At Chrysalix Energy Venture Capital we are often asked, "What's hot? Where should we invest?" Unfortunately, by the time it's hot, it's too late to invest.

While we have extensive experience investing in cleantech companies, it would be naïve of us to claim clairvoyance. Investment strategy must cope with a hazy crystal ball.

Having said that, there are three value curves depicting the life of a startup to use as a guide when building technology companies:

1. Logical markets
2. Overheated markets
3. Irrational exuberance, as we saw in the tech bubble of 2000

Logical Markets

During times of logical markets, the value of companies follows the shape of a curve with four parts; an early peak, the chasm, strong growth and slowing growth.

The early peak may be caused by the failure in management's execution. Execution may fail because great technology is different than a product, and thus it takes more time and money than management anticipates. This was referenced to as "Crossing the Chasm" in Geoffrey A. Moore's famous book of the same title.

However, a second hypothesis is based on a strong management team that recognizes that large companies can accelerate market penetration and reduces operational risk beforehand. Large companies can move the curve to the right and good management teams extract this value through good negotiation with an early acquirer, justifying the early peak.

Acquisition at the early peak requires the cooperation of a willing partner, and even the best managers cannot force an exit, so if it doesn't occur, a trough follows even for good management teams. Management should never assume an exit at this time and must finance the company through the trough, because raising funds in the chasm isn't fun.

Following the chasm, a company grows with products, sales and then profits. This is the logical time for an IPO. Ultimately, growth declines through market saturation, or competitive pressures leading to commoditization.

Overheated Markets

In an overheated market, early technology companies grow in a similar manner as in a logical market, but at some point value grows above logical markets. An overheated market will experience a correction, often an over-correction, followed by a period of adjustment that should bring the stock in line.

Why does this happen? Fundamentally, because people can make money — a lot of money — if the timing is judged correctly both on the upswing and the down. Who makes the money? The sophisticated and the lucky. However, for the unlucky, the unsophisticated, and the sophisticated who misjudge the timing, losses result.

Irrational Exuberance

The curve of 2000 was different. Irrational exuberance led investors to prematurely pour excessive capital into early stage companies, lifting market values to an early, overheated peak. No right-minded acquirer would have considered buying such companies, and no management team could have delivered performance to cross the chasm. When realization dawned, values crashed and companies died. Hasty acquirers were left licking their wounds after buying inflated startups. Although entrepreneurs are often criticized for the bursting of the Internet bubble, the blame lies with investors.

So which curve is cleantech on? Are we seeing an Irrational Exuberance bubble?

No.

We are not on the Irrational Exuberance curve. In fact, at both the Cleantech Forum in San Francisco and at the New Energy Finance Summit in London in February, the consensus was that early stage financing is the most under-funded portion of the cleantech space and that early stage company values remain reasonable.

So, if not exuberant, is cleantech overheated?

Yes and no; it depends on the sector. Overall, cleantech benefits from being in the largest market in the world, energy, and having many different aspects to the business. In addition, the fundamental drivers of change are here to stay: higher conventional fuel costs, security of supply and environmental degradation. Thus, it is more sustainable than the Internet of 2000.

However, there are current examples of high valuations in some sectors. The solar markets have price-earnings ratios far above industry norms. In the past few years the S&P 500 P/E ratio has been in the 15 to 20 range. Many solar companies are well over 100, and a few are approaching 1,000. Growth in the industry certainly justifies a higher value, but it is a subsidy-supported market and in the end, solar will become a commodity, where little will distinguish competitors. Price-earning ratios will descend to the normal range and the transition will be volatile. Some people will make a lot of money; others will lose a lot of money. Is this wrong? Maybe, but it is a fact of life.

The biofuels markets have also experienced high volatility and over-valued companies. Like solar, much of it is driven by poor government policy. The Bush administration's bio-ethanol fiasco demonstrates why the government has no place dictating technologies. By singling out ethanol it caused companies to appear, and be valued based on an unsustainable mandate that is poor economic policy, poor energy policy and poor environmental policy.

Good opportunities do exist and both solar and biofuels will have long term attractive returns. Energy efficiency, energy storage and carbon sequestration are ripe with opportunity, as are electric vehicles and water.

Recognizing the landscape as described above, Chrysalix has developed a strategy that steers us through the cleantech investment minefield.

First, we have a diverse portfolio. We spread our risk so we are not beholden to the whims of the financial marketplace.

Second, by having a diverse portfolio, we are conversely well-positioned to capitalize on the whims of the financial marketplace.

Third, we invest where values remain reasonable; in early stage companies, which are underfunded. This allows us to hold significant positions in companies when markets take off.

Fourth, Chrysalix partners come from diverse backgrounds, which makes for a very well-rounded team that is able to more effectively help our portfolio companies grow.

By combining these elements and by having an in-depth understanding of the market, Chrysalix is well positioned to realize significant returns for its investors.

Richard MacKellar is a managing director of Vancouver, British Columbia-based Chrysalix Energy Venture Capital [1], a global investment firm focused on early stage clean technologies. Its investment portfolio covers the entire spectrum of power generation, storage and efficiency, plus water safety and efficiency technologies. Portfolio companies include Purfresh, Fat Spaniel Technologies [2], Angstrom Power and BridgeLux [3].