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Cashing In on Clean Technology

Despite the credit crunch and falling oil prices, venture capitalists say green energy is still a good bet.

The future of all alternatives to oil rests on a single make-or-break factor -- money. And even as private investors fled other markets last year, clean-tech company coffers were still brimming with venture capital dollars.

Clean tech -- a loosely defined environmental category -- includes companies involved in solar power, biofuels, batteries, water, recycling, even farming. And as VCs clamored to get in, funding for the industry posted an all-time high of $2.6 billion in the third quarter of 2008. Experts linked the boom to soaring oil prices, generous tax credits, and a public fascination with all things green. Though they also say the torrid pace can’t continue, the amount of capital raised globally last year -- $8.4 billion -- still exceeds the 2007 full-year total of $6 billion, according to the Cleantech Group, a San-Francisco-based market research firm.

But these days, a rare confluence of events has sobered many clean-tech insiders. Facing liquidity hurdles, VCs are shouting from the rooftops that portfolio companies better start cutting costs. Oil prices have dipped to four-year lows, making traditional energy sources seem more viable. Credit remains scarce, which doesn’t bode well for a reputedly capital intensive industry. And as predicted, fourth quarter funding dropped last year to $1.7 billion, marking the first quarterly decline since 2004.

So could the go-go era of clean-tech investment come to a screeching halt? Unlikely, says Dan Squiller, a clean-tech CEO who bagged $30 million in Series D financing -- just days after bankruptcies and fire-sale deals mauled Wall Street in September. "Our new investors are just as enthusiastic about the company now as they were when the funding closed," says Squiller, whose San Diego-based firm, PowerGenix, manufactures recyclable batteries. "I think the clean-tech segment may be operating to a different drumbeat."

Here's why clean-tech executives and their investors are bullish about the long term.

What the Experts Say
Even as the economy sours, industry watchers say a host of factors should keep VCs funneling cash to clean-tech firms. Projected increases in global energy demand, declining production of oil and coal, growing concerns about climate change, and a desire for U.S. energy independence are "long-term drivers that haven't changed and won't change with respect to the credit crunch and the downturn," says Brian Fan, the Cleantech Group's senior director of research.

Still, he warned that companies will take a hit on valuations as VCs face roadblocks when trying to draw capital from their limited partners. “We forecast a pullback in clean-tech VC funding from the previous couple of quarters, when it was just record quarter upon record quarter,” Fan says. "But clean tech will remain a bright spot relative to other sectors competing for VC investment."

To an extent, clean-tech investment hinges on government policy. Congress recently approved an eight-year extension of the investment tax credit for utility-scale solar projects. President-Elect Barack Obama has pledged a new green economy along with support for alternative energy sources. And a cooperative of 10 Northeastern state governments have agreed to cap carbon emissions beginning this month. All have spurred cautious optimism throughout the industry's ranks.

Commodity prices also play a role in the evaluation of clean-tech firms, says Joe Muscat, Ernst & Young's director of clean tech and venture capital. But current lows shouldn't scare away the savviest investors who know the era of cheap oil is over, though pricing volatility remains.

"There are bigger drivers at work than what the spot price of oil is, and I do think clean tech will continue to be a significant percentage of the total of venture capital investing," Muscat says. "But it's going to be tough. There will be some consolidations and some failures because of the capital environments in this period of time."

Higher Returns for VCs
Potential investments -- including current portfolio companies -- are going to get much cheaper in the next few years, and therefore, returns on future investments are going to get much higher, says Richard MacKellar, managing director at Chrysalix Energy. The Vancouver-based VC firm, which funds clean-tech companies worldwide, has shied away from over-valued solar companies for more than two years. But with valuations deflating, MacKellar says Chrysalix is eager to resume activity in the space.

"What we're going to see is higher scrutiny and lower values," he says. "But I believe VCs recognize that this hiccup will lead to a sweet spot of optimum returns -- for those of us who do have the courage to make the investment in tough times."

As other investors retool, Good Energies, a global VC firm investing exclusively in clean tech, plans to keep pumping cash into the sector. "We're long-term investors and our philosophy is to always be a long-term investor," says CEO Richard Kauffman. "In terms of us, we're going to continue to invest through the cycle."

But as capital is rationed in the market, he pointed out that his firm faces a tough balancing act: preserving cash for existing portfolio companies, and supporting new companies with promising technologies. Since initial public offerings are currently off the table, many VCs will shift their focus to the latter, he says.

"Because they require less money, investing in earlier-stage companies is a reasonable strategy," Kauffman says. "By the time those companies have reached critical mass, perhaps the IPO market will be open again, or there will be additional capital available."

A Plan for Capital-Efficiency
Clean tech is famously capital intensive, but now is not the time to pitch a "bleeding cash model" to investors, says Jeff Wolfe, CEO of groSolar, which ranks at No. 757 on the Inc. 5000. As VCs ramp up due diligence, they could become leery of project-based financing, which often requires exorbitant amounts of capital. Instead, they may turn their attention to more capital-efficient companies.

Wolfe's firm, a Vermont-based distributor and installer of solar energy systems, has secured both Series A and B financing over the past two years. Sales doubled to $60 million in 2008, he says, and the company is attracting "significant interest" from venues for capital. "You've got to prove why and where you're spending the money," Wolfe says. "VCs will still invest in companies that can do that."

The market for clean-tech investment indiscriminately favored all firms in the space -- until now, says Larry Letteney, COO of Second Wind, No. 4,369 on the Inc. 5000. The Massachusetts-based company, whose leading investor is Good Energies, develops software for wind farms and recently introduced a new product called Triton. Letteney expects the product -- which uses sonic detection to calculate wind speed, direction, and turbulence -- to catapult revenue this year. Currently courting investors for its third round of financing, Second Wind boasts the kind of proprietary technology VCs love.

"There is not necessarily a high volume of innovative, technological companies with the capacity to grow and generate outside margins in renewable," Letteney says. "The environment that we face for the next several quarters really only fazes companies that can't display a level of low risk and high return, which would calm the fears of any investor."

Going forward, many in the industry contend that clean tech will steal investors away from other troubled sectors. "We're aware of a ton of cash peripherally, and it has to go somewhere," says Michael Brown, chairman of Greenline Industries, a California-based seller of biodiesel processors and No. 7 on the Inc. 500. To accelerate its overseas expansion, his firm closed a $20 million Series A financing deal early last year.

Brown, who hopes to bring biodiesel production to Africa, says support from the incoming Obama administration will ultimately be the biggest boon for clean-tech investment. “The smart money, out of Wall Street and out of the stock market, is just sitting there, and it doesn't want to be sitting there," he says. "I think that money is very sensitive to the election of Obama and knows that this is the sector to be in."
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