Climb By VSC: Episode 47

Rick Liebling: Shaun Abrahamson is a co-founder of Third Sphere, a seed stage climate fund dedicated to shaping a post climate change world through venture investments and founder support. Great to have you on the show and excited to talk about climate change hardware with us, Shaun, let's get into it.

Shaun Abrahamson: Awesome. Thanks for having me.

RL: You've had an interesting professional journey. From Investing in tech unicorns to sustainability initiatives like Lighthead and Beta Calm. Can you share with our listeners some of the moments or intersections in your career that truly ignited or deepened your passion for climate tech?

SA: Yeah, sure. I think my introduction to climate tech is now 25 years in the past, we feel a little bit old to say that but I've worked for a professor at MIT who was building out sort of physical simulations. So products like automotive, and we did some work with Bose on loudspeakers. And I think like halfway through my master's degree, he showed up and introduced this idea of life cycle analysis as a new concept. There were a handful of folks who were sort of building the first LCA phase. And so that was my introduction. And so my first thought on climate was that it was mostly an accounting problem. You know, when you sort of put it into the context of people who build physical things and sort of account for all of the emissions associated with all the components, it seems somewhat inevitable that we would get to the point where regulators or consumers or or some stakeholder would say, Hey, I prefer the one with low emissions. So that was there was this sort of naive introduction 25 years ago, and then the internet happened and so my some thinking at the time was internet seems much more interesting, and this accounting problem was gonna get solved. So fast forward about a decade met, someone who started one of the first consumer facing brands and climate at Graham Hill, and he started a blog, I guess, when they would call that called tree hydro. And it became really successful as ultimately sold to discovery but I think that was sort of the second time where it was clear to me that we weren't really dealing with an accounting problem anymore. And, you know, talking to the journalists that worked with Graham and so reading the material, it was clear that we were getting into this, I would say that sort of green premiums phase where if you had the money and you could afford to make the decision, you could choose to have a more sustainable lifestyle. And so I think by the time 2013 rolled around, I found myself living in Miami, there was a king tide and the water was sort of coming over into our streets. I just had kids and I was like, wow, we really haven't done that much. And it was sort of this interesting moment where I was seven years into angel investing. I had met some of the smartest investors that you know, I think names that folks would recognize, and most folks were pretty down on cleantech, right like we'd been through the cycle where sort of clean tech. One point, I think, most people sort of characterize as disappointing. We'll put aside the fact that we got Tesla and we got a couple of pretty notable companies from that era by sort of showing up and suggesting that somehow there was an investment thesis and climate got a lot of pushback. And I think a lot of people that push back would have been, you know, go and find something else to do. But I think study and I had the sort of same response, which is, wait a second, this doesn't make sense. We want to spend more time with this because it seems like people agree there's a problem. And the idea that it can generate a financial return just seems like a bad assumption or bad analysis. So let's try and understand more. I think that's the culture here, how we're generally set up if we hear that things can't be done or shouldn't be done that makes us more interested.

RL: So given that seed stage hardware investing is often significantly less competitive than software investing. How can investors leverage this gap for better returns, especially considering the potential hardware offers for impactful solutions in climate space? This is of course the area where you guys really focus so love to hear your thoughts on that issue between hardware and software from an investment standpoint.

SA: Yeah, so I think you've made the point. I think what we've discovered is if you look at some of the most notable generalist investors like YC, or Union Square Ventures, they're generalist portfolios are very much software, right? So in percentage terms, 80 to 90%. They both make climate investments so they have the subset of their portfolio that is climate. And I think we found that it's about two thirds hardware. That's where we landed up after about 100 investments in two years. So I think we have the data to support that climate is mostly hardware. I think the other thing that we discovered more recently, and maybe this was obvious, but we just never gotten to the data is that if you look at the number of companies founded in a given year, and you look at investors expressed area of interest, let's say using an effects data, hardware deals tend to have about five times fewer, in some cases, much more than that, but we talked about, in some cases, an order of magnitude fewer investors. And so you know, we often ask ourselves, would we rather have a good software portfolio or great hardware portfolio? Because it seems like it's equally easy to do. But either of those things, right? Software is definitely much more competitive. I think the opportunity for most investors is understanding hardware deals. By just understanding that they're less competitive, it should be interesting. I think the challenge of how to take advantage of that is you need to build an investment framework, right? So most folks that start investing, let's say you've built a company or you've worked with startups for a long time, so you have some sense of what it's like to launch, what are the types of problems that they encounter? I think you develop a framework and and I think the most of the framework that folks have developed in the last 25 years is meant for software. And so I think that really the only way to take advantage of this sort of disconnect and competitiveness is to figure out what's different. What questions you need to be asking, especially at early stage for hardware and happy to elaborate on sort of what some of those questions are, but that's where we've tried to spend a lot of time is like what are the key questions we need to understand up front to figure out if it's a hardware investment that we could actually make and be excited about?

RL: I'd love your take on this. There's been a persistent narrative that hardware is hard over the last decade, despite, as you're saying, clear data showcasing its promising returns. Why do you think that is? And how might investors look beyond us to recognize the potential of early stage hardware startups?

SA: Yeah, so I think there's a couple of good reasons to stay away from hardware, right? It was relatively straightforward to generate good returns with software. And so I think what we see is that LPs and managers basically what investors have in mind when they express a preference for software is they imagined something like the alphabet, they've got to a billion dollar run rate within five years raised under $30 million. So if you were an investor, very low dilution, very high growth rates, what's not to like, the problem is that that is not really what most software investments look like. In fact, it really is an unusual generational investment, maybe whatsapp. There's like a handful of other things, but most software portfolios are things that take 10 to 15 years to get to a billion dollar run rate. They are raising hundreds of millions of dollars. I mean, in the case of Uber we are well into billions of dollars. And so I think that the narrative probably was true going back 15 years when Google was the reference and now I think it's broadly just a misconception, right, I think it's a legacy point of view that somehow software outperforms hardware. And so I think our view is that what investors mean when they say hardware is hard is they mean, hardware is hard for us. As investors, we know how hard it is. For startups, it's about 25 to 50% harder to get to the same outcome. You have slightly higher failure rates, and you have to raise more than venture. So you have to master more parts of the capital markets. And then yeah, you have fun things like COVID where you have to rebuild your supply chain. So yeah, definitely more risk, but it's not five times more risk. And so when you look at the difference in supply and demand on the number of hardware, startups versus investors, that is not a reflection of the relative risk. We think it's a reflection of the relative level of comfort of investors. I think what fathers should hear and certainly what we hear, when we hear hardware is hard. We hear hardware is hard for us as investors because we don't yet have a framework for it. And that, to some extent for us, is the core of our opportunity that we see.

RL: Do you think that this, you know, kind of feeling within the investment circles has hindered advancements in climate tech?

SA: Yeah, I almost certainly think that over the years that we've talked to LPs and they're the people who decide which funds get commitments. They have not backed up the hardware as hard with data, unfortunately, but it's a very powerful, you know, it's a powerful catchphrase, right? It's very easy. No one's gonna get in trouble. You know, for going to dinner and saying, Hey, you missed out on this exceptional hardware fun because most of the guests at the table are gonna say yeah, hardware is hard. And so we do think that there's probably been a misallocation of funds. And there's probably a worse problem, which is, there's been an accidental allocation of funds into some parts of hardware that are actually very hard, that actually magnify risk quite substantially. And so what we expect to happen in the next few years is we'll continue to add that hardware is hard for the same reason that clean tech 1.0 happened, which is yes, there are some parts of the map and hardware where you do not want to be and we think it's going to continue to be a struggle. It's not that we are not optimistic, maybe not intentionally outside of climate. There's also good hardware success stories. And so we just think that when folks crunch the numbers and sort of look at supply and demand, high quality deals, eventually more money will show up and it's starting to happen.

RL: Let's talk about some of those kinds of success stories and what are some of the innovations you're seeing that are kind of leading the charge in the climate tech space?

SA: Yeah, so I think maybe the most interesting part of tech investing hasn't really changed in 50 years, meaning visit the concept that as you make more of a thing, you have a learning curve. And what's that learning curve, you get reduced costs and increased performance. And so I think if you took all the climate opportunities and sort of laid them out on a grid, where you could say, where do we get to repeat this enough that you actually see learning curve effects in a meaningful way? So you can see an order of magnitude change in cost and performance? And where do you see things that are more sort of one off more bespoke? So one way to think about it is, how many solar panels have we produced well into the billions or forever, we'll take cells or inverters, they're all things that are being produced in the billion dollar or the billion unit range. Conversely, if you said how many nuclear plants we produced, you can't clear 1000 globally, right. So the shorthand that we use for that is it a construction project? Was it manufacturing? And so that's one sort of dividing line. And I would say the innovations that are interesting to folks that are showing up and saying, Hey, there's a bunch of components that are being produced at scale that are getting faster and better and cheaper. Every night when I go to sleep. I do absolutely nothing about it. There's just an ecosystem making these things better. I'm gonna build on top of that, and I think Apple Tesla, like a lot of the most valuable companies in the world, that's the strategy. It's central to the strategy. It's not just chips, it's also sensors. It's also actuators, it's also batteries. And so when we see people combining those high volumes, things that are quickly increasing in performance, and decreasing costs, lots of things become possible, right? So you can ask questions like could you rebuild firefighting around robots? It sounds kind of insane. But if you follow the cost curves of water, it would take you to be able to out compete, or at least complement traditional firefighting. And so I use that example just to say that I think as much as Robotics has been around, and there's been a lot of progress in industrial robotics, even consumer I think most folks sort of underestimate when you combine batteries and actuators and controllers, and you pick a problem set where you can automate and basically put completely automatic or remotely operated things into the world. There's a lot of interesting things that you can do. We see that shine up in the first response, we see it even in carbon management, fuel production wastes, and capturing biogas. I think the key dividing line for us is that historically, folks thought about infrastructure, as you know, a minimum $20 million somewhat custom plant of some kind. And the really interesting opportunities are the things that are mostly off the shelf that can be assembled into something that's 10 times cheaper, that's kind of the filter that we use, and so that one axis is cost curves. Another axis is how much do you need to customize when you sell the less customization and the higher volume? The more you do production, the more interesting it is for us, it just means you can go faster and cheaper. It's 50 years of how tech disruption has worked. You're not actually taking risk in that way you can manage other risks in the business.

RL: Okay, that's really interesting. So you mentioned Apple and, and there are other companies CTL or Amazon, and they can really do that sort of massive scale stuff. But I'm interested in what are some of the challenges and you've touched on maybe a little bit there, but maybe you could elaborate some of the unique challenges hardware based climate startups face when aiming for that type of scale, especially compared to their software centric startups?

SA: Yeah, so I think there's some critical decisions around time to revenue that I think are not obvious, but if you if you look at the majority of hardware successes that we can find they tend to have one thing in common, which is they don't set up a company and then wait five or six years to generate revenue, and they don't generally build a large, complicated plant. To get to revenue. They tend to use existing contract manufacturing. Or a key partner, but they generally have made a partner decision where they can share the risk with that partner. Usually there's more than one and those partners are producing the key, let's say component, the most expensive, the most complex part of the hardware, and so the team is sort of free to go and focus on some other thing that creates value. And so that is a thing that we actively look for, like if we see a deck and there isn't a dependency on a partner on a key relationship that is generally shocking to us, and it will lead to a line of questioning around Oh, are you going to build all these things? Because we don't know who's going to fund this thing. When you need $50 million to build the first plant historically. There hasn't been an investor like that. And from our perspective, if we think about what we want in climate impact, getting to market quickly, maximizing the number of potential investors is a critical part of de-risking the solution. And so to take it one step further, in an ideal world, when a team gets to Series A, there isn't a question about whether it's an interesting climate company anymore. The only question is, is it an interesting company and the reason that's important is there aren't enough climate funds so there will never be enough climate funds to fund all the things that we need. We really do need generalist investors who can say this is an interesting business. And so yes, solving for times revenue is probably the main thing that the key way in which we see people do that is you pick usually a very thoughtful partnership. If you want a really strong signal, that part is probably on the cap table, but it is a very, very aligned partner. And that's the thing that a lot of VCs have to relearn. We didn't 25 years of software generally meant that you could work very independently. You may have a cloud service provider who I'm not saying the relationship isn't good. But it doesn't, it's not the same thing as having a relationship with a partner where if they are committing to take on some risk to produce something for you, you're really showing the risk in a different way than cloud infrastructure.

RL: And so, alright, we've talked a little bit about the investment and getting up and running. So once you've kind of reached that point, right, you see companies like Sunrun, or Cycle offering hardware services, rather than outright sales. So how is hardware as a service or has that model revolutionized? The way consumers interact with climate tech? How does this model alleviate some of the traditional risks associated with owning and maintaining hardware?

SA: Yeah, so I think conceptually, again, this is a pretty old idea, right? I mean, it's Buy now pay later. It's a subscription. It's leasing, renting whatever you want to call it. But for every major asset class going back 100 years, at least, there's a subset of buyers who basically say, I don't have the cash, or I do have the cash but I don't want to tie it up in buying this thing or a fleet of these things and also, by the way, I don't want to have to have exposure to technology risk, either that it doesn't actually work as advertised. Or there's a better thing that comes out in a couple of years and I'm stuck with the legacy thing. So you've got this sort of decision making framework that's familiar to most customers. And so being able to go with we've seen when a team can go from selling a thing to leasing a thing. The impact on sales is two to three acts. Right, you just immediately expand. So there's a bunch of folks that were clearly interested, but were sitting on the sideline and waiting for a moment where they could say it's cheap enough, it's direct enough, or I feel good enough about, you know, the obsolete S curve that I'm willing to make the investment. So again, it's not a new framework. I think what we see is the hardest thing about the framework is who owns the asset, right? Like if the customer is not going to buy the assets, there's only two options, right? Either that acid lives on the balance sheet of the company, in which case you need cash to pay for it, or it lives in an off balance sheet structure like Sunrise cycle, we'll get there. I think they actually may be there already. But you have to be able to get to an off balance sheet structure. And so then there's a question about who is interested in that other entity that basically works with the startup to buy assets and manage them and then essentially collect, you know, a subscription or lease payment. So structurally we know how to do that. Like that's not new. That's car leasing. That's, you know, real estate management companies that do this. The trick is, at what point can you actually fund that entity to own assets? And so what we tend to see is the IRA probably moved up the ability for companies to take a knife completely de risked or not completely mature technology and because of the tax equity and other incentives, money that may have looked to this unsettle investors that may have looked at this and said, No, I need another two or three years to get comfortable showing up and saying, Actually, we'll take a look at this because there's so many incentives. So that's one of the sort of magic tricks of the IRA. I mean, there's a lot of interesting parts of the IRA, but the thing that we see is you really are collapsing some of this discussion around When could you set up a decent structure and that and that's interesting.

RL: But you know, Shaun, for a lot of people who are just scrolling on social media, where maybe they're catching a little headline news headline here or there, it can easily get kind of negative about the future about where we're heading with the climate. But as someone who's deeply involved and engaged in looking at the solutions, I decided to kind of wrap things up a little bit today, maybe with you telling us some of the things that give you optimism for the future and what you're seeing that pays you kind of fired up.

SA: Yeah, there's a few different things. I hope this is as simple as I can. I think at the highest level, the repeatability of technology, learning curves, it's inevitable, right? So as long as we have talented people, looking at emerging technologies that are going to get cheaper we are gonna be able to solve most technical problems. So things like hard to decarbonize every year, that becomes less true, right? It's just a thing that we won't say, in 10 years. There'll be very, very little left that fits into that. And I think the hardest part is that especially in the energy world, energy is about infrastructure and construction projects. There is some tech, but it's mostly large sums of money going into big construction projects. The tech world is very much about high volume manufacturing. And so I think it's hard to sort of get your head around. How does something get 10x better in 10 years? And so the thing that is like maybe the thing to hold on to is that we didn't have smartphones, and then 10 years later, everyone, pretty much globally. I do mean like almost everything and so that is the scale of what can be done. I think it's more likely things take 20 years. There's some things that may take 30 or 40. But the only question is sort of how long, right and I think that that is not a tech problem. I think it's largely a misinformation disinformation campaign. And I think my sort of favorite recent characterization of that is Al Gore explaining, you know, what fossil fuel companies don't want you to know. And I think that the more you call that out, and the more that customers make decisions based on how they spend, I don't think we're doing nearly enough. I don't think most people can afford to pay a premium. So I think that the stacking thing that's exciting is that there will always be folks who want to be first in new technology, right? You needed to be in that line for the first iPhone. You needed to be in the line for the first PC. You needed the latest GPU, so like we have GPUs, by the way, because people decided they need better graphics cards. So again, like those are the things that are amazing, as long as the folks who like me want to have the new best thing. That's great. What's amazing is that we have the same additional group of people saying I want to be first for the new material for the new low carbon version of the material for the new fully electric version of the thing. And so you've got tech, and now you've got another sort of cohort of folks who want to be first for sustainability. And again, those two things are what cost curves are inevitable and there isn't any amount of fossil fuel that stops that it may just slow it down.

RL: Well this is a great shot. I appreciate the insight and the detail you can go into this as we wrap up. If someone wants to know more about the Third Sphere, they want to follow you and get more of your insights. Can you share with us a couple places where people might be able to find that information or follow you?

SA: Yeah, I think it's probably best these days, it’s LinkedIn. We just started a sphere on LinkedIn. And that's probably the best and simplest. We have a newsletter that's about 10 years old and folks can subscribe on so sphere.com It's about a monthly overview of the things we think are most interesting and climate and startup world and there's a fair amount of hardware. So hopefully you folks enjoy it.

RL: Fantastic. Yeah, definitely something to check out. Saun Abrahamson from third sphere. Thank you so much for joining us today on the client podcast.

SA: Good to see you, Rick. Thanks for having me.