Venture Capital for the AE Industry—The Why, When, How, and How Much
A major theme in our strategy work—especially with those clients who meaningfully engage their next-generation leaders—is one of “innovation.” For the most part, this involves development of proprietary technology—or customization of “off-the-shelf” tech—to deliver better, faster service to clients. For a hot second a couple of years ago, it seemed like every firm was digitizing and digital-twinning to beat the band. These days it’s a little bit of artificial intelligence here with some machine learning over there while everyone is ChatGPT-ing their way to transforming the way the industry works. Maybe. The innovation narrative that plays out in most AE and environmental firms is that most of these seemingly brilliant start-up, tech-driven business ideas that bubble up from within gain some early traction, secure more than nominal (all things are subjective) internal “funding” or management support, and then…just kinda fizzle out.
To find out why this pattern repeats in our industry, and what alternative approaches CEOs and leadership teams can take to actually productize their firm’s IP, I checked in with KP Reddy. He’s founder and managing partner of Shadow Ventures (Atlanta, GA), a seed-stage technology investment firm focused on the real estate and construction sectors with a mission to “revolutionize the way we design, build, and maintain our physical surroundings.” He knows a thing or two about start-ups in the AE and environmental industry—he and his team hear pitches from 30 new start-ups each week. In his experience, there are three related problems that combine to kill 90% of innovations before they can be monetized.
Think and act like a start-up: The first problem KP sees is that AE and environmental leadership teams “don’t have the right mindset.” They make a fatal flaw early by keeping the innovation team, systems, and product infrastructure inside their core, traditional fee-for-service business when they should instead spin it out and run it as a separate entity. The primary reason for this mistake is that leadership teams are “too emotionally attached” to the outcomes of their company-fostered innovation. So instead of “going to zero in three years they slowly go to zero in ten years. It becomes death by a thousand cuts.” This approach, per KP, is an anathema to a successful start-up. It leads to multiple unnatural and unhelpful behaviors built on a poor incentive backbone. When you staff your start-up with current employees from your core or legacy business who know they have a job to go back to and will get paid on the 1st and the 15th of the month, regardless of whether they fail or not, that’s a fundamental problem. It’s an innovation killer. “That’s not how a successful start-up works,” he says.
A winning team: According to KP, the second reason that innovations never get monetized is because the product company leadership team gets built from within the four walls of your service business. You might have a great idea, but after that “it’s all about execution.” Nobody from an AE or environmental firm leadership or management team “is equipped to do a start-up” successfully. The skillset and incentives are often diametrically opposed. “The first two key leadership positions to fill are those of the CEO and CTO,” he says. Hire them externally. Without them, the start-up will fail—slowly and miserably.
Risk and reward: The third reason innovative ideas fail to reach their full potential, according to KP, is that AE and environmental leadership teams are unable to deliver the appropriate funding model. “They know how to capitalize their core professional services business, but they don’t understand how you capitalize a product business – which is what these innovative ideas are.” Capitalization of a product business is nearly impossible to do internally. Beyond the earliest phases of product development, it requires external capital sources (sometimes venture capital [VC], sometimes private equity, or sometimes even debt) to set it on a successful growth trajectory.
Size and severity: Addressing these three issues upfront is critical if you want to take your firm’s innovations and monetize them. But even before that, you have to figure out if the innovations that you’re considering investing in even have a shot at being meaningful or not. According to Reddy, “This comes down to separating signal from noise. One of the biggest things that we in the VC community throw around is customer discovery. Talk with 100 clients and prospects—to figure out the sizing and severity of the problem.” In his experience, too many leadership teams live in an echo chamber where they delude themselves into believing that the problem that they are aiming to fix is massively widespread and requires an innovative approach when in fact it’s very limited, niche, and can be addressed by other more traditional means (such as insurance or litigation). Per KP, “The size and severity of the problem that your innovation is intended to address need to be of such a scale and so important as to warrant a venture investment.”
Five, ten, fifty: If some of your next-generation leaders have an idea to solve a problem that is of a size and severity that is meaningful (think energy transition, decarbonization, electrification, climate change, etc.), then you (almost) have a tiger by the tail. If this is the case, then you likely require capital of between $5 million and $50 million, and there’s a good chance you won’t see profitability for five or ten years. In our industry, this sum is pretty much impossible to self-fund. This is the “why” for VC in the AE and environmental industry. The way KP describes the situation is this: “VC as an asset class is different. It’s looking for 10x to 20x on its investment as a minimum. It’s seeking businesses that are doubling their revenues every two months. It’s a winner-takes-all proposition. The market needs to be big enough and growing fast enough to be interesting. VC adheres to the power law.” (The “power law” is a phenomenon that describes the distribution of returns in VC investing. Put simply, the “power law” states that a small number of investments in a VC portfolio will generate the vast majority of returns.) One in ten is a winner—maybe fewer. As Reddy sees it, “You only need one Google investment—who cares about the rest?”
Simple, but not easy: Reddy’s simple-to-understand, but far from easy-to-implement, four-step process to increase your chances of winning in the innovation or start-up world is as follows:
- First, separate the signal from the noise. Do your own research. Talk with customers and prospects to test the size and severity of the problem your innovation is addressing.
- Second, break up the band. Spin out the innovation into a separate, start-up business and capitalize it for 12 to 24 months (gulp!) with your firm as the 100% or majority investor with board control.
- Third, recruit a savvy CEO and CTO to lead the new company. One or both of them should have experience in successfully scaling up and exiting start-ups and ideally have connections with the VC community.
- Fourth, run it like a start-up for one to two years to accelerate the proof of concept while concurrently pitching/courting VC partners. This is the incubation period. And it’s this last step that is a big impediment for many AE and environmental leadership teams. It represents, in all likelihood, the biggest and riskiest investment that they will ever have made. This indeed is where the rubber meets the road for many teams, and they balk at the commitment.
Liftoff: If all goes to plan and your concept is proved out, you will secure a first round of VC funding. This is not the end of the journey; it’s just the beginning of the next stage. At this point, your firm’s investment in the venture will be diluted. You may or may not have control of the board of directors. And it’s possible—given the competitive environment—that your representation on the board has to be “masked” through a third party. And with every future round of funding, the original AE and environmental firm that originally spun out the innovation becomes a more and more diluted and passive investor. But the good news is it’s now a self-sustaining entity with sought-after technology margins, still with massive upside.
Success stories: There are multiple examples of how VC has supported AE entrepreneurs in successfully bringing their innovations to market including Procore, SketchUp, PlanGrid, ICON (a Shadow Ventures company), Spacemaker, EquipmentShare, and OnScale (another Shadow Ventures company), just to name a few. Per KP: “Each of these represents the power law dynamic in action with massive, asymmetric growth (and still room to run). Our strategy post-investment is to be extremely hands-on, get involved with product strategy, fix technical bugs, make sure the right team is in place to scale, and immediately drive customer adoption from our existing LP relationships. Most of our investors are looking to buy great products—they just need help sifting through the noise. We play a role of trusted matchmaker and, in the process, greatly increase the odds of success across our portfolio.”
Coda: In his travels around the industry, KP continues to be struck by how “tech-unsavvy” CEOs and their leadership teams are. He views this as an opportunity lost because if the C-suite is not aware of tech-enabled opportunities and tools, then they generally will not get the care and attention they need to create breakout opportunities for their firms. The mission for engineering and design firms has always been to leverage the most efficient tools to build the highest quality product at scale. He advises that leadership teams get smart about emerging tech by investing in a VC fund themselves, or in one or more start-ups, to learn and get some skin in the game. There is no better way to learn than to get active.
You can contact Mick Morrissey at [email protected] or 508.380.1868.