Bridging the Funding Chasm: Critical Need for Investment in Hardware-based Climate-Tech Start-ups

There is a decline in investments in climate-tech start-ups according to data from PwC's recently published State of Climate Tech Report. And this has been happening the second year in a row. Not too surprising, given the ongoing challenging broad market conditions. On the slightly positive note, climate-tech investments have outperformed the broader market by achieving a less pronounced decline (40.5% for climate-tech versus 50.2% for the broader venture and private equity investment year-over-year). Another piece of positive news is on the increasing share of climate tech investments in total start-up investments. While these are reasons for hope, we are far from where we need to be given the urgency to address the climate crisis.

In addition to the urgency of the crisis, its magnitude is also significant. According to International Energy Agency (IEA) estimates, net zero transition would require $4.5tn of global clean energy investments in 2030, up from $1.7tn today. Stated policies scenario points to over $2tn by 2030. Regardless of what scenario we are targeting, we have to act now and quickly. We have to do it as the whole ecosystem, which makes innovations happen in climate. That ecosystem has many different layers and actors. But for the purpose of this article, let's assume two of the most important actors are: innovators (a.k.a., founding teams - always the real actors of course), who bring innovations to life and investors (most likely venture capitalists and private equity investors), who help innovators on the way.

Start-ups are defined as newly created companies that produce cutting-edge technology (Berg, et al., 2020). There are two widely acknowledged business types in the world of start-ups: 1) #software and 2) #hardware. Innovators and investors are attracted more to the former. In fact, in an article that I wrote about addressing climate change almost a year ago, I had started to explore the idea of system companies (quick note: I define system companies as the integrated platform of software and hardware. Some others call it software enabled hardware) in the context of how best to address climate change. In a little experiment that I conducted for that article, I compared the number of results for exact phrases "we are a software company" vs "we are a hardware company". I used this comparison as a proxy for demand between these two different type of businesses. The results were hugely favoured towards software. The outcome is similar if you try the same experiment now as shown below. Of course, it is not a perfect proxy and the outcome is probably diluted by similar results, etc. Also I have no idea about how Google displays these results. However, none of that is critical to the purpose of this article.

Higher demand for software companies from innovators and investors is understandable for the reasons listed in my article from the beginning of 2023. In summary, this is mostly because software is considered easier to launch, less capital-intensive, hence more scalable and is associated with a higher margin profile. On the other hand, building a manufacturing facility is more complicated than writing code. It takes much longer to develop and innovate hardware solutions and could encounter various issues around the supply chain, performance at larger scale, etc. Of course, this is more or less the framework that investors tend to use to assess potential investment opportunities. Hence, software businesses have historically been viewed more favourably, while hardware is viewed "too hard".

However, in order to make a meaningful impact for #netzero and bend the curve for #CO2emissions, we need to build, invest in and scale more of combination of hardware and software companies, i.e., "system companies" as I like to define it. In a system company, hardware would be the physical, tangible part of the system, while software is the code-based, intangible part of it (Berg et al., 2020). Berg et al. (2020) gives the example of a connected house with the hardware component used to measure, collect and transmit data and the software to coordinate the operations of hardware, store and process the collected data. Another good example from clean energy technology space would be a battery storage system. Battery modules, representing the hardware component, store, charge and discharge electrical energy. Battery management software (BMS), representing the software side, monitor, controls and optimizes the operations of the battery system.

In order to build hardware-based start-ups, scalability is key. DiResta et al. (2015) define the difference between a project and a product as making one vs. making many. In order to turn a project (making one) into a company, the product needs to be scalable (making many). While traditionally it has been difficult to make many, things are getting better. Resources for innovators to build hardware-based start-ups are increasing. Rapid prototyping, decreasing costs, ability to do small-batch manufacturing, open source hardware and growing community allow start-up founders to transform their projects into products.

On another positive note, in the energy space, larger share of VC investment in energy start-ups goes to hardware-based start-ups. However, it is worth noting that there is a meaningful difference between early-stage and growth stage start-ups. Relatively lower share of hardware in early stage demonstrates investors' concerns for future funding risk for hardware start-ups. Below charts are from IEA's World Energy Investment 2023 report.

Energy sector has outperformed others in early stage funding recently. It was the only sector that grew year-over-year in 2022, while others experienced a decline according to IEA data. However, it is not the same story for growth stage investments, where there was a sharp decline across all sectors, including energy.

This bears the question of whether there is a funding gap for climate-tech start-ups. According to Polzin and Sanders (2020), there is enough aggregate capital for a successful energy transition in Europe. However, financing gap exists due to a mismatch between type of funding available and projects that need capital. They say primarily there is a lack of private, small-scale equity investment to promote R&D and demonstration for novel technologies.

In a report published by S2G Ventures, they also conclude that there is sufficient aggregate capital in aggregate. However, the problem that they see is the limited appetite to deploy large amounts of capital into "harder-to-abate" sectors. While there is enough capital on the two bookends, i.e., earlier stage riskier venture financing and infrastructure-type capital for established and already bankable technologies, the middle piece is missing. That middle piece is late-stage VC / early growth. According to the analysis of S2G Ventures, of the $270bn private capital raised for energy transition between 2017 and 2022, $55bn (20%) was for late-stage VC / growth funds.

Funding gap in either of these two categories is a challenge against achieving net zero transition.

1. the scale-up of climate-tech companies is essential to achieving the accelerated roll-out of new clean energy technologies. Building a large scale hardware clean-tech start-up needs a lot more capital than its software counterpart. Furthermore, large-scale manufacturing is critical to benefit from economies of scale, learning curves, manufacturing optimisation and hence cost-down. Otherwise, we put market penetration for clean energy technologies at risk unless we build several of large scale manufacturing facilities and make the product economical for the end-consumer.
2. Supporting new innovations at demonstration or prototype stages. According to IEA's estimates, over 35% of CO2 emissions reductions by 2050 will come from emerging technologies, which are still at demonstration or prototype stage as of today. Such technologies are not yet available as a commercial product. In order to make it happen and contribute to net zero transition targets in the medium to longer-term, early-stage funding for hardware start-ups is critical.

In addition to the funding gap, another issue that we might need to address is the mismatch between CO2 emissions and investments: According to a report published by Allianz Research, mobility and transport receive disproportionately higher share of investments, while it is the opposite for all other sectors (built environment, industrial manufacturing and others).

In conclusion, the climate-tech investment landscape reveals a delicate balance of challenges and promise. While investments have recently declined, the resilience of climate-tech start-ups and their growing share in start-up investments offer hope. However, urgent action is required, especially given the monumental scale of clean-tech investments needed for a net-zero transition.

In order to contribute to this challenge, in addition to my role as an investment professional, I am also looking forward to engage with the investor community to understand their perspectives on hardware-based climate-tech start-ups. The ultimate goal is to construct a robust framework for investors to use for their assessment of investment opportunities and contribute to a more sustainable and scalable climate-tech ecosystem.

References

PwC: State of Climate Tech 2023: https://www.pwc.com/gx/en/issues/esg/state-of-climate-tech-2023-investment.html

Jacobson, I., Spence, I., & Ng, P.-W. (2017). Is There a Single Method for the Internet of Things?: Essence can keep software development for the IoT from becoming unwieldy. In ACM queue (Vol. 15, Issue 3, pp. 25–51). https://doi.org/10.1145/3121437.3123501

DiResta, R., Forrest, B., & Vinyard, R. (2015). The Hardware Startup: Building Your Product, Business, and Brand (1st ed.). O’Reilly Media, Incorporated.

An Investor's Guide to Deep Tech (November 2023): https://web-assets.bcg.com/a8/e4/d3f2698b436aa0f23aed168cd2ef/bcg-an-investors-guide-to-deep-tech-nov-2023-1.pdf

IEA World Energy Investment 2023: https://iea.blob.core.windows.net/assets/99b024be-d605-4c4c-ab6c-94425f515667/VCtrendsslides.pdf

https://www.iea.org/data-and-statistics/charts/global-energy-sector-co2-emissions-reductions-by-current-technology-readiness-category-in-the-sustainable-development-scenario-relative-to-the-stated-policies-scenario-2019-2070

https://www.allianz.com/content/dam/onemarketing/azcom/Allianz_com/economic-research/publications/specials/en/2023/september/2023-09-25_Climate-tech.pdf

https://www.s2gventures.com/2023-capital-imbalances-energy-transition

Polzin, F., & Sanders, M. (2020). How to finance the transition to low-carbon energy in Europe? Energy Policy, 147, 111863-. https://doi.org/10.1016/j.enpol.2020.111863

van den Heuvel, M., & Popp, D. (2023). The role of venture capital and governments in clean energy: Lessons from the first cleantech bubble. Energy Economics, 124, 106877-. https://doi.org/10.1016/j.eneco.2023.106877

Berg, V., Birkeland, J., Nguyen-Duc, A., Pappas, I. O., & Jaccheri, L. (2020). Achieving agility and quality in product development - an empirical study of hardware startups. The Journal of Systems and Software, 167, 110599-. https://doi.org/10.1016/j.jss.2020.110599

Egli, F., Polzin, F., Sanders, M., Schmidt, T., Serebriakova, A., & Steffen, B. (2022). Financing the energy transition: four insights and avenues for future research. Environmental Research Letters, 17(5), 51003-. https://doi.org/10.1088/1748-9326/ac6ada