Monday, April 13, 2009

The moral hazard of cleantech hubris

Since last summer, many firms have lined up to get their share of taxpayer subsidies. It is not always clear which firms deserve such subsidies and which ones do not, but as always, it’s predictable that the undeserving firms will do their best to appear deserving.

One of the companies seeking Federal aid is electric car maker Tesla Motors. Tesla has shipped its Roadster to an affluent niche market, but hopes to find a broader (niche) market with its $57,000 Model S sedan. Plans for the Model S have been on again and off again; right now they’re said to be on again.

Tesla is personified by chairman/CEO/founder Elon Musk, a 37-year-old serial entrepreneur who appears to be simultaneously running his 3rd and 4th startups.

My coworker Randy Stross (author of Planet Google) wrote about Tesla in his New York Times column. His Nov. 30 column questioned Tesla’s suitability for Federal bailout dollars:

The Tesla Roadster is an electric car that goes fast, looks sensational and excites envy. The seductive appearance, however, obscures some inconvenient truths: its all-electric technology remains woefully immature and don’t-even-ask expensive. If enough billionaires step forward to inject additional capital to keep the doors of its manufacturer, Tesla Motors, open, I’m happy for all parties.

If investors pass up the opportunity, however, why should taxpayers fork over the capital that Tesla needs? The company is requesting $400 million in low-interest federal loans as part of the $25 billion loan package for the auto industry passed by Congress last year.

The program is intended to encourage automakers to improve fuel efficiency, but should it be used for a purpose like this, as the 2008 Bailout of Very, Very High-Net-Worth Individuals Who Invested in Tesla Motors Act? Can you conceive any way that federal dollars could be put at greater risk — and for no equity in return, keep in mind — to benefit fewer people?

Tesla Motors, a privately held company based in San Carlos, Calif., has spent almost all of the $145 million in capital it has raised to date. It says it will soon receive another round of $40 million from its private investors to sustain operations.

In the start-up ecosystem of Silicon Valley these would be respectably large numbers, but in the automotive world, fully developing an entirely new line of technology can easily run $1 billion. That is what General Motors’ first attempt at an electric vehicle, the EV1, was estimated to have cost to develop in the 1990s.
Stross had two inaccuracies in the original article. First, he confused the $109k Roadster with the “mass market” $59k Sedan (later corrected online).

Secondly, he said Tesla wanted $400m in Federal loans: today, the current estimate is $700m. The money would from the Department of Energy’s loan guarantee program instituted by President Bush. The first $250m would be funded by 2005 legislation to reduce carbon emissions, the second $450m from the 2008 program for drive-train electrification. (The loan guarantees will charge fees to cover the program’s projected default rate, estimated at 25% by the GAO.)

While Stross’ comments were harsh, they don’t seem unusually so. Silicon Valley companies are often called on their wildly optimistic predictions. And in this climate of bailout fatigue, formerly entrepreneurial companies embracing government subsidies should expect some level of public examination and accountability.

Still, this was in November: after four months, all was forgotten, right? Wrong.

In video clips posted Friday to Yahoo Tech Ticker, Musk was interviewed by Sarah Lacy. In one of the video excerpts, Lacy shows one of Tesla’s scarce Model S prototype and asks the question “Should your taxpayer dollars go towards producing it?” She then began her interview with Musk:
Lacy: The New York Times did this piece that everyone in Silicon Valley got very up in arms about…
I don’t think “everyone” in Silicon Valley got upset. Some are too busy trying to keep their own startups alive to worry about Musk’s electric cars. A few tech entrepreneurs (like Paul Allen) were even willing to be politically incorrect and oppose the bailout.

Let’s restart the hard-hitting investigative interview:
Lacy: The New York Times did this piece that everyone in Silicon Valley got very up in arms about, saying that, you know, that the government money going to Tesla, would be this, you know, huge risk of capital that would only benefit the wealthy and venture capital backers who put money in the company, and called the Roadster basically a $109,000 concept car.

What do you say to that article?

Musk: Randy Stross is a huge douchebag! [Both laugh uproariously.] And an idiot!
Wow! I’m impressed! What a command of the English language! What an ability to inspire confidence among taxpayers that their $700m will be well spent! I’m not sure which is the greater need: journalism lessons for the new-media host or PR lessons for the centimillionaire entrepreneur.

After this ad hominem attack, Musk changes the subject:
Musk: First of all, what is he doing picking on electric car company? I mean, why would he pick on the little guy who's trying to do good, when you’ve got egregious wastes of money in the tens of billions occurring in … in … in Detroit? Why?
Hmmm... So wasting nearly a billion dollars on a little car company is OK because it’s not as bad as wasting $10 billion on a big car company? Musk said the money was intended for a “mass market car,” but (since no one owns a car in Manhattan) only in Silicon Valley would $57k be “mass market.”

Musk supposedly has an undergraduate economics degree from Wharton, so I assume this is just posturing rather than a serious answer. Here is how I would explain why that answer would get an “F” in my technology strategy class:
We can look at a wide range of cutting edge technologies in the past — biotech, dot-com, PC makers, disk drive makers and semiconductors — and see that when many companies enter the market, some companies survive while other companies fail. A priori, there was no way to tell the winners from the losers: if there were, investors would not have invested in the losers.

Today, while society may want electric cars, we don’t know which companies will survive and which will fail. If Tesla fails, U.S. taxpayers could lose $0.7 billion.

A VC expects to lose its entire investment anywhere from 10% to 33% of the time. It compensates for that risk by taking equity and getting a 10x return for the big winners. Here, the government would be supplying 80% of Tesla’s invested capital, but will only earn a fixed fee should Tesla have a smash success.

If you and the current investors don’t want to put up that money — but instead want taxpayers to bear most of the risk — perhaps you know something that the public doesn’t about the riskiness of the investment.

Economist Ken Arrow calls that a moral hazard problem due to information asymmetry. Economics tells us we should be suspicious when people who know the most want others to shoulder the risk.
When funding is tight, many tech companies will grow slowly until their positive cash flow will enable further re-investment. However, in this case, Tesla wants to expand its capitalization fivefold to fuel explosive growth, in hopes of grabbing market share before GM, Nissan, Toyota and others bring their electric vehicles (or plug-in hybrids) to market.

However, by taking Federal funding, Tesla would move into the realm of a regulated government-sponsored enterprise, along with all the other companies received bailouts and subsidies. Government money means playing by government rules, however irrational those might be. The best and brightest of Wall Street are fleeing from the TARP-sponsored wards of the state, presumably a lesson that (most) cleantech entrepreneurs will learn someday, as well.


Anonymous said...

I don’t know what your resume reads like, but I bet you’ve been nowhere as successful as Musk has been. I’ve been following the Tesla story for years and there are always people like you and Stross saying it can’t be done. (By the way, Stross’ NYT article was egregiously inaccurate – to say it only had two things wrong with it is mind boggling.)

At first it was experts saying they could never design a high performance electric car; battery technology wasn’t ready yet, blah blah blah. Then the experts said it wouldn’t have any range. Then the experts said they would never be able to build the factory. Then the experts said they would never actually manufacture them, nobody would buy them, blah blah blah…

My first reaction after reading your article was to point out all the things you got wrong or misrepresented, but it would take more time than it deserves – bitter know-it-alls like you and Stross can’t be swayed by facts.

Joel West said...

Dear Anonymous,

Like Musk, you seem to assume that any demi-god (cleantech or otherwise) is above criticism. It appears that you didn’t read the article. I never said he couldn’t make a good car — or even that I expected him to fail.

I said that investments in startup companies are inherently risky, and these are huge sums that we’re talking about. My discussion was mainly about risk and whether it’s appropriate for the government to take this risk. Any public expenditure of this magnitude requires this sort of public examination and accountability.

Musk is the one who sounds bitter. Stross was nowhere in sight, and he had a chance to put his company’s best foot forward. Instead, he called a NYT columnist a “douchebag.” This is immature at best, and a waste of valuable airtime at worse.

This is what I would have said:

“Anyone in the limelight will get critics. We have proven that we can design cars that will excite buyers — creating demand far above what we can satisfy. Based on initial reaction, we believe the Model S will be an even bigger success.

“We could spend our time worrying about what the critics say, but in the end the only thing that matters is results in the marketplace. We believe that over time, our critics will recognize that we’ve created the first great American car company of the 21st century.”