Despite the promise of cleantech like biofuels and water purification technologies, some venture capitalists say it can be tricky to invest in the field because it doesn’t necessarily offer the fat and easy returns that make them drool.

The challenges aren’t obvious from the numbers. Cleantech investments in North America grew 35 percent to $1.63 billion in 2005, according to the Cleantech Venture Network, the industry monitor that held the Cleantech Venture Forum conference in San Francisco last week.

But some of the most promising clean technologies just don’t fit the classic VC model of a six-year exit with returns of 10 times the original investment, industry watchers said.

Biofuels are examples of technologies with great promise and a large, growing market that are just too time- and capital-intensive for most VCs to back, said Sean Brownlee, a partner with the 3i venture capital firm.

“Some of these technologies are not quite venture, and not early enough for project finance,” he said. “We’re both saying, ‘Go talk to that guy,’” he said, pointing his index fingers and crossing his arms. “And I feel sorry for those guys, because there are some good technologies there.”

Time and Capital

In the energy industry, utilities and governments are extra careful before adopting new technologies, often requiring tests far more extensive than those required for industries like semiconductors or Internet applications, VCs said.

“People point to the project finance market as being a problem,” said Matt Horton, a principal at VC firm @Ventures. “Many companies need to do $30, $40, or $50 million plants to prove their technology, and many VCs have stayed away from them.

Take water technologies, for example. Before municipalities will adopt new water technologies, many require long testing periods and certifications, Mr. Brownlee said. Many water startups are looking at seven- to 10-year adoption periods. That’s too long for venture money. So some of the best water technologies might never get funding, he said.

“The reality is, on something like that, they probably aren’t going to get the classic 10x return VCs are looking for,” he said. “Take ethanol, for instance. That’s fine. But VCs don’t do project finance. We need to figure out how we can do it if it’s not a 10x return, but it is a sure thing. Maybe we need to come up with a hybrid play.”

These capital-intensive and time-to-adoption challenges are a big part of what is keeping some $100 billion of VC money sitting on the sidelines, uninvested, he said. “The real struggle is the timing,” he said. “What’s really unique in cleantech is the very long time it can take to get your money back or get an exit.”

Growing Pains

Scaling up has been another big challenge in the cleantech sector. It’s the opposite of industries like pharmaceuticals and software, said Michael Liebreich, CEO of research firm and consultancy New Energy Finance. In those fields, proving the technology works is the hard part, and scaling up is the easy part, he said.

“Here, scaling up is the difficult bit,” Mr. Liebreich said. “A lot of clean energy stuff has an element of heavy engineering about it, and you can’t wish it away. You can have a brilliant technology, but if you want to get to scale, heavy engineering has a long asset life, and that means investors want to make damned sure it works. They want a lot of testing, and maybe warranties as well.”

The long rollouts will probably surprise some VCs new to the cleantech space, he said.

“Even with these brilliant ideas that are all about IP, the purchases may be so slow, because they are selling to slow-moving utilities,” he said. “You’ve got to be careful that the development lifetime matches the fund lifetime, because when you get that wrong, there’s nothing you can do. It could well be longer than they think, and that could destroy the returns.”

Marine or ocean-wave power is a classic example of this problem, he said. “Obviously, there’s energy there to be harvested,” Mr. Liebreich said. “But given the time it will take to create a dominant play in marine energy, it’s not a VC play. For a meaningful entry into the energy grid—say 1 percent—we’re probably looking at 15 years. So for a VC, it’s hard to see, and yet it’s part of the solution.”

What it all comes down to is more risk. “In this market, more so than in other areas, companies are facing both technology risk and market risk,” Mr. Horton said. “In some cases, the market is not able to absorb it just yet, and it does impact the timeline.”

Some VCs Not Worried

To be sure, some investors balk at the idea that cleantech investments are more dangerous than those in other emerging sectors. “That ridiculous,” said Clifford Adams Jr., a director at investment banking firm Coady Diemar Partners.

After all, research by Clean Edge, an Oakland, California-based research firm, shows the clean-energy segment alone was worth $40 billion in 2005 and is expected to grow to $167 billion by 2015.

As oil prices remain high, concerns about pollution and the dependence on foreign energy sources increase, and cleantech startups see successful IPOs and growing stock prices in solar energy and other areas, VCs are understandably drooling over the market (see Solar’s Bright Future).

Many clean technologies do match the traditional VC model well, such as clean-energy software, sensors, and grid management, VCs said.

And Craig Cuddeback, a spokesperson for the Cleantech Capital Group, the Cleantech Venture Network’s parent company, pointed out that many investors are already making money.

“Investors in biodiesel and synthetic fuel, for example, are pretty excited about the return that they get,” he said. “The reason VCs look at the cleantech area is because of the size of the market and the ability to be disruptive. The returns can be huge.”

New Models Needed

But others said there is plenty of reason to think new financing models are needed for the cleantech space.

For one thing, most cleantech investment—about $42.4 billion out of about $44 billion invested in the clean-energy sector each year—does not come from venture capital, Mr. Liebreich said.

What’s a VC craving a bigger chunk of the market to do?

More partnerships in project finance might be one way for VCs to get a bigger piece of some high-reward, long-time-to-adoption technologies, Mr. Brownlee said.

Mixing VC money with government money or capital market financing is another way to go, he said. Many early cleantech startup companies are selling shares on the London AIM or Canada TSX venture exchange, said Mr. Brownlee.

Mr. Horton said he is already seeing evidence that some companies are aware of the financing gaps, and are finding innovative ways to work around them. “We’re seeing a crop of companies that are more savvy,” he said.

He pointed to ClearFuels Technology, an ethanol company, as an example.

The company closed a $2.4-million VC round in 2004 and is now raising a $9-million Series B round (see Q&A: Eric Darmstaedter). The company is also building a commercial demonstration plant, funded by a $50-million tax-exempt revenue bond allowed by the state of Hawaii and expected to be completed this year.

Engineering and construction corporation Black & Veatch is partnering with ClearFuels to build the plant and, depending on the results, will consider providing performance guarantees to help ClearFuels get financing for a future commercial facility.

But not every promising startup is finding solutions, and many are falling needlessly into the “valley of death,” Mr. Liebreich said.

In the end, if VCs want to take advantage of some of the most disruptive clean technologies, VC firms might also have to accept lower returns or longer timelines, said Mr. Brownlee.

“If we’re going to go after some of these deals, the model has to change, or else we will be restricted to only specific deals within the space, and that would be a shame,” he said. “We’re going to have to be more patient.”