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Accelerating Next-Generation Biofuels
Biofuel developers must find the best way to produce the alternative-energy source and form a viable business model to reach widespread useby Martin Sabarsky, J.D.
Among the high-profile approaches addressing the need for large-scale renewable energy resources, biofuels have attracted significant attention. The enthusiasm of policymakers and investors for first-generation biofuels from crops such as ethanol from corn and biodiesel from soybeans waned after peaking in 2006 and 2007. However, increased media and investor attention is now being paid to technologies and companies involved in the development of advanced biofuels. Those technologies include cellulosic ethanol, as well as biofuels based on renewable, non-cellulosic feedstocks such as algae.
Many advanced biofuel production processes are out of the discovery research stage. They are now evolving to optimize the economic metrics of small-scale or unit-level production and expansion to large-scale production. Both of these are risk reduction prerequisites to render any advanced biofuels process suitable to traditional project finance and widespread deployment. However, several strategies may accelerate the successful deployment of advanced biofuels. This article addresses strategies for optimal product mix and the two main business models of advanced biofuel developers.
Product Mix Considerations
Cellulosic ethanol and algae companies should recognize the strategic value in developing biorefineries. Rather than make a single product, biorefineries would produce a flexible mix of complementary products. They would optimize cash flows by balancing the revenues from different products against the associated feedstock and processing costs.
For example, cellulosic ethanol companies could convert cheap, mixed sugars into ethanol when ethanol maximized cash flows. In response to changing commodity cycle dynamics, they would be able to shift to bio-based plastics or other bio-based products. This flexibility allows the companies to exploit long-term fluctuations in supply and demand. Building in these strategic options would entail additional up-front and periodic costs. It might mean additional expense in the design and construction of pre-treatment tanks for cellulosic ethanol processes or in developing additional production strains. Companies that fail to recognize this opportunity and weigh the costs and benefits appropriately cede a significant competitive advantage.
In addition to biofuels, cellulosic and algae-based feedstocks can be used to make
The majority of algae-based biofuel companies face a more interesting product mix optimization situation. Typically, only 20 to 40 percent of the total biomass from photosynthetic algae is comprised of lipids, or oils, that can be converted into biofuels such as biodiesel. The rest is mostly proteins and carbohydrates. Algae companies face two key product mix strategy decisions: finding the optimal product mix given a specific commercial production strain and selecting optimal commercial production strains from competing candidates. Conceivably, the value of the whole algae biomass for a non-biofuel application may be worth more than the sum of the parts, depending on existing market prices and marginal operating expenses associated with extracting and purifying one or more component. In this event, production would simply skip the downstream process. Conversely, a high price for one or more of the extracted components could make the parts worth more than the whole. A flexibly designed and staffed facility could switch and run the more complete process with the appropriate strain.
In addition, product mix considerations are relevant even when an algae company is committed to extracting lipids. Here, the algae company is focused on the quantity and qualities of the lipids produced. However, the large percentage and volumes of residual proteins and carbohydrates render these components neither waste products nor by-products. Instead, they are co-products that can have equal or greater value than the lipids themselves. Production strain selection criteria even prior to commercialization need to take into account the required co-product specifications. They are a function of the requirements a customer or collaborator will specify in the offtake agreement.
Licensing Business Model
The licensing business model involves the license of rights to use technology from a biofuel technology developer to one or more commercial facility developers. Key issues involved here include licensee selection, exclusive versus non-exclusive rights, territorial restrictions, product or field restrictions, diligence obligations, and economic terms. However, there is an even more fundamental question advanced biofuel developers must ask themselves. What is the earliest stage of development at which a licensing program is optimal? And what does this imply in terms of obtaining value from licensees in the form of favorable economic terms, as well as the quantum of materials, information, intellectual property, and standard operating procedures that would be necessary for a licensee to successfully deploy the technologies? There already exists a classic positive correlation between the level of investment and risk taken on by the technology developer and the value attained in a licensing package. An additional consideration is that the technology may be viewed as unfinished until it clears the demonstration-scale phase. One would expect to see relatively few willing licensees prior to this. Moreover, hearkening to Groucho Marx’s line about not wanting to be a member of any country club that would have him, biofuel developers should be wary of taking on licensees prior to success at demonstration-scale.
If they do so, there should be well-defined diligence obligations to ensure adequate investment by the licensee and coordination with the developer. Should a licensee fail for reasons having something or even nothing to do with the technology, it may cast a pall over the developer’s technology or other licensees. This could impede other project development initiatives.
There are examples of licenses being made at early stages of development such as the laboratory or pilot plant stage. For instance, Celunol, now Verenium, granted a geographically limited license to Marubeni prior to construction of a cellulosic ethanol demonstration facility. However, it seems likely most licensing business models will instead follow the example set by DuPont Danisco Cellulosic Ethanol (DDCE). DDCE’s strategy is to develop and license a robust, “turnkey package for an advanced biorefinery.” The centerpiece of their approach is first to demonstrate the technical and economic metrics of large-scale cellulosic ethanol production in a $50 million, 250,000-gallon-per-year demonstration facility in Tennessee.
Own-and-Operate Business Model
Value inflection points associated with advanced biofuel development.
The own-and-operate business model involves the technology developer attracting the human and financial capital to build and operate one or more commercial biofuel facilities in which the technology will be deployed. One would expect the corporate structure to follow traditional project finance norms. Accordingly, each facility would be developed by a special-purpose entity (SPE). The SPE would own and operate the facility as its sole function. The technology developer would own equity in each SPE based on financing arrangements.
The financing constraint has outsized importance in the current economic environment. To attract private equity to fund a first commercial facility, advanced biofuel owners and operators must consider the valuation of the associated SPE, the amount of equity they can retain, and the rights given to financiers for participation in subsequent rounds of financing.
A developer should be able to receive a share of the cash flows of the SPE commensurate with the equity the developer owns. In addition, the developer has the option to structure the SPE to provide for up-front or periodic cash flows for license fees, management fees, and royalties on product sales. These latter types of arrangements look like the cash flows of a licensing business model. They would not make sense for 100 percent owned SPEs, but would make sense for partially-owned SPEs. However, there is a consequence of a greater number and amount of licensing-like cash flows coming from the SPE to the developer. The private equity financier may commensurately reduce the valuation of the SPE for purposes of the negotiated equity the developer will be allowed to retain. This wouldn’t be the end of the world for the developer. Arguably, the minimum amount of equity the advanced biofuel developer should own in the first commercial facility is zero ? meaning the most important aspect of the first commercial facility is not its cash flows or economic value per se. The greater benefit is the strategic value of removing the risk at commercial scale that a successful commercial facility provides.
Regarding who should own how much equity in a given SPE, non-dilutive financing of a first commercial facility with government grants can present several complications. This type of financing can provide a downside protection or magnified returns to equity investors. However, the question is whether the biofuel developer gets ownership of the equity in the grant versus the investors, or whether ownership is shared. Within the advanced biofuel industry, this remains to be seen, as the initial set of private equity commercial project financing has not yet occurred.
Licensing and own-and-operate business models are not mutually exclusive. An owner-operator can decide to limit its model geographically. It could then pursue a licensing model elsewhere. Similarly, a company pursuing a licensing model can decide to shift to an own-and-operate model.
The commercialization of advanced biofuels has reached the crucial point of late-stage, pre-commercial development. Going forward, the foundation laid by key strategies will define the success or failure of the initial commercializations. All developers will need to build optimal product mix strategies to be successful. And with both business models, a focus on the optimal strategy to facilitate the first commercialization is essential. If advanced biofuel developers do both, they can accelerate the successful development of their first commercial facilities. At that point, advanced biofuels will have justified the current high levels of enthusiasm.
Martin Sabarsky, J.D. (’06) is the CFO and COO of HR BioPetroleum, a leading developer of algae-based biofuels and bioproducts, and serves as the co-chair of the Algae Working Group within the Biotechnology Industry Organization. He is a graduate of Brown University, Harvard Law School, and the Rady School of Management at the University of California, San Diego.