The New Climate VC
A modest proposal to blow up an entire industry in service of fixing the planet
Munger
I miss Charlie Munger, as I think many of us do who’ve built careers at the intersection of investing and operating in growing businesses. Investing, I hear you ask? We at Coral do not pretend to be professional investors, although we’ve put (tiny) checks into a number of Angel investments over the years. No, I mean this more holistically; Anyone who has worked in climate tech, a venture or PE backed startup, or really any company that’s raised private-market capital is absolutely playing a game the rules of which are largely dictated by the investors of the company. Incentives = outcomes.
Startups, which frequently are money-losing for years and thereby wholly dependent on their financial backers, are subject to this rule even more than most. Here’s another Mungerism, from his incredible interview on the Acquired Podcast in 2023;
"More often than not, they (early-stage entrepreneurs) hate the venture capitalist, they don't feel they're their partner trying to help them — they're only taking care of themselves."
He is, of course, entirely correct. VCs, as we have written many times, are money managers, and measured / incentivized as such. Their fee structures create misaligned incentives with the desired outcome of building impactful, scalable, profitable climate-centric technology companies.
So today, in the followup to our piece last week on the playbook for climate entrepreneurs to navigate the 2024 funding landscape, let’s do the same for VC, and try to determine what a scalable, mission-driven, ridiculously lucrative fund structure could look like in 2024 and beyond.
2 and 20
To build the future, we must first understand the past and present.
Most VCs follow the “2 and 20” fee structure, which was first popularized by hedge fund managers in the 1970s. In short, this means that the venture capital fund can claim 2% of their assets under management as an annual fee, and receives 20% of the profits once their portfolio investments reach a liquidity event (either a sale of the company or IPO) at the tail end of the fund’s life.
Simple example; a VC fund of $100m pays $2m annually to the firm as a management fee. If the portfolio exits for a net gain of $200m after the return of initial capital investments, the firm receives $40m of that windfall. This can be lucrative, especially in case of “stacking” management fees. VCs will often have multiple funds running simultaneously, with each paying out separately.
In theory, this structure makes a lot of sense for all parties. Portfolio companies get patient capital that wants them to maximize value at the end of their road, VCs get salaries from management fees and profit from carried interest, and LPs (the VC’s investors) get well-above S&P 500 annualized returns.
Except.
Numbers go up
It is not clear if, as a sector, venture capital is actually profitable for all stakeholders in 2024 and beyond. Historically, the sector has been quite small; with somewhere between $30-50bn invested in startups annually before 2010. This sounds like a lot of money, and is, but is fairly trivial in macroeconomic terms.
Overall inflows of capital in the space started to materially climb in 2011, peaked in 2021 at the height of Covid market insanity, and is normalizing at a much higher set-point than previous data would imply. This trend precisely coincides with the steepest, most sustained bull market in decades.
This uncovers a critical point. Among the primary goals for VC firms is to always be able to raise the next fund. It takes a long time to realize profits from early-stage investments (7-10 years at minimum), and so the way that VCs have demonstrated performance is via an increase in valuation of their current portfolio companies as demonstrated by the price that subsequent investors are willing to pay for shares in the same. These are called “markups.”
It’s much, much simpler to demonstrate markups when the stock market is skyrocketing, interest rates are low, and stuff is generally worth a lot more this year than it was last year. These days, with severe valuation multiple compression, higher interest rates, and geopolitical uncertainty…
Alternatives
So markups are a lot harder to come by. Follow the money. VCs need to demonstrate performance in order to continue justifying the next fund, and the only way to ask for money is to have made money. Real, cash-on-the-table money as a function of a revenue multiple and commercial traction, not markups.
IPOs are few and far between, so VCs will need to manufacture exit events through company sales. We predict that we’ll see many, many startups being sold 3-5 years into their journey, at a valuation of about double their last round price, for the next decade. In 2021 this would have been insane, now it’s a necessity.
Climate
This brings us, at long last, to what may be the entire point (did these intros get really long, or is that just me?); Climate tech companies, as we’ve written before, need patient capital. They are bits + atoms businesses, either directly or in their change-management process to drive user adoption, generally have a long chasm pre-commercialization.
Here’s the upside; They also have the potential to be extraordinarily lucrative, in a way that even the VC business of outliers has rarely experienced. The structure is fixable, with creativity, incentive alignment, and the willingness to expand the LP base. Here’s what we think a pure-play climate VC should look like.
1% management fee on AUM.
10% carried interest on exits
Only companies with science-based emission reduction contribution targets are considered for investment
Day-1 CXO in residence program, staffed to focus on GTM / distribution and governance / investor communications. We need to better-equip climate companies to differentiate from SaaS companies, not try and steal SaaS metrics for hardware businesses
Investments into portcos are structured at a cap of $10m valuation pre-revenue, 6x revenue ongoing.
VCs are compensated for the CXO service through profit-sharing (note; profit, not revenue) agreements with portcos, capped at the same percentage as the VC’s position, and vesting on a 10 year schedule. The vesting window is critical, as it minimizes the impact to cash at the early stages of the company’s journey when $ should be reinvested into the business.
Once net profit-sharing cash flow reaches 2% of AUM from a given fund, all management fees are waived for the remaining life of the fund vehicle.
This is an odd, different structure, but we think it’s much weirder that the capital stack responsible for much of global innovation works on a fee structure invented for hedge funds ~50 years ago.
Consider the incentives. LPs get better returns by paying the lowest fees in the business, the VC becomes self-sustaining away from the raise-the-next-fund cycle and can therefore be a true value-add partner to their portfolios, and entrepreneurs get a team that is paid generously to help them build a generational, profitable, impactful company.
Everyone wins.
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