In the technology investment world, we are very familiar with the acronym “ARR”: Annual Recurring Revenue. This is one of the most important metrics of a successful SaaS business. A start-up’s ARR value and growth rate determine its valuation, its viability as a stand-alone business, its return to investors, founders, employees and ultimately its value to stakeholders.
Although ClimateTech startups are bound to the same law of (financial) gravity as every other business, in that they will sooner or later need to generate ARR (or some other comparable metric of predictable and durable revenue), they also need to generate another form of ARR that is equally important in the eyes of climate-conscious investors and customers:
Avoid, Reduce and Remove emissions – the ARR of ClimateTech.
For the purposes of this blog post, let’s refer to Annual Recurring Revenue as ARRf (where the subscript f stands for financial) and Avoid, Reduce and Remove as ARRc (where the subscript c stands for climate).
The most profitable companies have grown by doing more. More manufacturing, more customers, more shipping, more products, more (positive) EBITDA, more everything → more ARRf
Companies focused on ARRc are all about doing less of something that has historically been associated with doing more: less (or no) emissions (CO2equivalent emissions, or CO2e). Customers never had to pay for the externality of doing more, which is instead internalized -and not always compensated - by ClimateTech companies. This is a significant delta in performance and the first hurdle that climate-conscious startups needt o overcome.
Expecting ARRc and ARRf to compound simultaneously seems counterintuitive:
Altogether, the ARR of ClimateTech leads to the Recycling of resources, the capital R of a climate-positive circular economy in which we live in equilibrium with the finite world resources we have (even the sun and wind are finite resources because we have only so much land / water surface and silicon / steel productsto harvest them).
So, can ARRc and ARRf work together? The reality is that they must.
A prime example of aligned ARRf and ARRc is our portfolio company Cemvita: they are reinventing chemical refining with carbon-negative biological processes, and doing so more economically than with traditional methods.
Another example are climate companies that can prove that incumbents are working towards are-alignment of their existing ARRf with the new demands of ARRc- after all, every company in the world will have to become a climate company.
Because getting ARRf and ARRc to work together is so difficult but so important, it actually makes sense that startups with credible climate positive technologies and healthy unit economics are incredibly valuable. The opportunity is simply massive: ClimateTech companies like Cemvita that find the rare intersection ofARRf and ARRc that creates both climate and economic value can become the next (clean) global Oil & Gas Major.
Hard is in the name of HardTech (The hard things about hard things as Ben Horowirz would say).
ARRc-focused companies have all of the problems of ARRf-focused companies: they too need to identify product-marketf it, iterate tirelessly and execute flawlessly, but they also need to have a technology or product or service that can Avoid, Reduce or Remove CO2e “units” from the world. ClimateTech companies seem to be the combination of two companies that need to flourish at the same time: a climate company that solves a climate problem and the same climate company that solves a financial viability problem.
As a more practical example of that, when we talk to ClimateTech companies, most of the focus to date has been on the climate side of the company building equation: buildingthe technology, testing, piloting, demonstrating, scaling up. Science needs to be taken from the lab into industrially relevant conditions. Process engineering and manufacturability need to be verified before real commercial conversations can take place. At best, the financial validation comes in the form of paid pilots, Non-Recurring Engineering (NRE) revenue, or Techno-Economic Analyses (TEA). In some cases, partnerships with incumbents can be a promising signal, but they don’t fully validate that there is indeed market demand. All of these mechanisms leave a lot to desire in terms of validating the unit economics or ultimate profitability of the company.
In general, we can assume that both “companies” within a climate company have a less than 100%chance of success, and the compounded probability of success is significantly lower than the probability of success of each company taken in isolation.
In addition, unlike software companies that might be unprofitable as standalone businesses with heavy SG&A but favorable contribution margins that would make them a palatable (or at least feasible) acquisition from a large incumbent, the same “cost synergies” are generally not available for climate technologies where the science fails to cost-effectively scale or transfer into the real world or quite simply that cannot achieve economies of scale quickly enough to beat thegoing price of the carbon-intensive commodity they are replacing.
This means that the failure rate of ClimateTech companies is likely going to be higher - much higher - than traditional venture-backed businesses. Once again Climatech is hard, very, very hard!
Building multi-billion dollar ClimateTech companies will always be an incredible challenge. So what’s waiting on the other side of the tunnel? For those companies that can achieve a strong ARRc, there is a premium on the multiple of ARRf that investors and markets are willing to pay: ClimateTech startups are essentially valued on a multiple of (ARR)2. So ClimateTech companies that get both ARRc and ARRf right can be extremely valuable.
Because of the great challenges between ARRf and ARRc, the environment and financial markets will reward the climate tech who achieves ARR2with outsized returns. These companies will be the most valuable companies in the world (or as Larry Fink recently said, the next 1,000 unicorns will be green companies). At ECV we look forward to partnering with the next game-changing company that compounds (ARR)2 to become one of the most valuable companies that the world has ever seen.
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