Lots of room for investors eager to cure oil addiction

Since venture capitalist Martin Tobias switched from investing in software to investing in energy startups, he’s dumped his Porsche Cayenne in favor of a biodiesel-fueled Volkswagen Beetle. Not only is he sparing the air, but he also gets the convenience of being able to fill up at the office.

Tobias is CEO of Seattle BioDiesel and a venture partner at Ignition Partners, where he has led investments in Seattle BioDiesel, which builds small refineries to make biodiesel from soybeans; NextGen Emissions, which is developing new kinds of emission controls for diesel-powered vehicles; and a stealth energy company.

He says he’s drawn to energy because it’s still such a new area for venture capitalists. “In software investing, you come up with a good idea and three months later you’ve got five great companies-all well-managed and with good VCs behind them-all going after the same niche,” Tobias says.

In energy, on the other hand, “you’re competing against dumb people.” Plus, energy is “so freakin’ under-funded we could increase by 10x the amount of money and still not fund all the good ideas,” he says.

Research by VCJ turned up just nine venture-backed biofuel companies in North America, and of that group three raised their first venture capital in 2005 (see “Notable alternative fuel investments” table).

If the clean-tech craze continues, the alternative energy market may not be under-funded much longer. Indeed, several notable VCs and techies have jumped into the space:

  • Bill Gates invested $84 million in Pacific Ethanol (Nasdaq: PEIX) late last year, via his Cascade Investment LLC.
  • VC star Vinod Khosla has started a boutique firm that will focus in part on clean tech and he has already invested an undisclosed amount in BC International, a Dedham, Mass.-based company that makes fuel-grade ethanol from “cellulosic biomass,” such as wheat straw and citrus peels.
  • Meanwhile, trendsetter firms like Kleiner Perkins Caufield & Byers and Draper Fisher Jurvetson have clearly stated their intent to mine the space. KPCB has earmarked a significant chunk of its most recent fund for clean-tech deals, while DFJ recently boosted the cap on its new energy-focused fund by 50% due to strong LP interest.

And it certainly doesn’t hurt that the President of the United States has made alternative energy a priority. Since George W. Bush announced his Advanced Energy Initiative, American politicians are suddenly trying to develop a 12-step program to cure the country’s addiction to oil. That’s sparked scads of media coverage of ethanol, biodiesel and other alternatives to conventional crude.

There’s so much buzz about alternative energy these days that Nicholas Parker, chairman of market research and consulting firm Cleantech Venture Network, worries that the venture market for energy investing already has a “bit of a lemming effect going on.”

Instant classic

Oil alternatives look like a classic VC opportunity. Supply is constrained, demand is skyrocketing and technology appears fully capable of addressing at least some of the imbalance. “It’s an enormous macroeconomic trend that appears immutable,” says Erik Straser, a general partner at Menlo Park, Calif.-based Mohr Davidow Ventures, which is eagerly hunting for an alternate fuel investment.

Such a statement would have been laughed at perhaps even three years ago, says Nancy Floyd, co-founder and managing director of longtime clean-tech investor Nth Power, which raised its first energy fund 13 years ago. Back then, electricity and natural gas looked like the best opportunities for energy investors. But the oil market has changed so dramatically and is so fundamental to the global economy that it has become an obvious place to invest.

Nth Power, in fact, is looking at the market from a variety of investment angles. It has put money into Seattle BioDiesel (which has raised $9.5 million over two rounds). Since biodiesel made up just 60 million gallons of total diesel sales of 100 billion gallons in the U.S. last year, Seattle BioDisesel has lots of room for growth.

Nth Power also has a variety of potential crossover investments, like Spectra Sensors, whose laser spectroscopy techniques can find contaminants in natural gas pipelines; Smart Synch, which uses wireless technology for meter reading; and Serveron, which makes chromatography equipment.

Like Tobias, Floyd says energy is under-funded, and she notes that she has not seen any signs of deal inflation or oversubscription of energy funds. She believes that VCs will see lots of interesting energy deals for at least the next 10 years and that one of those deals will be a huge hit. “There will be a Microsoft- and a Google-type company in energy,” she predicts.

But energy companies aren’t like the tech companies that VCs are so familiar and comfortable with. Energy represents a strange territory for most venture capitalists. For starters, it’s a market with technologies that are largely well known.

“Historically, we’ve created disruptive technologies before there was a market for them,” notes Stephan Dolezalek, a managing director of VantagePoint Venture Partners and co-head of the firm’s nine-member clean-tech investment group. “This is a market-driven phenomenon, not a technology-driven one.”

The downside to that is there are areas of the market that will likely be closed off to venture investing, such as much of distribution infrastructure. There’s also the chance that the best ideas will come from someplace beyond the normal scope of venture capitalists, like Brazil, where ethanol and other alternative fuels already dominate the market.

On the plus side, there are large companies available to acquire good ideas. VantagePoint has not yet invested in an alternate-fuel company, though it is looking closely for one. Dolezalek says he isn’t worried about the market passing him by. He compares the field to the early days of the personal computer, when the first Apples hit the market.

Dolezalek is looking both short-term and long-term in this field. In April 2005, VantagePoint and the California State Teachers’ Retirement System (CalSTRS) invested $30 million in a Series A for New Energy Capital Corp., a North Waltham, Mass.-based company that finances, owns and operates renewable energy facilities, such as biodiesel and ethanol plants. He expects that biofuels will need the same kind of project finance capital that the oil industry has always needed, and he thinks there will be an opportunity for good returns from project finance for biofuel refineries and solar energy.

Another of Dolezalek’s investments, Ann Arbor, Mich.-based STM Power (formerly Stirling Thermal Motors), is both a short-term and a long-term play. In the short-term, STM converts waste materials into power generation for industrial concerns. In the long-term, its Stirling cycle engine technology might become useful in running vehicles. VantagePoint is one of eight venture firms that have invested about $57 million over three rounds in STM.

Idle your engine

Despite the buzz about alternate energy, there are plenty of challenges that face investors. For one, there are some big questions that still need to be answered, like which plant material will be the dominant component of ethanol? Is it going to be sugar cane, corn, algae, switchgrass or something else we haven’t considered yet?

Another challenge comes from Big Oil. “The big majors are actively hostile to all alternatives, including ethanol,” Tobias says. For that reason, Seattle BioDiesel can sell only through independent distributors and retailers, he says.

It isn’t entirely clear what role Big Oil will play. For example, VantagePoint counts BP as a strategic partner, and clean-tech venture firm Chrysalix says Shell is a major partner in one of its funds. Though neither of these venture firms have yet invested in biofuels, both say they’re actively looking.

“Every one of the big companies is taking biofuels quite seriously,” says Dolezalek. “They’re going to own the vast majority of what’s going to be in the market if gas switches to biofuels.”

Michael Sherman, vice president of investments at Vancouver-based Chrysalix (which is raising what it hopes will be a $100 million second fund), says it’s a given that large oil companies will be key to the development of the market. “None of these deals is going to be done in a vacuum. It’ll take a lot of strategic resources and some patience.”

Then there’s the little problem of the future not always being what we expect. Various sources may crow about the miraculous future of biofuels, particularly ethanol, which can be distributed and sold through oil and gas infrastructure. But Cleantech Venture’s Parker notes that all forms of renewable energy have potential constraints.

To wit: Wind turbines need steel, which is in short supply because of huge industrial demand worldwide, hybrid vehicles need more nickel than is available for mass production, and biofuels need feedstock, a by-product of crop production. That last one might not sound like a problem, but Parker notes that a drought on the order of the “dirty 30s” in the United States would seriously damage biofuel production. He also thinks such a serious drought is probable, given the impact of global warming.

As long as Martin Tobias is driving his Beetle to work, everything should be OK. If he starts to ride a bike, then it’s time to worry.

Michael Fitzgerald may be reached at michael@mffitzgerald.com.