What do VC investors want to see from smart city startups?

In 2021, global and European venture capital investments reached all-time highs. It seems the market is exploding and so are startup valuations. In the last few years, sectors like FinTech, Enterprise Software, Mobility & Transportation, Health and Energy received increasing attention from investors. Some of those deals can be considered under the umbrella of Smart City as well, as the term refers to a rather broad field of different technologies and applications areas (such as energy, mobility, water, waste, among others).

However, the Smart City sector truly faces special characteristics such as high political and regulatory influences, resulting long sales cycles, high public interest and welfare potential and usually a link to physical infrastructures. Typically, these are aspects many investors don’t directly fall in love with and so it is a crucial task of founders to answer some serious questions VCs will have.

How do you tackle regulatory issues?

Regulatory affairs can be a dealbreaker when politicians decide to ban or at least handicap certain business models.

This is what happened in the case of WunderMobility from Hamburg, who started as a carpooling service in Germany, but had to stop their local business due to legal restrictions and re-start as a ridesharing service in Eastern Europe and the Philippines, before they started to offer a PaaS (Platform-as-a-Service) service to established mobility providers. Other companies like CleverShuttle had to cope with the comparable problems and changed from a B2C to a B2B2C model. In other cases, regulatory changes created interesting business opportunities. Remember long distance coach unicorn FlixBus, who were just able to start their business when the German government stopped the ban of long distance coaches? Or drone data and workflow provider Flynex, who can offer their services across Europe since the EU drone regulation was harmonized earlier this year?

All these startups became successful, because they were flexible enough to react to regulatory changes and some of them managed to pivot their business models several times – and had the right team and investors to do so.

If founders in Smart City sectors want to receive a VC investment, at the latest during a due diligence they have to explain in detail which current laws and by-laws influence their business model, which future regulatory changes will positively or negatively influence their business and what is the recent political debate on those topics. Startups also have to understand different legal frameworks in different international countries. It is also a great advantage to show how founders keep up with those topics and how they try to engineer the political debate, for example by working closely together with opinion leaders and legal experts, lobby groups or as members of political committees. Having relevant experts in advisory boards (or supervisory boards) might be an advantage as well.

How will you survive and shorten long sales cycles?

The public sector is a complex and rather clumsy environment to do sales. Sales cycles easily expand over a year or two. Typically, time-consuming public tenders are required if the contract value is above a certain value. Thus, it is hard to scale fast in the smart city sector and customer acquisition costs are high. This is maybe the most crucial reason why some investors avoid that sector.

Compared to other sectors, a sophisticated go-to-market strategy is much more important to investors. First of all, a clear market segmentation and targeting of customers is essential, because is it a huge difference between selling to cities directly, to municipal companies or to third parties who are already implement in the city infrastructure. Simply hiring a sales junior to ‘cold sell’ on LinkedIn won’t work. You often need to show your special knowledge in a specific application through whitepapers and expert contributions in online and offline media as well as events. Next Kraftwerke, a virtual power plant, is a great example of a comprehensive blog and wiki that provides a lot of useful information not only for potential customers. Also, lead generation is usually even not done online, but on traditional trade fairs and conventions such as Smart City Expo Barcelona or eWorld in Essen.

Besides direct sales, collaborations with system integrators and engineering consultants play a major role. This is because they have long-lasting and trusted relations to potential customers and not seldom framework agreements that allow them to place products and services much faster. However, if you win customers, their ‘stickiness’ and customer lifetime value are usually quite high. Investors will require a concrete and detailed plan how you plan to reach your customers and at what cost, how long the sales process shall be as well as the typical contract value based on your pricing strategy. Your strategy and alternatives to shorten sales cycles will likely be discussed.

Moreover, from a financial standpoint long sales cycles means that the ‘valley of death’ between launching costs and exponential revenue growth is longer, and you have to cover this. While in other sectors the time between two financing rounds is usually around 18 months or shorter, in Smart City it should at least cover 18 months or even a bit longer. Investors will ask you for a concrete financing strategy that – besides venture capital – may include other options such as public grants as well.

High public interest and social welfare

A very positive development for smart city entrepreneurs is the rise of impact funds and the increasing importance of ESG criteria (Environmental, Social and Governance) for more or less all funds. As smart city innovations usually also benefit society, they address a couple of SDGs (Sustainable Development Goals) making them compliant and interesting for any investor who places emphasis on sustainability. Also in that regard founders should be as concrete as in finance and sales and – based on the business model – name the SDGs they address, calculate the reduction potential of CO2 emissions or water loss, or how much you improve the inclusiveness of society etc.

On the other hand, being active and visible in the public space can be a burden as well. Particularly European citizens seem sometimes to be less hungry and positive towards innovation. But it is also the right (and actually the duty!) of responsible citizens to ask critical questions about their environment and the public realm. In some businesses there is a significant danger of negative public opinion, driven by the careless behaviour of startups and negative media responses – take for example of potential e-scooter bans in Paris due to accidents, or scooters misused as submarines in the Seine. If founders have a gut feeling that their technology or business model might have acceptance issues or are at least in need of explanation, investors will recognize it as well and so there should be a good strategy and story shaping that public opinion, including crises communication strategies.

Using physical infrastructures and hardware

A lot of VCs hesitate, when it comes to hardware. Hardware adds a lot of complexity, from slower development cycles including prototyping iterations to supply chain management to final manufacturing capacities to logistics.

Typically the amount of working capital is higher in hardware-based businesses. Thus, many VCs quit discussions when they just hear about hardware. Needless to say that this is unfair and ignorant, since there are dozens of ways to deal with hardware and the variety is huge. From an investors perspective, in the best case startups would only buy and use, or re-arrange, standard hardware from external suppliers and their main know-how is still the software. This reduces the problems to logistics including installation and working capital.

At the other end of the scale, businesses that require manufacturing facilities, e.g. to produce e-cargo bikes such as Laplandar from Denmark, need to carefully work out plans and processes along the whole value chain that investors can understand, follow and challenge. VCs will need to see how you can build your business on hardware and physical infrastructure, at the same time scale fast enough, and additionally understand what is required both from the business and the investors. There are very successful, inspiring and motivating examples like Northvolt who also managed to raise huge amounts of VC with a pure hardware businesses. It is all about the deep understanding of the required processes from all involved parties.

Not every investor understands Smart City

Due to this complexity of the sector, not every VC understands this market. Thus, founders are well advised to do their own analysis first and identify the VCs with experience in Smart City and who bring a higher understanding of the problems.

In particular, it is crucial to have someone helping you to enter the market with a valuable network. There are a couple of smaller and bigger VC funds – both with early and later stage focus – concentrating on smart city all over Europe, for example French fund Eurazeo, Übermorgen.VC from Switzerland, Smart Infrastructure Ventures and 2150 from Germany, the Estonian fund Karma Ventures, Inven Capital from the Czech Republic, or the Dutch firm SET Ventures. In addition, corporate venture capital units of established actors like Engie New Venture, EnBW Venture Capital or Future Energy Ventures (E.ON) drive that sector.

Finally, it can be a major advantage to have at least one investor with relevant understanding and experience of Smart Cities among your shareholders, as this will help to increase the quality and value of shareholder (and/or advisory board) meetings especially when recent developments are less beneficial.