Investing in a downturn

CHALLENGES OF TECHNOLOGY INVESTING

Cost to build: People are the most important element of any company. One of the major challenges to be cognizant of when investing in technology is that young companies are top heavy. Highly qualified engineers and experienced managers are required to lead the business to early success, and these people are expensive. Therefore, an essential role of a technology investor is to bring the business to a cost structure that makes sense while equity incentivizing the management team for future wins.

By the same token, especially relevant to investing in energy technology, is the cost of capex to build prototypes. Unlike other industries, the cost to build and field trial anything is expensive and hence needs careful capital planning in the investment stage.

Opportunity overload: The second thing to think about is that the people who build technology companies are creative inventors and geniuses. Hence, they inherently lack focus. It is the responsibility of the investor to maintain focus and allow the business to quickly get to a minimum, reliable product at the lowest possible cost.

Commercialization: Probably the biggest challenge that a young company faces after it has developed a product prototype is the challenge of commercialization. In other words, the valley of death or the crossing of the chasm (see Figure 1).

The bottom line is that technology investors have to realize the journey does not end at a successful demo or upon removal of technology risk. One may get lucky and achieve exits at a tech demo stage but most will have to prove commercial viability. So the juncture of a successful technology demonstration is actually the start of the journey. Hence the path to cross the chasm has to be charted with capital planning and time planning so as to yield a reasonable return in spite of the chasm.

To their disadvantage, many investors forget this and mistakenly believe that the hockey stick growth will happen to them without crossing the commercialization valley of death.

IP/ Technology: Another challenge core to technology investing is the need to protect and exercise one's intellectual property rights. A technology investor has to be informed enough to understand good IP from bad and be able to evaluate "barriers to entry" and "freedom to operate." Further, a technology investor must not only prioritize innovation but also continue building a fortress of strong IP protection. Without IP, a technology investment does not really exist because IP leaves as soon as one's smartest engineer joins the competition. Having a strong IP strategy, IP advisors and the ability to discern and build strong IP protection is key to any technology investment.

Lastly, in the oil and gas industry, startups generally have to deal with the challenges of high capex costs, risk aversion coupled with slow adoption among oil and gas operators. Due to the high capital intensity of projects, operators often make the choice of "If it ain't broken don't fix it." This high cost of trial, makes for lower number of trials and hence a much wider chasm. This further challenges commercialization and the opportunity to make a return.

In spite of all these challenges, there remains significant opportunity to make substantial and outsized returns in the current market. A competent investor can create significant value in a low-price environment, as the need and importance of technology grows immensely during a downturn.

RELEVANCE IN THE DOWNTURN

Downturns in the oil and gas industry are known to be cyclic, but somehow they always take people by surprise. A downturn has its own way of cyclical cleansing of the industry's underperformers and forced reinvention of the industry's practices. Oil and gas operators who were busy drilling holes and pumping oil as fast as possible when markets were good, today have time on their hands. Further, these same oil and gas operators are under significant duress and trying to save all the pennies they can. This means they are looking for any NPV (net present value) that can be captured, whether it is reducing project cost, increasing project efficiency, or reducing project risk. All three of these activities are normally the result of a new technology adoption.

Today, for example, customers and operators are very interested in understanding how shale is actually producing. They are asking questions, such as:

• What portions of horizontal wells are actually producing?
• What is the best completion methodology?
• What is the most optimal direction of completing fracturing?
• Can re-fracturing rejuvenate production?

Operators are willing to try a variety of new technologies: sensing and measurement, advanced digital core analysis, distributive acoustic and temperature sensing, computer modeled stress analysis for fracturing, and even big data to optimize their completions and production techniques.

In numerous examples, such technologies have now proven to add significant value to operators. These technologies have extended the life of the fields and allowed operators to produce more from the same wellbores, while sustaining for longer in significant downturn. These technologies are more relevant today than ever before, making technology companies attractive value propositions to invest and to grow.

HOW TO PICK WINNING INVESTMENTS

To pick winners in technology investing, one has to deal with all the normal investing risk layered in with technology risk.

The NUMBER ONE key realization in technology investing is that here too (as with all investments) TEAM is the most important ingredient. The IP and technology can be a close second, but the management team is most important. Don't fall in love with a technology and just invest in it. The management team needs to be right. Poor management teams have turned amazing technology into dust. While good management teams have reinvented themselves, found new technology solutions and recreated companies from nothing. Selecting a quality leader (CEO) and a strong team with good chemistry remains more important in technology investments than any other type of investments.

The second criterion to think about is market size. If any of the technology is breakthrough but penetrates only a small market, then the slow adoption rate and risk averseness will lead to low revenue and substandard returns. It is important for the success of the investment that the technology solves a problem in a large enough marketplace.

It is also crucial to understand the value proposition created. The NPV has to be substantial whether its reducing risk, reducing cost, or improving performance. In a typical technology sale, the technology company might only be able to capture 10% to 30% of the value created. The rest of the value will always be captured by the operator, and if the value created is marginal, the profits will be marginal too.

Next is the understanding and appreciation of the capital required to bring this technology to market. Here the investor needs to understand the cost of bringing the technology to trial phase and the subsequent cost to take it to scale. If the product requires a very large amount of capital to bring to market, it might not be a good investment. Thorough in-depth analysis must be performed upfront to make this determination.

Last but not the least is the technology itself. It has to be based on sound scientific principles, properly protected with IP with sustainable barriers and ideally have a prototype that already proves that the principle works.

There are many other elements to sound technology investing but they do not all have to be mentioned here because they are common to all types of investments.

CONCLUSION

In conclusion, technology investing is a very important and necessary public good, which allows new innovations to enter and sustain the future of the industry. Further technology investing can be extremely lucrative if done right, and it provides results that supersede traditional equity investing. However, technology investing involves additional risks and requires significant industry specific expertise to be able to pick winners from losers. In the current downturn, there are a lot of interesting technologies to be funded and supported, and there will be significant value created in investing in those companies. However, it is not for the faint of heart.

ABOUT THE AUTHOR

Shantanu Agarwal is a partner with Energy Ventures US Inc., a private equity firm providing capital to high-growth oil and gas technology companies. The firm manages and advises four oil and gas funds with a combined capital base of US$775 million. Energy Ventures is headquartered in Stavanger, Norway, with offices in Aberdeen and Houston.