Red light for green-tech start-ups?

A tidal wave of venture capital has poured into clean tech over the past four years, reflecting the confidence investors and entrepreneurs have that high energy prices and climate change make the sector ripe for technical innovation.

But the economics of the energy business pose funding challenges to start-ups in the field, a situation that could be exacerbated by a softening economy, say investors.

Namely, many energy technology companies need lots of capital--far more than a Web 2.0 or biotech start-up--which in many cases is beyond the resources of start-ups' initial investors.

Going from technology in the labs to a demonstration facility for, say, biofuels or solar power, can cost tens of millions or hundreds of millions of dollars, creating what many call a "funding gap."

"You can't just do a typical venture capital A, B, then C round and have a company that is self-sustaining and cash-flow positive," said Daniel Goldman, chief financial officer of GreatPoint Energy, which has a technology for converting coal to natural gas. "There is an order of magnitude more capital required--it's much, much larger than other sectors that VCs are used to investing in."

Slumping stock markets, driven by signs of a U.S. recession, make the option of getting expansion money through an initial public offering a lot less likely, said Rob Day, a clean tech investor at @Ventures.

"Some companies that were relying on going the route of an IPO will be in trouble," he said, adding that venture firms that are relatively new to the green-tech arena may pull out.

Sectors within clean tech considered "="">solar, are perhaps most vulnerable.

Even before fears of a recession set in, start-ups and their backers needed to find creative ways to get their products to market.

A few models have emerged, the success of which could make or break individual companies while providing guidance to the entire sector.

Dialing for dollars
Some new companies are trying to attract the interest--and money--of their potential customers as they battle-test their products.

GreatPoint Energy initially took $37 million from venture capitalists to develop its catalyst-based gasification process. To bring its technology into the field, the company has signed on several "strategic partners," attracting in excess of $100 million.

On Friday, it announced a partnership with Peabody Energy, which will provide coal to GreatPoint for a commercial-scale natural gas facility near Peabody's mines. As part of the deal, Peabody will invest in GreatPoint Energy.

These strategic partnerships not only serve as a way of getting equity, they also give GreatPoint access to experts in related technology and project management, Goldman said. Raising more money at a later point will be easier because large industrial concerns have already backed the company, Goldman said.

"I think (the partnership model) is going to be more of a trend because you need these large corporations to add credibility to a company and because they bring a tremendous amount of value," he said.

Similarly, year-and-a-half-old ethanol start-up Coskata signed a partnership with General Motors. GM invested an undisclosed amount in Coskata, which will build an ethanol biorefinery at a GM facility to test its fuel on GM's flex-fuel cars.

According to CEO Bill Roe, Coskata in the coming months will announce partnerships similar to its GM deal to fund construction of commercial-scale plants, which cost between $300 million and $400 million.

By contrast, venture capitalists in some biofuels enterprises have been thrust into the role of providing what amounts to project financing. That's normally the purview of companies like General Electric's financing division, but traditional sources may be reluctant to back a company with an unproven technology, say investors.

Biodiesel maker Imperium Renewables raised more than $200 million in venture capital and private equity, which helped the company to open a 100-million-gallon per year facility last year. Its expansion plans were scaled back, however, when it canceled an IPO earlier in January, citing market conditions.

As many of these biofuels facilities are just now getting off the ground, it's too early to say how well it will work out for venture capital investors who do finance plant construction.

Gorillas needed
The "funding gap" dynamic is also attracting a wider range of companies and financial instruments to clean tech and energy.

For example, US Renewables, which started its first fund in 2005, is in the business of financing and developing energy projects, rather than investing in technology development. It focuses on projects in biofuels, biomass, geothermal, landfill to methane, and solar power.

Private equity and other institutional investors like hedge funds are warming to clean tech as well. The Carlyle Group's energy buyout and investment structure has invested in a geothermal project. The Masdar Initiative, based in Abu Dhabi, spearheaded the creation of a $250 million fund in 2006 dedicated to clean tech.

To scale up, many smaller companies need to orchestrate financing that involves a few different sources, Jim Matheson, a clean-tech investor at Flagship Ventures, said at a recent panel on investing.

Government incentives, in particular, can play a significant role. States are keen to encourage development of the budding clean technology industry and attract construction of plants that can create so-called "green collar" jobs.

The state of New York is footing half the bill--or $14.8 million--to build ethanol start-up Mascoma's first demonstration plant. Tennessee is fronting $41 million for a switchgrass-to-ethanol facility. "Different regions are more aggressive than others," said Mascoma CEO Bruce Jamerson.

Although some hope that 2008 will be the year where green-tech start-ups go public to reward their investors, what's more likely is mergers and acquisitions, said Claudia Fan Munce, the managing director of IBM's Venture Capital Group and chairwoman of the National Venture Capital Association. She said there are no indications that the conditions for IPOs will improve this year.

"In clean tech, M&A's make the most sense because they require the scale of the 800-pound gorillas--GE, Siemens, IBM," she said. "When the dust settles, there will be some consolidation."

Public green-tech companies have felt the recent market volatility, even though the sector's long-term prospects are strong, given high demand and supportive government policies.