What is project finance and how can it fund profitable plans?
Imagine developing a business plan to build a battery recycling plant. Or a large EV recharging center next to the highway. It costs $5M to build.
Financial projections show it will be highly profitable. Everything needed is off the shelf, so the risk is low. Once we build the first facility, we can replicate it all over the country and then cover the world. The opportunity is nearly limitless. We’ll be billionaires within a few years.
Unfortunately, we don’t have $5 million to build the first facility. And the hundreds of millions of dollars we’ll need afterward to churn out all the copies. Unlike a software startup, there’s no way to bootstrap ourselves to an MVP with a small team working over the weekends. We need financing.
I shine up my spreadsheets and make a trip to the bank. They politely laugh in my face. The Small Business Administration is eager to help — as long as I have collateral to guarantee repayment. And a personal guarantee that the government gets my house and kids if I default. Um…no.
So I put together a pitch deck and make it nice and pretty. The TAM is $1 trillion dollars, and we have a world-class team consisting of you and me. We have no competition other than the status quo. Within 5 years, we’ll be generating tens of millions in profit. All we need is a measly $5M in seed funding. Please? Pretty please?
Come on, guys, you threw $700 million at a blood-testing startup that the laws of physics said was impossible. You invested $50M in a sock puppet, for God’s sake, that blew it all on Superbowl ads. You can spare $5M for me. My plan is guaranteed to make a healthy profit.
Profits? Remember them? Doesn’t anyone care about profits? Apparently not.
What Do VCs Want?
This is not a deal that gets venture capitalists excited. In a nutshell, here’s what the VCs are looking for:
- Put in a small amount of money
- Grow insanely quickly
- Have unique technology or marketing that locks out competition
- Get acquired for the technology or brand within a few years for 100x the investment
Unlike other types of investing, profits don’t matter in venture capital, only revenue growth. In fact, if the company is generating profits, it’s doing something wrong — any extra cash should be reinvested in growing faster.
Without unique technology that can be defended with patents or a valuable consumer brand, the VC model doesn’t work. Even if the business is insanely profitable, there’s no reason for an industry giant to acquire it at a huge premium instead of building a competitor themselves.
The acquirer of a profitable business is private equity. But private equity only pays a small multiple of EBITDA — an order of magnitude less than a strategic acquirer. For VCs, an acquisition by private equity isn’t quite a failure, but it’s not a big enough win to be a worthwhile investment.
How about angel investors? I only need $5M. Less than the cost of buying a small apartment building. Unfortunately, angel investors follow the same model as VCs looking for outsized returns.
Introducing Project Finance
I asked my friends who invest in solar and wind farms how those are funded. They introduced me to project finance.
If you need to finance a large project with hard assets that can generate substantial profits, project finance is the way to do it.
Project finance is far more complex than venture capital, with many different debt and equity holders involved. If you’re interested in more detail than I can include in this article or even understand, there are plenty of resources online, starting with Wikipedia. This is my favorite article on financing a solar energy farm.
The basic idea is that every project is set up as a separate entity, usually through an SPV (special purpose vehicle) with multiple equity owners.
There are outtake agreements for the output of the facility — power for a solar farm or materials for a recycling plant. There are long-term supply contracts for all the required inputs. And fixed-price contracts for the construction of the facility.
These long-term agreements lock in pricing for all costs and revenues over the lifetime of the project, leaving nothing to chance. We don’t want a big drop in the price of electricity 5 years from now to send our solar farm into bankruptcy if the revenues don’t cover the mortgage payments.
Gambling on the price of electricity to go up is fine for venture capital, but not for lenders making small returns. If we’re generating electricity, before we start building, we have to lock in a long-term power purchase agreement with a utility to guarantee revenues over the life of the facility.
Once all the costs and revenues are fixed, the project becomes “bankable” — banks, private equity, or other lenders have the confidence to provide the loans for hundreds of millions of dollars.
Building a solar farm requires more financial engineering than civil engineering. The process is fundamentally about finance rather than technical innovation. Innovative solutions are avoided if they don’t have a track record to guarantee performance over the entire 20-year life of the project.
Project finance can fund the construction of facilities that cost hundreds of millions of dollars. However, their complexity means the legal fees alone would swamp our $5 million dollar project.
Adapting Project Finance with Joint Ventures
Project finance might be overkill, but the concept makes sense for our small project. Venture capital-based startups take wild guesses about future revenues and costs; we can lock them down to guarantee a profit.
Instead of leasing land ourselves and finding customers for our high-speed EV charger infrastructure, we find a company to partner with that already has the land and traffic, i.e., a truck stop or a large highway restaurant.
We set up a joint venture with them to share the profits. The partner leases the land to the JV and guarantees minimum usage. We bring the expertise and management, and perhaps additional equity investors.
Rather than finding angels or VCs to invest in our company, we look for financial investors to put cash into the joint venture. With a solid partner guaranteeing that costs are covered, it shouldn’t be difficult. People who invest in profit-generating real estate or small businesses are a better fit than VCs and angels.
The JV gets bids on all the costs, including construction, charger equipment, and ongoing maintenance and repairs.
With enough revenue guaranteed to cover the principal and interest, we find a lender to finance the deal and begin construction.
The loans get repaid first from revenues; remaining profits flow up to the JV, including us and our investors.
In many ways, setting up the facility has more in common with investing in commercial real estate than venture capital.
Go Profitable or Go Home
Once we’ve proven the business model with the first project, each successive one becomes easier.
If we succeed in showing high profitability on the first project, we’ll have partners and investors clamoring to join the second. We’ll be able to demand better terms and keep more of the profits for ourselves.
The key, then, is getting the first pilot project built. For that, I need to find a partner.
For the EV charger infrastructure, it may be a truck stop chain or the owner of a mall alongside the highway. The draw for them may be the enhancement to their existing business or highlighting green credentials more than a little extra profit from the facility.
The goal for the first project is to prove our business model. We need to show profitability. We don’t need to get the profits ourselves as long as our operating costs are covered. This is our MVP. We may offer the partner 90% of the ownership of the joint venture just to see it get built.
This is a different way of funding a startup than getting a big check from a venture capital fund. For startups that require a large amount of capital for hard assets that can show profitability for each facility, it’s a better way to get started.
Soon we’ll have ownership stakes in hundreds of joint ventures for facilities all over the world. The future is limitless. We’ll be billionaires soon without venture capital.
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