BY RYAN DINGS

In a previous Playbook post, we discussed the three characteristics your climatetech company must have to unlock project finance:  

Build an asset that can operate as a stand-alone business, generate a good or service that produces predictable revenue, and ensure it’s highly replicable.

Those three attributes unlock the opportunity for your climate tech company to explore project finance. But how do you actually secure project finance and lower your capital costs? We’ll explore that below. First, a quick refresher:  

Power of Project Finance

A project finance model can be implemented across any physical asset where you have a technology capable of producing a good or service sold to a credit worthy third party creating a reliable, recurring stream of revenue. That applies to many climate technologies. Solar. Wind. Hydo. Geothermal. Nuclear. Energy Storage. EV charging networks. Green hydrogen facilities. Green cement. Green steel. Battery recycling. Carbon removal. Fusion (in 2075 –I kid, I kid... I meant 2065). The list goes on and on. Because climate tech is   filled with physical technology that plays a critical role in producing the low carbon or no carbon energy, fuels, and resources that we need to power a net zero economy, there is tremendous opportunity for these technologies to be positioned as physical assets  structured as standalone entities and independent businesses.  all of which means project finance plays a critical role.  

Unlocking the power of project finance signals a transition from the teenage years of venture building and the entry into young adulthood, when you can think more responsibly about the business you’re building and maximize the value of what you’re creating. You’re building new ways of thinking, flexing new managerial muscles, and thinking about growth in different ways.  

Don’t worry, you’re still having fun and enjoying plenty of sleepless nights. You’re just obsessing about IRR as much as TRL!  

What are you achieving when you unlock the power of project finance?  

1. You’re finding creditworthy offtake. That’s right, we’re talking about customers. Now, it may be hard to find a creditworthy customer for the first project you do. But offtake agreements are the key to project finance, because that represents the recurring revenue you can generate from the technology. The revenue is the foundational piece of the financial model, and from it you can build an understanding of what type of net operating income you can target and ultimately what IRR you can generate.  

2. You are safeguarding your asset in an entity and safeguarding the rest of your business from that asset. By putting the asset into an entity designed solely to manage that asset, you’re opening the opportunity for investors to evaluate the investment risk of financing that asset based solely on the asset’s performance. You’re also protecting the rest of the business in case something goes wrong. If the asset ends up going bust, it doesn’t ruin your entire business, just the financial viability of that one entity.  

3. You can derisk the financial performance of the asset. You can insure the asset or the offtake agreement, you can create cash reserves, you can pick only credit worthy offtakers, use the best materials, enter long term operations and maintenance contracts, and the list goes on. There are all sorts of things you can do to create a less risky business when you’ve isolated the asset into its own entity.  

4. You can create a model that feels entirely replicable. So you can create an entity to hold your first plant, and another entity to hold your second, and another to hold your third, and it feels very comforting to investors because they are getting the benefit of investing in a singular entity knowing that the team in charge has figured out a way to repeat the performance.  

5. You let investors isolate the investment risk of the asset from the rest of your business. Now, investors can look directly at the asset, the revenue stream it creates, the many ways you’ve derisked financial performance, and the IRR you’re targeting. And they can make an investment decision based on the risk they see and the return you’re proposing.  

Spoiler alert – the risk adjusted return investors will seek in a project finance deal will be less than they will seek in a venture capital deal. Most climate tech startups will see venture capital cost 30% or more. Project finance will cost 10-20% (the devil is in the details, but the numbers are heading in the right direction – yours!).

Suddenly, you have reduced your cost of capital for this asset, increased the likelihood you can build an appealing project finance model and got one step closer to scaling your company. But, just because you’ve identified a plan to install an operating asset in a separate entity doesn’t mean your involvement stops. On the contrary, you’ve got a lot of work to do to establish and manage the entity and operate its business. Let’s run through the key aspects.  

Establishing the Entity

Just like you filed articles of incorporation for your startup, you’ll need to file articles of formation for a limited liability company (LLC).

Your startup will act as the parent company of the project company, initially owning 100% of the LLC’s equity and serving as its manager. You’ll need to treat this LLC with all the same legal and operational formality you apply to your core business.  

Managing It

Once  established, it’s time to manage the project company like a business. That includes developing a business pan with:  A detailed understanding of the physical asset and how the LLC will hold ownership  

1. An offtake agreement in the LLC;s , so it can sell the goods or services which the asset will generate and receive revenue in return,  

2. A financial model detailing the sources and uses of capital,  and the pro forma income statement which forecasts revenue, operating expenses, and a target IRR (internal rate of return) for investors,  

3. Operating agreements that detail who manages the operations of the physical asset (likely the parent company will play a partial role in operations and maintenance), and

4. The administrative aspects of the business (bank accounts, insurance, lawyers, accountants).  

And of course, another  critical aspect of managing the business: and raising the capital to finance it.  

Financing It

With all of these pieces in place, you can turn to your sources and uses statement and understand exactly how much capital you will need to build the plant that your LLC will own and operate.  

You will likely need to start identifying those sources by having the parent company put capital in. This is called sponsor equity – and you, as the climate tech startup, are the sponsor of this deal. That number could range from a few percent (if the project is deemed less risky) to 25% or more (if this is one of the first few projects using novel technology).  

With a sense of what you can put in, you can then go to seek to raise the rest of the equity required for your project. You use your financial model as a guide and seek out investors who are willing to invest at the target IRR you’re proposing. Investors will likely seek a higher IRR, and you can adjust your model accordingly, but you must start by understanding the IRR your project can generate, so you don’t overpromise and underdeliver.  

Raising project equity is very different from raising VC.  Investors will still diligence the team and the tech, but there will be far more scrutiny given to the financial model and operational performance of the project. Significantly more.  

Odd but true: The lower the return, the higher the diligence.

This applies especially if you’re using depth as part of your capital stack. Dept brings leverage– but also complexity.  

Keep in mind three things about debt at the project level. First the cost of debt needs to be lower than the target return to equity for leverage to apply. Second, in many instances, the lender will want a guaranty from the parent company, which will put the parent company on the hook if the project company can’t pay, thereby eliminating one of the benefits of having the LLC in the first place. Third, the covenants and the reporting associated with debt could become overwhelming, especially for early-stage firms using project finance for the first time. The principal amount, rate, term, and repayment schedule matter the most when it comes to debt, but take time to understand all the terms of your loan agreement.  

If leverage does apply, then you can adjust the debt and equity in the “sources” portion of your sources and uses statement to optimize return and optimize everyone’s comfort. Equity investors love levered returns, as long as there is confidence there is sufficient net operating income for debt service. Lenders love clipping coupons as long as they are confident their principal will be returned!

With the sources of capital figured out (sponsor equity, third-party equity and third-party debt), you can now turn to the uses of capital, which is construction and operation of your plant.  

Operating It … and Replicating It

You’ve formed it, you’re managing it, and now you’ve got to get this plant up and running so you can provide the offtake your customer is looking for and you can generate the returns you promised to your investors.  

You will hire architects and engineers to design it, contractors to build it, and dedicated staff to manage it. But make no mistake, you – and the entire parent company – need to be involved in ensuring the success of the project company. You want to make it clear that this project works, it can deliver the returns to investors you targeted and is capable of being replicated over and over again. That replication of a proven model with a predictable return will continue to drive your cost of capital lower and lower. And it will illuminate a pathway to profitability for the parent company – perhaps even an exit opportunity in which you can realize the aspirations when you started the business.  

That is the power of project finance!