Green Acres

Peak oil—the point at which global petroleum production maxes out and begins to fall—is expected to arrive in the next 10 to 30 years. Some experts argue that peak oil has already hit.

So is this the last chance for gas?

It could be. But if it is the end for petroleum, it’s just the beginning for the various resources in the running to replace it. One of the leading candidates, and one drawing intense interest from venture capitalists, is biofuel—fuel made from renewable sources like corn, soybeans and even trees.

VCs invested more than $740 million in 27 different biofuel companies in 2006, according to the Cleantech Venture Network, a research and advisory firm that watches environmental technologies. That’s up nearly 700% from 2005, when VCs invested just $110 million in 15 biofuel enterprises.

Energy entrepreneur John Biondi, CEO of C5-6 Technologies, agrees that there is increased willingness in the venture community to investigate biofuel. C5-6, a five-person startup developing a technology to vastly improve the ethanol conversion process, is in the midst of raising a $5 million series A round. “We’re certainly having more discussions with firms that you wouldn’t think would be interested in this kind of opportunity,” Biondi says.

Among the VCs most interested in biofuel is Vinod Khosla of Khosla Ventures. He’s so bullish that over the last year he’s invested roughly $100 million of his own money in a range of biofuel startups, including Altra, Cilion and Mascoma. Speaking at the World Congress on Industrial Biotechnology and Bioprocessing in March, Khosla issued the bold prediction that 100% of petroleum transportation fuels could be replaced with biofuels, although he declined to put a time frame on the transition.

The surge in VC interest in biofuels has some warning of a bubble. “With 930 energy startups operating worldwide—198 of which are venture-funded—energy technology looks primed for a classic private equity boom and bust,” declares a Lux Research cleantech report issued on April 30.

Setting aside the bubble discussion entirely, there are many other risks with biofuel investments that should give investors pause. For one, biofuel investments are expensive. Infrastructure heavy, they typically require at least $100 million in risk capital, compared to about $10 million for, say, a software startup. What’s more, biofuel investments often require up to $100 million in follow-on money, in the form of debt and project financing—two areas that the average venture capitalist may not be very familiar with.

A number of other prickly questions remain to be answered:

  • Will subsidies last? Government subsidies and alternative-fuel mandates are important. How long will they continue? And will these crutches mean weakness when it’s time for the biofuel industry to stand on its own?
  • Will oil prices subside? A significant and sustained drop in the price of oil would seriously dampen interest in all alternative fuels.
  • Who wants to drive a vegetarian vehicle? Americans love their muscle cars. Will they ever embrace non-petroleum-powered autos?

The challenges are daunting enough that even some of the most active clean energy investors have so far steered clear of biofuels. “We still haven’t found the right combination of capital intensity, profitability profile, and lack of regulatory dependence to invest in a biofuel manufacturer,” says Tucker Twitmyer, a managing partner at EnerTech Capital who’s been looking at biofuel deals for more than three years.

People may debate the impact of global warming, but there is no doubt about the diminishing supply of oil.”

Nancy Floyd, Founder and Managing Director, Nth Power

Cellulosic ethanol is biodiesel derived from grasses, plant waste, trees and other nonfood sources. Khosla believes that nearly all ethanol produced and consumed in the United States will eventually be cellulosic. As a first step, a Khosla-backed Range Fuels will receive up to $76 million from the U.S. Department of Energy to build a plant that produces ethanol from wood chips and forest residue.

The range of materials that can be used to make biofuel is actually quite wide. Nancy Floyd, founder and managing director of Nth Power, which invests in emerging energy companies, has funded a biofuel startup that uses cheese whey to make ethanol. It’s called Earthanol and its technology can extract fuels from a variety of waste streams, sources that are essentially free.

Another attractive option is butanol, which is produced by fermenting biomass with bacteria. It has higher energy content than other biofuels. And because it is closer to gasoline than ethanol, butanol blends well with gasoline and can power some of today’s cars without any engine conversion. Unlike corn-based ethanol, butanol is not water soluble—it better tolerates contamination by water—which means it can be distributed more easily through existing oil pipelines.

Green says VantagePoint recently invested in a stealth butanol startup, but he declined to reveal its name or how much his firm invested.

The variety of options in biofuel has some VCs making multiple bets. “At this point no one really knows which technology will be the ultimate winner—from an investment standpoint, a distribution standpoint or a consumer-acceptance standpoint,” says Craig Cuddeback, chief operating officer at the Cleantech Venture Network. “Those questions are all up in the air, so VCs are spreading their bets.”

VantagePoint readily admits that the market is still so fluid and the various technologies so young that it can’t afford to put its money in just one type of biofuel. Instead it’s taken a portfolio approach with multiple investments. Besides Mascoma, it has invested in Chemrec, a Swedish company with gasification technology to convert “black liquor” (the major byproduct of pulp mills and a highly concentrated form of biomass) into motor fuels and power for electricity, and New Energy Capital, a New England-based company that invests in, owns and operates renewable energy and distributed-generation projects, such as a biodiesel production plant in Delaware and an ethanol facility in Indiana.

VantagePoint hedged its biofuel bets even further by backing electric car company Tesla Motors. Tesla CEO Martin Eberhert has said he believes all cars will eventually be electric and that there will be no need for gasoline, ethanol, butanol or any other kind of fuel. If he’s right VantagePoint’s biofuel investments will turn out to be losing propositions.

But Green doesn’t see it as black and white. “We don’t believe there will be any silver bullets here,” he says. “Rather, there will be room for a variety of different solutions.”

The power of potential

The biggest issue is that there’s no such thing as an energy entrepreneur. The shortfall we see in most plans is that there is not the right amount of expertise behind them.”

Hemant Taneja, Managing Director, General Catalyst Partners

In spite of the hype around biofuels, it’s important for VCs to keep in mind that few consumers use the stuff today—and there is no guarantee they will in the future. Some venture capitalists admit they have adoption-rate concerns, especially given the fickle nature of consumers and the shifting political and economic winds.

What if the price of oil suddenly drops to $30 a barrel? What if government subsidies go away?

“Those are legitimate questions and they’re ones we’re always asking ourselves,” says Weiss of Virgin Fuels. “We have to expect oil prices to be volatile, but overall we believe oil is running out. People may debate the impact of global warming, but there is no doubt about the diminishing supply of oil.”

Khosla, for his part, has publicly stated that he doesn’t believe a drop in oil prices would slow the development of biofuels. He recently told Dow Jones that alternative fuels are an “energy-security and climate-change issue, neither of which is related to fuel prices.”

Some VCs, like Nth Power’s Floyd, hope to make the consumer question moot by focusing on biofuel companies with large commercial contracts, such as Imperium Renewables, a refinery subsidiary of Seattle Biodiesel. Imperium’s strategy is to locate its refineries on the coasts, where it can provide power to thirsty users such as shipping lines.

“Imperium goes where the customers are, which is predominantly on the coasts, especially where there are deep water ports,” Floyd says. “It deals with major end-use customers, marine applications like shipping and ferries, as well as power generation.”

And because Imperium makes biodiesel, which can usually be burned by current diesel engines, it can take advantage of diesel infrastructure. “Biodiesel is a very compelling story compared to corn-based ethanol,” Floyd says. “Even though we don’t have a lot of diesel cars in this country, I like the fact that you can sell to large end-use customers and you can do that right away.”

GreenFuel Technologies is another venture-backed company that doesn’t rely on consumer demand. It is working on a unique technology to make biofuels from—and for—power plants. “With GreenFuel we don’t have to worry about the distribution network or the whole question of consumer acceptance and access,” says Jennifer Fonstad, a managing partner at Draper Fisher Jurvetson.

GreenFuel raised $11 million from DJF in 2005, followed by $6.8 million from Polaris Venture Partners last year. GreenFuel has developed an application with a dual purpose: it reduces greenhouse-gas emissions at power plants and produces biofuels at the same time. GreenFuel takes carbon-dioxide produced by a power plant and feeds it to algae, which are then converted into biofuel. NRG Energy is now testing GreenFuel’s “Emissions-to-Biofuels” technology at a coal-fueled power plant in New Roads, La.

We still haven’t found the right combination of capital intensity, profitability profile, and lack of regulatory dependence to invest in a biofuel manufacturer.”

Tucker Twitmyer, Managing Partner, EnerTech Capital

To date, DFJ has made only one investment in a biofuel company, but Fonstad says her firm continues to look for new opportunities.

One of the ingredients all VCs are looking for in the biofuel sector is top-flight company leaders. “The biggest issue is that there’s no such thing as an energy entrepreneur,” says Taneja. “The shortfall we see in most plans is that there is not the right amount of expertise behind them. What we see are people who have grown up in other industries who are saying, ‘Hey, maybe we should go tackle this opportunity.’”

Green notes that when VantagePoint started its cleantech practice about four years ago, it was concerned about the scarcity of talented entrepreneurs, but it now believes that the opportunity in biofuels is attracting talented leaders. “These are people who are asking themselves, ‘Do I want to be involved in developing the next Palm Pilot or do I want to be in a cleantech or biofuel venture that’s actually making a difference?’” he says.

Unlike other high-octane investment sectors, the field of biofuels still offers plenty of room to maneuver. Even VCs like EnerTech’s Twitmyer, who have so far been happy on the sideline, are getting more tempted to join the game. “These companies are addressing a very big problem and the right solution could result in a very healthy return for investors,” he says. “When you look at a differentiated technology like cellulosic, the number of investment dollars relative to total potential return is very favorable. So, yes, this is still an attractive sector with enormous potential.”

Which way to the off ramp?

As far as exits, VCs say a merger or acquisition is always a possibility but point out that public markets have embraced ethanol and biofuel opportunities in a big way. Four biofuel companies have managed to go public in the past two years. VeraSun Energy and Aventine Renewable Energy both went public in June 2006, followed by Hawkeye Holdings in September 2006 and U.S. Bioenergy in December 2006. And there are more in the pipeline, such as ASAlliances Biofuels and Biofuel Energy.

Taneja expects to see more IPOs in biofuels than in other sector in the years ahead, partly because the businesses are predictable—they can lock in long-term contracts. “Look at VeraSun,” he says. “That’s a $2 billion company today and they produce $500 million to $600 million worth of ethanol a year. That’s a very successful outcome for investors.”

He adds that public investors are actually encouraged to see state and federal support for biofuels. “The reality is that as the technology matures for, let’s say, cellulosic ethanol, you’re not going to see a perfect, economical solution on Day One. Government is bridging the gap before these plants mature and can make it on their own, and that’s important.”

As petroleum supplies dwindle, it’s not hard to see why Wall Street is so bullish about biofuel companies—maybe more than other traditional VC-backed startups. “How badly does the world need another enterprise software startup?” asks Green of VantagePoint. “Now, how badly does the world need a company that can solve our dependence on oil?”

Tom Stein and Tim Devaney are Silicon Valley-based freelance writers who specialize in covering technology startups and venture capital. Stein may be reached at tom_stein25@yahoo.com. Devaney may be reached at tim.devaney@sbcglobal.net.