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Despite the flood of headlines announcing $400 million cleantech venture funds and rumblings of the sector’s overvaluation, cleantech investments comprise just 11 percent of total U.S. investment, and worldwide venture capital and private equity investment in the space dropped from $3.7 billion in Q1 2007 to $2.4 billion in Q1 2008, according to New Energy Finance. All hype and speculation aside, cleantech is still considered a risky investment by many investors’ standards, including venture capitalists.

“VC funding traditionally works really well for technology companies with high margins, but cleantech businesses, for the most part, bring in longer-term returns, typically with lower margins,” says Barry Cinnamon, CEO of Los Gatos–based solar installer Akeena Solar (Nasdaq: AKNS). Cinnamon also points out that cleantech companies often continue to need expansion capital, which is not consistent with today’s venture capital investment patterns.

Many of today’s cleantech companies tend to be heavily reliant on factors beyond investors’ control, ranging from fuel prices to tax credits and federal incentives, which makes them inherently risky. Unlike the dotcoms to which cleantech companies are often compared, cleantech companies also rely on the viability of a particular technology and the company’s ability to build products at scale and cost. In many cases, neither technology nor commercial viability can be proven right out of the gate.

Venture funds that invest in cleantech tend to stick to more established sectors, such as solar and biofuels, or energy-efficiency plays that resemble the more familiar software deals of yore. Venture investments in cleantech are also migrating toward later-stage deals, according to a recently released Ernst & Young report, which noted that later-stage deals made up 43 percent of financing rounds in the first quarter of 2008. Echoing a sentiment heard frequently in recent months, Richard MacKeller, managing director at Chrysalix, a Vancouver, B.C.–based venture fund focused on early-stage energy plays, says there is simply too much money chasing too few deals in the cleantech market.

The result is a dire need for funding at the extremes—early stage research and development and late stage project financing—as well as for the large number of cleantech companies that don’t fit neatly into the existing venture capital mold, which demands high, short-term returns. Fortunately, a host of new financial models is emerging to finance underserved segments of the cleantech market.

In the beginning
Federal funding for early-stage research has been steadily cut over the last few years, and startups have turned to private capital to fill the gap. But venture firms’ “early stage” funds have swollen to numbers that push them away from true early-stage investments, which require smaller but vital amounts of capital, says Jon Bonnano, chair of the Keiretsu Forum’s Clean Tech Committee and president of renewable energy startup Principle Power.

“The No. 1 nameplate venture firms have hundreds of millions to invest, so doing a $1 million investment isn’t interesting to them,” Bonnano says. “It takes so much to conduct due diligence on these investments that you need bigger blocks. Plus, funds have time limits on them; they have to get their money in play and get a return in five to six years so they can get the returns to fuel the next fund.”

In 2004, when northern California utility Pacific Gas & Electric (PG&E) was coming out of bankruptcy, the Public Utilities Commission (PUC) required the utility to set aside $30 million to establish the nonprofit California Clean Energy Fund (CalCEF) to invest in clean energy technology, with a focus on taking products from research to commercialization. The $30 million was entrusted to three venture capital firms, which were asked to invest the money in cleantech.

“What CalCEF found out was that VC funds, as a rule, don’t invest in the early stage, and that was a disappointment,” says Sue Preston, general partner for the CalCEF Clean Energy Angel Fund. “They were making good investments but they weren’t targeting the area the utilities commission was interested in, which was moving technology from the lab to the early stages of commercialization.”

That problem was the motivating force behind the creation in 2008 of the California Clean Energy Angel Fund, which brings together angel investors to focus on such early stage investments.

Early stage investments are a desirable opportunity for angel investors, who can have more say in company decisions than they would have as a smaller investor in a large VC-led deal. “With the early stage cleantech deals, where we’re contributing all or most of the funds, it generates a lot of momentum on the investor side,” says Bonnano. “We at least get to be at the table, discussing terms.”

The CalCEF angel fund has a similar approach, according to Preston. “Our primary goal is early stage investment so there is likely to be funding after us,” she says. “We’d like to have a signature role in the first funding round and participate in the second round, but our level of involvement will diminish as VCs get more involved. We see ourselves as adding value to the management team and market strategy and helping to further and finalize the development of technology, so that when our portfolio companies go out for VC financing, we have increased their valuation.”

Companies that receive funding from Keiretsu also benefit from the forum’s vast professional network. Each quarter, Keiretsu picks its most promising companies and sets up face-to-face meetings with as many as 15 of the top VCs in the country. “Our network is either working at these funds or has friends there, so when we invest in a company and they do well, we put them in front of name-brand VCs,” Bonnano says. “For an entrepreneur it’s fantastic.”

The CalCEF fund is planning to raise $20 million and 750 Keiretsu members contribute anywhere from $200,000 to $2 million per deal, but Preston and Bonnano both say there is a need for more cleantech investments in the $500,000 to $3 million range.

“I’ve seen a few angel funds increase their focus in this area and work to figure out how to get into the space, but we certainly need more,” says Preston. “Most angels are prior successful entrepreneurs who invest in areas that they have a comfort and experience with, but this is a new area so we don’t have a stable of entrepreneurs who have been there and are now investing; most angel investors don’t know how to evaluate cleantech companies.”

Preston says there also need to be more, different types of early-stage funding in cleantech. “There still aren’t a lot of resources at the early stage for companies,” she says. “Money is competitive, and part of the problem for a lot of entrepreneurs is that they have a great idea that might make for a good business for a small group of individuals but doesn’t provide enough liquidity for an institutional investor. In such cases, individual angels may be willing to invest and share in revenue, and I’m hoping that grant money, particularly federal grant money, will open up in the next five to 10 years or else we really will have a stagnation problem here.”

That funding may open up even sooner. At press time, the Department of Energy had announced the distribution of $126.6 million in research grants to two large-scale carbon sequestration projects and $7.5 million to marine energy research projects, while the BP-backed (NYSE: BP) Energy Biosciences Institute announced a set of 49 cellulosic biofuel research projects that will share $20 million. The World Bank teamed up with the U.S., UK, and Japanese governments to launch a $500 million cleantech fund solely for early stage research and development.

Just reverse it
So, once cleantech companies get off the ground, how do investors collect on their bets? Unlike other tech companies, a lucrative public offering is not always the best growth strategy for cleantech companies. As a result, so-called “reverse mergers” have become increasingly popular, particularly as more companies, such as Akeena Solar and Carmanah Technologies (trading on the Toronto Stock Exchange under the symbol CMH), have illustrated how well the mechanism can work for a variety of cleantech sectors.

In a reverse merger, a company looking to secure funding finds a “shell company”—an overthe- counter (OTC) stock that is publicly traded but no longer conducting business. The public shell company agrees to acquire the private company and relinquish the majority of shares and control of the board to the private company. It allows a private company to go public without the time and money required to go through the IPO process.

Once on the OTC Bulletin Board, the company can trade its shares, grow revenue and eventually qualify for trading on a major stock exchange. Reverse mergers are often combined with Private Investment in Public Equity (PIPE) investments, in which case they are sometimes referred to as “alternative public offerings” or APOs. PIPE money comes in the form of either stock issued at a set price or convertible debt issued to raise capital. In Akeena Solar’s case, for example, the company concurrently raised $3 million in PIPE financing as it traded its stock on the Bulletin Board.

Akeena CEO Cinnamon says he had experience with nearly every type of financing through various startup experiences, but when it came time to source funds for Akeena, he listened to friend and financial advisor Joe Abrams, who “likes to do reverse mergers,” according to Cinnamon. Cinnamon says two things contributed to the reverse merger’s success: an experienced advisor (Abrams oversaw the process for a company called Intermix, which eventually became MySpace), and his company’s ability to meet stated goals.

Akeena raised the money it needed and qualified for the Nasdaq in late 2007. Cinnamon says he thinks a reverse merger could be an appropriate funding model for any cleantech company, but cautions that CEOs need to be aware of the pitfalls of the process, beginning with finding the right advisor to help find the right shell company. “You need partners who really know what they’re doing and you need to really know your business, because you’ll probably need to keep raising money, and the next round goes a lot better if you’ve delivered on your promises to your first investors,” he says.

It’s also important to get and keep investors aware of and interested in your company when you’re on the OTC Bulletin Board, Cinnamon says. “It doesn’t do you any good to be a public company if no one knows about you and no one invests,” he says.

There are also challenges involved in being a very small public company. “You still have to do all the things Wall Street investors expect,” Cinnamon says. “You have to file quarterly, hold earnings calls, send out press releases, ensure that your business dealings are transparent—I had done it before, so it wasn’t new, but it’s not easy managing all that while you’re trying to grow your company.”

On the positive side, CEOs of public companies can’t be replaced as easily as venture capital investors can replace the CEO of one of their portfolio companies. A public company’s management team also doesn’t need to deal with as much input from investors who, as can often be the case in cleantech, don’t know their business well.

Although reverse mergers are gaining favor thanks to their usefulness in the cleantech market, Cinnamon says there is still a stigma attached to them. “It’s kind of like we grew up on the wrong side of tracks,” he says. “Some people have a real distaste for reverse mergers, but we were confident and we made it work.”

“Plus, I think we were also lucky,” he adds.

Long-term value
In the end, just as a variety of cleantech solutions are needed to address global energy, water and transportation needs, a variety of financing options are necessary to support the huge variety of cleantech companies and sectors. Currently, the trend in VC and institutional finance is a focus on late-stage growth funds, leaving a gap in early-stage financing.

But where there’s a gap there’s an opportunity, which angel investors and some committed early-stage VC players such as Chrysalix are hoping to exploit. “We need more people doing this,” Bonnano says. “We need many more people and many more dollars working to find best-of-breed technologies and scale them up fast.”