Q&A on Startups and Investing Strategy with Massachusetts Clean Energy Center’s “State Angel” Arif Padaria

It’s tough out there for angel investors and venture capitalists—not to mention entrepreneurs scrambling for money so they can build the next big thing. Nothing surprising there, but it’s especially true in cleantech and energy, where the exit market has not yet matured, and the process of building early-stage companies is as thorny as ever.

Enter the Massachusetts Clean Energy Center (MassCEC), a Boston-based state agency that supports and promotes local clean energy companies. Led by executive director Patrick Cloney, MassCEC is trying to develop the cleantech ecosystem in the Bay state by focusing on renewable energy generation and workforce development, and by making investments in early-stage projects and startups. The agency has helped finance dozens of companies big and small, including A123Systems (NASDAQ: AONE), 1366 Technologies, FloDesign, Solartrec, and Next Step Living. It has investments in areas like solar, wind, biofuels, hydro, and energy storage—and an increasing focus on energy efficiency, smart buildings, and smart grid technologies.

Earlier this fall, I spoke with MassCEC’s managing director of investments, Arif Padaria, about the state’s energy landscape and his agency’s role. MassCEC receives $25 million a year from the state’s renewable energy tax, and about $8 million of that is controlled by Padaria, to be used for investments in early-stage technology companies.

Padaria, 42, is a software entrepreneur and computer scientist by training, and a tech investor by recent career. In the early 1990s, he dropped out of a PhD program at Princeton to help start a couple of software companies, both of which were acquired. He then went the business school route, got his MBA at Columbia, and went to work on Wall Street as a tech investment banker with Broadview; later he got into venture investing at TVM Capital and Pilot House Ventures (with a stint in strategic investing at Microsoft in between). Padaria started at MassCEC in January 2010.

Arif Padaria

A big part of his charge is to help selected Massachusetts cleantech startups traverse the so-called “valley of death” and obtain their first financing round, which is usually in the $1-3 million range. MassCEC participates in these rounds and gains an equity stake in the companies.

“How do we impact that?” Padaria says. “I’m essentially a state angel group. I come with a whole network of investors, especially in software. I’m going out there, beating the bushes, trying to find the right deals. My goal is return on success, not just return on investment. We take a thought leadership role in ecosystem development. We go into a field where nobody else [i.e., an institutional investor] is willing to touch it, so to speak.”

Padaria elaborated on some of these themes in our chat below. Here are some edited highlights:

Xconomy: Where does the MassCEC investment fund fit into the ecosystem of cleantech angels, venture capitalists, and federal government financing (such as grants from the Advanced Research Projects Agency-Energy)?

Arif Padaria: Where we really fit is on the angel side. VCs are pleased that someone is coming in to take the risk to move a company to a level that may work or not work. If it does work, it could be interesting enough. At the same time, I don’t have a deep enough pocket to continue to fund it. I will always remain a small investor and not get in the way of that growth.

[In terms of federal funding] the ARPA-E grants are much, much larger. They have an impact in a completely different way. The first investments we did were because of the fact that these [companies] were thoroughly validated by ARPA-E, got ARPA-E funding—1366 and FloDesign, for example. As it makes sense to keep them here [in Massachusetts], we added to the ARPA-E investment by giving them some additional investment components. All the good stuff that comes out of MIT and other top Massachusetts universities can quite easily move to other states.

X: What are the goals and issues, for both you and the startup, when you make a typical deal?

AP: My goal is not so much follow-on investments. I hold on to some equity, but I can kick it up to the right guys at the next level. The issue I’ve found in cleantech is the two Ps. Pricing and policy. Fundamentally you’re not going to get away from policy or government or rebates. With FloDesign, we gave them rebates, and helped them with the siting of their pilots. One issue was to keep FloDesign here, and not have them move to California. So I kept a hook in the deal. Two out of three [company facilities] have to be in Massachusetts: headquarters, research and development, and manufacturing.

X: What’s your advice for entrepreneurs and investors who are making the transition from IT or life sciences to cleantech?

AP: The whole environment is very different—how you execute, what the partnerships look like, what the sales and development cycles are. Instead of jumping in and wanting to start a company, which is very challenging, I think going in and working for a year or two at a larger, more established energy company is important. Even if it’s a coal, oil, or natural gas company, [it’s useful] to get a grounding in the value chains and sales cycles, and not just be getting excited about the technology and saying, ‘Hey if we build it, they will come’—that doesn’t happen.

The other real issue is that life sciences is not exactly comparable, because the exits are large pharmaceutical companies—there’s a pipeline there. Here, we don’t have an automatic pipeline in terms of acquirers, and certainly the IPO markets are very challenged. The other exit is through a strategic buyer, which is very small. In the next year or so, we’ll see a lot of roll-ups happen. It’s starting to happen already in terms of energy-efficiency companies. Platforms are being built, and private equity companies are sucking them up. Those are cash businesses.

X: So where is the cleantech investment ecosystem headed, more broadly?

AP: We need a lot more excitement around cleantech for people to jump into cleantech. The ecosystem is just so small right now, also for the services people. MIT is in the forefront, UMass is also there, and there are a lot of professionals from the IT side.

MassCEC is trying to do more project finance stuff. For example, you build a wind turbine that’s sexy, and nobody wants to build it, so you take the risk. Some new models will emerge that are more like a hedge fund. But the [limited partner] business is such that they don’t have a clean bucket for that. You’re either doing venture debt, or private equity, or a hedge fund. The question for our industry is, what is the real exit, what is that multiple you expect to get? I don’t know all the answers. You’ll see a lot more deals tied up with strategic investors—VCs will go into a company alongside GE’s or Siemens’s venture group.

Even though the capital intensity might be $30-40 million to get to break-even, and I’m putting in a sliver of $500K in a $2 million round, it’s really great engineering. Take Solartrec [a solar startup based in Somerville, MA]. The goal is to get to the prototype. By mid-next year, they’ll go out to raise a $5-10 million round. The goal is to move the needle now. For a Series A investor, that makes total sense. They need to see the proof of concept here. The runway from there is still probably another $20 million beyond that. But the metrics are in line with what cleantech folks are getting used to these days. These are not software metrics—you don’t build a company for $20 million all in. But the remainder could be done through government loan guarantee programs, and venture debt can be used.

X: How will you gauge the success of your investments, and your fund?

AP: One success metric is, who is the handoff to? Who are the top-tier investors I was able to bring in? Another is if the company’s successful, what did they do for that particular area—whether it’s algae, or biofuels. Did they move the needle, did they become thought leaders? Are they looked to as the next big emerging company? And the jobs they created. Ultimately if you’re going to be sustainable, you’re going to create some jobs, whether they’re higher engineering jobs or manufacturing jobs.

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