Lessons from the Cello Energy Biofuel Fraud Case: Do Your Homework

As far as speed bumps for cellulosic ethanol ventures go, this one’s a doozy: Jurors in a federal court have ordered Cello Energy, a biofuel startup run by Alabama’s former ethics chairman, Jack Boykin, and backed by both Silicon Valley cleantech investors Khosla Ventures and pulp maker Parsons & Whittemore Enterprises, to pay more than $10.4 million in a fraud case. According to the Alabama Press-Register, back in 2007, Cello promised P&W that it would make $16-a-barrel fuel from cellulose derived from things like hay, switchgrass and wood chips — and it has gone downhill from there. The case suggests at least two lessons for investors getting giddy about a buzzy technology: do your homework, and get ready to wait.

Cello reportedly accepted a $2.5 million investment from P&W in 2007 to help finance its first plant. Several months later it received a $12.5 million investment and a pledge for up to $25 million for construction and operation of additional plants from Khosla. Cello agreed to use discounted wood waste from the company as feedstock, but “a string of witnesses testified that samples of the fuel allegedly produced at Cello’s facility…were derived entirely from fossil and not renewable sources,” the Alabama Press-Register reports. This week a jury in Mobile, Ala., decided that Boykin’s original claims (made with his partner and son Allen Boykin) were fraudulent.

Fraud, of course, is unacceptable. But it’s also hard to sympathize with investors that threw down millions of dollars without knowing what they were really funding. Reading the blow-by-blow coverage of testimony and heated arguments in the Cello Energy trial (P&W’s lawyer at one point compared Cello to an adulterous spouse), it becomes clear that in a time when VCs were tripping over themselves for biofuel plays, P&W and Khosla Ventures weren’t exactly diligent. The excuse? P&W CEO George Landegger said he trusted Boykin after he promised to invest his own money in the $25 million project. For Khosla Ventures, whose founder Vinod Khosla has called cellulosic biofuel his “real love” and invested in more than a dozen biofuel companies, due diligence was not necessarily a deal breaker, and according to emails revealed in court between Khosla and partner Saul Kaul, Boykin refused to give the investors enough time for due diligence. That made the deal “nerve-wracking” for Kaul, but Khosla wrote, “Great job on this one. Herculean effort. But my bet is it will pay off.”

A key difference between Khosla and P&W’s outlooks on Cello and the Boykins right now seems to be the time frame in which they might have expected to see results. P&W took a stake in the venture early on, and may have expected swift commercialization (the CEO reportedly described the startup’s facility as underwhelming). Khosla, meanwhile, with his love for cellulosic biofuel, knows well that commercialization of a new cellulosic biofuel technology will take longer than that. Kaul reportedly told jurors, “We didn’t expect it to work right out of the gate…We’ll stand by patiently and supportive.” If the technology does pan out, Khosla Ventures will get about half of Cello’s revenues. If it doesn’t, well, the firm has plenty of other bets.

P&W also sued Khosla Ventures, claiming that the venture firm committed what’s called “tortious interference” — basically meddling with its business relationship with Cello and reducing its value (a bit curious, considering P&W’s claims that Cello’s process doesn’t actually work). The gist of P&W’s complaint about Khosla’s investment — made without P&W’s knowledge — is that it diluted the value of P&W’s stake, the Press-Register reports. P&W’s agreement with Cello included an option to invest another $10 million for a one-third ownership share in the company.

The jury ruled in favor of Khosla, whose investments made it the second-most active cleantech venture fund last quarter, behind only Kleiner Perkins, according to the Cleantech Group and Deloitte. As part of the original investment agreement, the firm said it would help Cello raise more funds, but after this week’s ruling, that, too, will likely be a Herculean effort.