The latest problems at Tesla and the Romney campaign’s mantra about the government “stifling free market competition by picking economic winners and losers” raise questions about the wisdom of government loans. This debate usually comes down to whether or not governmental agencies such as the Department of Energy (DOE) choose the correct companies to invest in as wisely as the markets do.
The assumption is that financial firms and venture capital funds are smart and do a good job picking winners – after all, we’re talking about highly sophisticated investors with objective judgment and a sole goal to maximize their return, right? Well, VCs indeed seem competent at this job, but their success rate is not as high as one might think. According to Prof. Shikhar Ghosh of Harvard Business School, about 75 percent of U.S. venture-backed start-ups actually fail.
First, let’s be clear about what “failure” means. By Prof. Ghosh’s definition, a failure is an investment in a start-up that does not return investors’ capital. His findings are based on data from more than 2,000 companies that received venture funding from 2004 through 2010. If you look at liquidation of all assets, then the failure rate is around 30 percent to 40 percent, he explained in the Wall Street Journal. On the other hand, if you look at start-ups failing to see the projected return on investment – for example, a specific revenue growth rate or date to break even on cash flow, then the failure rate jumps to more than 95 percent, he said.
This might come as a surprise, especially if you follow figures from organizations like the National Venture Capital Association, which according to the WSJ, estimates that only 25 percent to 30 percent of venture-backed businesses fail. Shikhar has his own explanation how VCs have such a good reputation even with such a success rate: “Venture capitalists “bury their dead very quietly,” he told the WSJ. “They emphasize the successes but they don’t talk about the failures at all.”
Interestingly, it seems that in the cleantech sector we have a situation that is very similar to what Shikhar is describing. Richard Stuebi of NextWave Energy, who is also an active participant in the cleantech capital markets, estimated that only 3 in 10 VC investments in the cleantech sector produce favorable returns.
In fairness, his data is a bit old (2004 might as well be a lifetime ago, in start-up years), but some of the issues he brings up in his presentation might still be very relevant to VCs operating in the cleantech sector these days. The issues he mentioned include misguided strategies such as “me-too” strategies (VCs don’t generate differentiating advantage), overoptimistic or unwarranted assumptions, and excessive reliance on government support to spur/sustain the market. It’s interesting to see how some of the advice he gave back then to VCs, such as “evaluate these obstacles accurately (conservatively)” or “consider risks associated with subsequent financing requirements” were points that were brought up later against the federal government in the Solyndra case.
And what about the government? How well is the DOE doing with its green loans programs? It’s hard to tell as most of the 31 investments listed on the DOE website are from the last year or two, but some data, though limited, is still available. FactCheck.org looked into one of Romney’s ads that claimed, among other things, that “federal money was wasted on failing companies that are now laying off employees.” FactCheck.org discovered that the ad fails to note that “an independent review of the DOE program says its failure rate has been better than anticipated.”
According to Bloomberg News, the default rate on the $16.1 billion DOE loan portfolio is less than 3.6 percent, much less than the default rate the White House planned for – as much as 12.85 percent for loans to solar, wind and bio-energy projects. “I’m willing to bet more-than-even money that the default rate, when all is said and done, is under 5 percent,” Greg Kats, who worked at the DOE from 1994 to 2000, including five years as the department’s director of financing for energy efficiency and renewable energy, told Bloomberg. “I do not see a scenario in which the default rate gets out of single digits,” he added.
There will be those who will argue that we shouldn’t focus on the comparison between the DOE and VCs on returns on investments or even do these comparisons at all, as it’s like comparing apples with oranges. I believe that no matter what your position is in this debate, it’s important to know the facts. This also means acknowledging that the markets don’t always have the right answers and that even the savviest investors can be wrong much of the time. After all, in almost every failed investment you will also find couple of VCs that were also involved and invested in the failed company. I guess it means that even those money makers of the Valley are just human beings, right?
Raz Godelnik is the co-founder of Eco-Libris, a green company working to green up the book industry in the digital age. He is an adjunct faculty at the University of Delaware’s Business School, CUNY SPS and the New School, teaching courses in green business, sustainable design and new product development.