Technical Due Diligence for Investors
In this week’s edition of The Energy Letter, I discussed the need for technical due diligence when evaluating a company whose business model depends upon commercially unproven technology. In the fast-changing world of energy—as in information technology, telecommunications, pharmaceuticals and biotechnology—understanding new technologies is fundamental to successful investing. Without technical due diligence, you’re flying blind.
There were many IPOs in the renewable energy sector over the past two years, including such high-profile names as Solazyme (NSDQ: SZYM), Amyris (NSDQ: AMRS), Gevo (NSDQ: GEVO), Codexis (NSDQ: CDXS) and KiOR (NSDQ: KIOR). Each of these companies claimed novel technology for producing renewable petroleum substitutes. Bold claims were made about the potential of each of these companies, and analysts assigned them outperform ratings.
Investor money poured in—but much of that capital evaporated as share prices tumbled.
What went wrong? In short, expectations for the sector were simply too high. These high expectations were often encouraged by the companies themselves. In some cases, analysts made attempts at technical due diligence, but they asked the wrong questions and as a result they provided poor advice.
In Part I of this article, I will cover the key aspects of conducting technical due diligence.
The Challenge of Scale
Chemical processes can behave differently at different scale. Results that were achieved in a laboratory can’t always be replicated at a larger scale for various reasons. Therefore, the cautious approach for a renewable energy company attempting to produce a petroleum substitute would be a series of scale-ups. This would ideally proceed from the laboratory through a pilot facility through a demonstration facility to a commercial facility. At each step, technical issues should be resolved and the knowledge gained should be applied toward the next stage of scale-up.
Each scale-up can be thought of as a gate, and a technology should satisfy the desired metrics before proceeding to the next step. Most technologies die out somewhere between the lab and commercialization, because technical issues either can’t be resolved, or it becomes clear that the economics of the process aren’t acceptable.
Skipping steps in the process of scaling up—for instance, jumping from the lab to a demonstration size facility—greatly lowers the probability of success while putting much more money at risk.
There are no specific rules defining the size of these particular facilities, but in general lab experiments will demonstrate one aspect of a technology at scales of ounces or milliliters. Piloting moves up into scales of pounds or liters per day, and will incorporate more pieces of the process. Demonstration facilities reach the realm of barrels per day (1 barrel = 42 gallons), and are typically integrated facilities designed to demonstrate that all aspects of the technology work in conjunction with each other at that particular scale.
A facility producing 10 barrels a day (150,000 gallons per year) is demonstration size, while one that produces 1,000 barrels a day is on the low end of commercial size. To put those numbers into perspective, the average size of a corn ethanol plant in the US is just over 4,000 barrels per day and the average size of an oil refinery in the US is 125,000 barrels per day.
In order to get the detailed technical information you will need, you will probably be asked to sign a non-disclosure agreement (NDA). This is a legitimate and necessary step for companies who wish to protect against someone copying their technology and starting a competing company, or leaking proprietary information to competitors.
An NDA will enable access to information you might never obtain otherwise, and you will often learn that what companies reveal privately is much more conservative than their press releases. On the other hand many companies that are promoting their technology and trying to get funds will answer some questions before asking for an NDA — and ideally you want to learn as much as you can before signing an NDA.
As you dig for information, the first people you will encounter will likely be those promoting the technology. They will probably be careful and very optimistic with the information they provide. But your objective should be to talk to people involved in the day-to-day operation of the process. They will be the ones to tell you about potentially significant issues.
The first question to ask is “At what scale has this process been demonstrated and how long was it operated continuously?” You may have to ask this question in a couple of different ways, because you will get misleading answers and important information may be withheld.
Ask about the planned source of the raw materials and the composition of the final product. Knowing the composition of byproducts and waste products is also important. Product quality and waste disposal issues have bankrupted companies attempting to commercialize a process.
Also of critical importance are the assumptions used to model a commercial plant. How were the construction costs estimated? What is the scale-up factor between what has been demonstrated and the next level of scale-up? The larger this factor, the greater the technological and economic risk.
Clearly distinguish between how much of the process has been proven and how much has been simulated with computer models. Computer models can be highly useful tools, but a model won’t necessarily tell you whether a process will work. It will give you some guidance, but computer models that have not been properly validated can be grossly in error.
Overly optimistic assumptions about feedstock costs—such as expectations of a long-term supply of cheap, free, or even negatively-priced biomass—generally underlie company claims that they can produce renewable petroleum for $1 or $2 per gallon. Therefore, you should understand the sensitivity of the economics to feedstock costs. If the presumed feedstock is grass, then feedstock costs will likely be similar to the cost of hay (~$100 per ton).
Find out about predecessors and competitors. Very little is invented from scratch; almost everyone builds off of previous work. Who came before and did similar work? Who is doing similar work now? How is their work better than that of others? Then ask these questions of competitors. This is an effective tool for identifying problems. Competitors are always happy to explain what is wrong with the other company’s process. Some may insist that they are so unique they have no competitors, but that is rarely the case.
Talk to former employees. If there are skeletons in the closet, they may tell you where to look. A former employee will likely be bound by a confidentiality agreement, but that doesn’t prevent them from pointing you to a specific bit of information in a patent that doesn’t mesh with the company’s public claims.
There will often be specific technical claims that are outside your particular area of expertise. Consult someone who knows the area. Sometimes you can locate a free opinion. Look for quotes from people who are skeptical of the process. Contact them for further information.
To break this down into a short “cheat sheet”, here is a summary of some important questions that you probably want to ask. This list is not all-inclusive, but does cover many of the important points. Try to cross-check answers by talking to employees or competitors.
1) At what scale has the process been demonstrated, for what duration, and is the process currently running?
2) What are the source and the cost of raw materials for the process?
3) How much feedstock is required for a commercial facility, and what are the logistics for transporting feedstock into the facility and waste out of the facility?
4) What is being done with the product, and is it approved for sale in the fuel supply?
5) What are the primary energy inputs into the process, and what is the energy balance?
6) Will there be intermediate scale-up steps before a commercial facility is built?
7) What are the key assumptions for a commercial facility (e.g., size, cost of production, location)?
8) Has the process been demonstrated on the specific biomass intended to be used in a commercial facility?
9) What are the patent or patent application numbers relevant to the process?
10) What prior work is most similar to yours, and who are your perceived competitors?
If you manage to get honest answers to those questions, you will be well on your way to burrowing through the hype to understand the true potential of a process.
In Part II of this article in the next issue, I’ll present an in-depth example of technical due diligence in action.