The president’s recent budget proposal includes $282 million for advanced biofuel technology research. This is quite encouraging given the rather public pull-back in continued biofuels investment from the investment community.
This pull-back is not surprising. The first wave of advanced biofuels investments (Advanced Biofuels 1.0 or ABs 1.0) haven’t quite worked out. These investments focused on extending beyond corn and sugarcane ethanol into a variety of technologies including advanced fermentation processes, advanced solid-state catalysis, algae digestion, and pyrolysis processes. They targeted new chemical products to be produced from cellulosic feedstocks, such as butanol and gasoline.
Silicon Valley and many other investors have taken a hit on these bets. Matt Norden’s blog post covers that story pretty well. It is clear why they haven’t worked and, in hindsight, we should have seen a few things coming. Let’s take a look at some of them:
Underestimated capital costs
With biofuels, getting to market involves constructing a commercial production plant. When ABs 1.0 startups did the math on costs, they came up higher than expected – but not higher than any other commodity chemical plants. Taking an audit of a few S-1 filings from 2012, the lowest capital costs for small, “Beta-version” plants were in the $180+ million (Fulcrum BioEnergy). This is on top of the, let’s say, $50-100 million in research and development most startups required to get to that point. This puts ABs 1.0 in a risk category that will make it very challenging for a pure-play startup to cross the proverbial chasm and show a return for investors.
Technologies haven’t quite worked
Many of the VC-backed ABs 1.0 players were just applying new advancements to old technology pathways without addressing their known limitations. For example: Biochemical fermentations have limited yields. Catalytic processes have high capital costs and relatively low product specificity. Producing deoxygenated hydrocarbons from biomass requires significant oxygen removal, reducing yields. Algae processes have several concurrent mass transfer limitations creating scale-up inefficiencies. These limitations make it unclear if these technology pathways are efficient enough to realize sufficiently attractive economics for a first commercial project that would merit follow-on investments.
The bar is too high
Investors wanted solutions that could compete with fossil fuels on an unsubsidized basis. While this is a rational expectation, it’s actually quite ridiculous. There’s really nothing better than oil for making liquid fuels, given its physical properties. Biomass is an inferior feedstock in nearly every way. Expecting petroleum parity implies a significantly more efficient process than oil refining from inherently limited technology pathways. That expectation seems unrealistic given the known technology pathway limitations. Something more tenable for early processes might have been more appropriate.
There will be no Google-type of success with the technology pathway focus that was in-place for ABs 1.0. A new one is needed. But there also exist inherent challenges to investing in biofuels with a standard VC model. A new one of those is needed as well.
Although I am not an expert in investing, there are a few things I think may need to happen to make the capital and technology risk work:
- Strategic investors may need to come into the fold in earlier rounds. This may require a new relationship between strategic investors and traditional technology investors to provide the proper risk context to make these types of investments.
- Migrate from all-equity investments to a mix of equity and debt (or convertible notes). This obviously has a different risk profile and may require creation of a fundamentally different fund. Other creative structures involving anti-dilution clauses might provide additional incentives for early investors.
- Make going public an expectation from the beginning, with the caveat being getting acquired (getting acquired is less likely). This may focus the startup’s go-to-market planning.
- Investors must have courage. Nobody ever made money through fear, so there’s a level of insightful, bold leadership that’s needed by someone in the industry. In other words, biofuels needs an Elon Musk.
These suggestions aren’t without challenges, but there’s nothing groundbreaking about them either. We’ve seen many examples of the first two among ABs 1.0 companies as well. So we’re not talking about starting a revolution here.
An encouraging comparable is the emerging bio-based chemicals industry. In this industry you see stronger involvement among strategic investors than traditional VC-backed startups, indicating a better alignment of risk for these investments. Since the market is different, the existing technology pathways may be sufficient to reach commercial operations at more reasonable costs. We’ve even seen Bio-Amber this week set its terms for a $128 million IPO.
Getting organized with the right type of fund from the beginning would certainly pay dividends down the line for investors (no pun intended). The technology pathway(s), however, will have to radically evolve in tandem in order for investors to have a shot when Advanced Biofuels 2.0 arrives.
[Image credit: Steve Jurvetson]