential to ensure you can generate cash to repay loans or as a first step to generating the public benefits they seek via grant or policy programs.
Benefit Now, Pay Later
As customers, we’re exposed to a wide variety of ways to purchase products. Think about all the ways you can access vehicles, such as buying, leasing, financing, renting, or paying for usage. We also pay monthly subscriptions to access services such as mobile networks, software, music libraries, or insurance. Software is great, because the cost to serve each additional customers, is relatively low, but what happens when you need to make a new e-bike, heat pump or indoor vertical farm?
This is where credit products play a role. There are various types of lenders, from contract manufacturers to banks, who will lend money based on expected sales (revenue-based finance) or against equipment, usually used in production (equipment leasing). In some cases, sales data is already available via to 3rd party fintech firms, who can automatically qualify your startup for credit. For equipment, manufacturers have often already worked with financial organizations to ensure there is a leasing option.
Startups can also make their products available via leases to their customers. Often these are called “off-balance sheet” structures because entirely separate legal entities are funded and created to own the assets that will be leased.
If you look at a solar developer like Sunrun Inc., you’ll find a looong list of legal subsidiaries that exist to allow them to purchase and own solar and battery systems, installed on residential or commercial buildings. They can then lease out these systems to the building owners. And these entities have different investors from the folks who own Sunrun’s public equity or Sunrun’s banks that provide them credit facilities.
In the climate tech space, there is already a history of leasing or renting, as we’ve done with products such as vehicles and buildings. So it’s no surprise that residential solar, batteries, ebikes, EVs, etc., are all available via leases or pay-per-use models. It’s not just about cash flow for customers. It’s a way to address concerns about technology risks, like how long will the battery last for my fleet of ebikes? When startups can offer leases, they unlock customer growth — in some cases, we’ve seen threefold increases in sales, when leasing and financing options are introduced.
This step up in demand, then kicks off unit cost reductions, as we discussed in Chapter 1. If network effects are the magic growth accelerator for software, then leasing and learning curves do the same thing for hardware. Leasing structures aren’t something that VCs fund, but there are other investors who seek out these types of financing opportunities. In many cases, these investors have seen the evolution of categories such as solar and, now, battery storage and are looking to ensure they don’t miss the next climate assets like fire fighting drones or repurposed oil and gas wells for energy storage.
While equity finance is critical to building teams, other types of capital such as credit or leasing structures are essential to provide access to the next generation of more planet-friendly human infrastructure.
Venture, credit and off balance sheet structures are often made available via financial organizations like funds or banks, but climate startups often work closely with a few partners to build and distribute products. And they’re often very motivated to help provide financing to climate startups.
Most software relies on hardware provided by others. Customers bring their own phones or PCs. Cloud service providers rent out computing and storage capacity on a per-use basis. This means software companies can avoid building out their own data centers and only pay as they need resources.
But climate tech startups often need to design and manufacture hardware or even build their own production facilities. And this usually means startups will have key partners, because some hardware is only available from a limited number of providers. Think about the Corning glass that was critical to the iPhone or Panasonic battery cells that made Tesla packs possible.
The success of climate tech startups is often tightly linked to successful partnerships, and because of the tight working relationship, it’s not uncommon for partners to become equity investors, too. Tesla investors include key partners such as Panasonic, Toyota, and Daimler. What’s often less visible is that these partners also provide financing in terms that help startups manage cash. For example, being able to pay for parts after 120 days can be a critical form of financing because in that amount of time, startups can build and sell inventory and avoid using cash from the sales of equity.
The urgent need to scale climate action has mobilized entirely new categories of non-dilutive climate funding from public and private organizations. At the earliest stages, programs such as
Breakthrough Energy Fellows provides funding to individuals to flesh out plans to get promising technologies out of labs and into first deployments. LACI’s Market Access Program is an example of funding for first pilot projects in Los Angeles — similar programs now exist in other places, too. ClimateWorks has granted over $1 billion to 600 organizations over the last 14 years across a range of climate actions.
National Science Foundation grants have been a reliable source of early-stage capital for our portfolio companies in the US. In the last few years, opportunities have ramped up from agencies such asthe Department of Energy, findable on Grants.gov or the EU’s Innovation Fund.
There are also multiple types of venture and credit investors who have the goal of making investments more attractive for traditional financial investors. These investors give up financial returns to help make investments more attractive for traditional investors, sometimes referred to as “first loss” capital. The Inflation Reduction Act makes climate investment more attractive in multiple ways. The DOE Loan Programs Office includes Tesla as a portfolio company and the primary goal is to provide guarantees for other lenders, increasing potential returns for investors in companies or company projects such as electric vehicle manufacturing or next-generation nuclear energy.
Beyond grants and structures to reduce risk for investors, there are also ways to reduce taxes, from R&D tax credits to tax equity. In fact, the same structures used to create off-balance-sheet leasing schemes for new climate assets are also likely to produce the most attractive tax equity opportunities because of a clever idea called transferability. Just as the SAFE note changed early-stage equity, tax equity transferability is an important financial innovation that will enable more customers to adopt climate technologies quickly while generating attractive returns for investors.
Climate Capital Stack
We’ve introduced a bunch of capital sources and investors beyond traditional early-stage VC, and these are summarized in the table below. Story remains paramount but now it includes a new chapter on how different capital sources can be assembled to achieve scale and impact while addressing the needs of different types of investors.
Securing a grant often allows for product development and customer discovery that sets the stage for pre-seed investment. Venture capital ensures that a team can be built to deliver the first products, and this paves the way for credit finance such as equipment finance or revenue-based finance. And with some proof points about customer demand and stable production, off-balance-sheet options can be used to supercharge demand.
What used to be a sequence of seed, A, B, and C rounds now includes grants, credit lines, equipment finance, factoring, terms from suppliers, and various legal entities with additional investors from areas such as infrastructure and asset finance.
The key challenge for founders is to understand the needs of each of these investor groups. And the challenge for VCs is to make sure we understand how to help founders navigate these options, since we’re likely to be among the first to invest and one of the last to exit investments.
Grants — capital provided with conditions such as product or technology milestones, but with no expectation of financial return.
Venture Capital — investors who purchase equity with the expectation that they might lose some or all of their investment, but also have the possibility of generating the largest possible return compared to other investors.
Credit Products — expect lower financial returns than VCs, but in return, they have more ways to ensure they don’t lose their investment. For example, they can take back equipment and sell or re-lease it or they can cut available credit if company revenue declines.
- Venture Debt
- Revenue-Based Finance
- Equipment Finance
- Inventory Finance
Key Partners — such as key component suppliers or contract manufacturers also have multiple ways to help make cash available to startups. Like Apple’s first funding, they can offer flexible payment terms. But partners can play a similar role to all of the above investors. They often do not focus as much on pure financial returns becausethey generate outsize returns in other ways, such as growing revenue for their core business.
Impact Capital — comes in all of the above flavors. While grants generate no financial return, impact capital is usually designed to accept low or no financial returns to increase the possibility that startups can secure capital from other investors.
Off-Balance-Sheet — are companies designed for the primary purpose of buying new climate tech assets and then making them available to customers via lease or subscription agreements. Customers avoid upfront costs as well as any risks associated with owning new or possibly soon-to-be-obsolete assets. It’s easiest to think about these as their own businesses where all of the above investors can participate.
Design for Finance
Designing for venture capital is largely about recruiting plans that have a high probability of getting to threefold or greater increases in enterprise value. The design challenge begins with attracting talent to build and sell and ensure customer success. But early-stage climate finance is often also concerned with a “first plant” problem — i.e., the first operation that will be able to make physical products that can be sold to customers, ideally without losing money on each unit produced.
The most common approach to this problem is to use contract manufacturers. Like cloud services, contract manufacturers have made the large, necessary investments and can provide access to a service on a per-usage or per-unit basis (yes, there are minimum order sizes, so not quite as simple as cloud services). The approach avoids the first-plant problem and leaves a relatively simpler issue of financing inventory.
But in many cases, startups are innovating around the production process, especially in industrial processes such as indoor vertical farming or cement production. In these cases, it’s essential to ask what can be leased or financed. For example, if you can make use of existing industrial robots, can these be leased or even borrowed from manufacturers or their customers? It’s nearly impossible to lease a custom-made piece because lenders can’t be sure of what happens if the startup fails and they need to resell the equipment. But if there is a known used market for a piece of equipment, there is a very good chance that it can be leased. These simple design choices can mean the difference between needing to use equity to fund first plants versus being able to access credit products to do the heavy lifting.
Sometimes financing is mostly about designing a relationship with a specific, usually much larger, partner. Tesla first explored building their own manufacturing plants, but settled on a partnership with Toyota that included Tesla purchasing part of an old Toyota plant, but with an agreement to jointly develop the Toyota RAV4 EV drivetrain. The state of California also supported development of the site. This type of transaction is significantly more complex than a venture capital fundraising effort and has scared away many founders and investors. The counterpoint is that being able to solve this type of transaction certainly creates a moat — it ensures less competition for startups that can figure out how to design more complex transactions.
The choices of what to build and what to buy or lease were a defining part of cleantech 1.0 failures, so it’s worth allocating the time to make intentional decisions about how product and product choices map to available financing options.
When Things Go Wrong
There is a common VC perspective that is negative on any flavor of non-equity finance, which has mostly meant venture debt. One core challenge with venture debt is that the main collateral is cash. So when things go poorly and cash is getting low, venture debt lenders have the right to get paid out, and as Paul Graham correctly describes, a low-cash situation can turn into a no-cash situation. If only this was just true for lenders.
In 2022, as company valuations reverted to pre-pandemic norms, many inexperienced or unscrupulous venture investors managed to turn near-death startups into dead or even zombie startups. They delayed decisions about bridge financing or offered terms that would almost guarantee that common stock held by teams and founders would become worthless under most exit scenarios.
Interestingly, for many types of credit that don’t use cash as collateral, founders might have to give up specific assets, such as a fleet of bikes or a piece of manufacturing equipment. Or they might simply lose access to a certain amount of capital because they no longer meet some criteria, like revenue or cash on hand, but they won’t find themselves scrambling for cash because they had to pay back a lender. In the case of off-balance-sheet lending, despite the complexity, the main risk to the startup looks mostly like losing a large customer versus being forced to shut down because investors failed to agree to a new plan.
The most fortunate change for founders in the last few years is that there are now multiple ways to understand investor reputation, which often means that investors might have legal rights to take certain actions, but usually opt to work with founders to ensure the best outcome for everyone. Founders should know about resources such as NFX Signal, Climate 50, Founders Choice, etc. Investment terms certainly matter, but investor reputation matters even more. So the main challenge for founders and equity investors is going to be understanding what other investors do when startups have a near-death experience.
More than Capital
All investors can play a productive role, especially early on, by effectively expanding networks to access talent, customers, and additional investors. Many early-stage investors have been effective syndicate builders, and for climate startups, this syndicate also includes new categories of investors who can offer grants, credit, and off-balance-sheet structures. Cost of capital is important from dilution to interest payments, but it’s essential to understand what else you can get — what work will investors do? And what can you expect from them when things are at their most difficult?
Also, partner firms have often been viewed as secondary options for financing because many have less experience as investors and so may not understand the norms of early-stage VC. And, for software firms, key needs such as distribution and production are largely solved by platforms such as app stores and cloud services. But partners often bring multiple valuable assets, including sourcing, customers, payment terms, as well as financing.
In the next parts of the chapter, we’ll briefly review equity fundraising, especially for investors who are focused on the potential for climate impacts. Then we’ll explore what fundraising looks like for various credit products and terms, including the most complex off-balance-sheet structures. And we’ll share example materials. We’ll review different types of investor communications and what happens when things don’t go according to plan (almost a certainty for all startups). We’ll also discuss what startups should ask of different types of investors and why investor reputation must be a core part of any transaction. And finally, we’ll step through case studies from startups that have combined almost all parts of the capital stack to unlock growth and impact.
Coming Soon: Chapter 2, Part 1 Private Credit