Cobalt Biofuels plans to build a pilot plant in the San Francisco Bay Area by next year, the company told Greentech Media on Tuesday.

The Mountain View, Calif., startup, which earlier this month closed $25 million in its third round of funding, plans to build a pilot plant producing "tens of thousands of gallons" of biobutanol per year, said Steven Shevick, Cobalt's chief financial officer.

"It's a huge achievement for the company to close the round in this time of turbulence," Shevick said, adding that raising more money will not be easy in the near future given the credit crunch and slumping economy.

The pilot plant will give Cobalt a chance to showcase its technology to potential customers before building a commercial plant, which it plans to do – after raising more money for it –several years from now.

The commercial project will be located near sources of non-food materials, such as sweet sorghum and wood pulps to produce biobuanol that it plans to use for the feedstock.

Shevick declined to disclose the costs of building the pilot and commercial plants, or their locations. The pilot plant will be close to its Silicon Valley headquarters, and Cobalt expects to complete the pilot plant in 2009.

The commercial plant will be built and begin producing biobutanol two or three years after the pilot plant comes online, Shevick said. The company will need to raise more money to build the commercial plant, but Shevick declined to disclose the fund-raising goal.

Cobalt is researching the right microbes and process for turning plant materials into butanol. The company has developed a fluid separation technology that uses much less energy and reduces water use by purifying and reusing the water during production.

Biobutanol can be blended into gasoline or ethanol for powering cars. It also can be used as a solvent in chemical and industrial operations.

"We're very bullish about the prospects for biobutanol," said Matt Horton, a principal at @Ventures, a Cobalt investor. "We like that there is an existing commodities market for biobutanol for [Cobalt] to sell into while they're waiting for the long process that is the development of a new fuel. I feel it's a much better fuel than ethanol is and I feel it's got a great future."

Butanol fetches a higher price now in the chemical and industrial processing market than it would in the transportation fuel sector, Shevick said.

Butanol can fetch $5.50 to $6 per gallon in the chemical and industrial processing market, which uses about 300 million gallons of butanol per year in the United States alone, Shevick said. Ethanol, on the other hand, went for $1.74 per gallon for the January delivery, according to the Chicago Board of Trade Tuesday.

But Cobalt is aiming for the transportation fuel market, as well as the chemical and industrial market, because it's larger, particularly with the U.S. government's biofuel mandate requiring the country's transportation market to use 36 billion gallons of a variety of biofuels by 2022 (see House Passes Energy Bill).

The mandate has spurred growth in the number of companies entering the biofuel market, particularly ethanol companies. Oil giant BP (NYSE: BP), in addition to investing in ethanol companies such as Verenium, also is gunning for the biobutanol market. BP teamed up with DuPont last year to begin developing biobutanol (see Betting on Biobutanol).

Startup companies that aim to commercialize their biobutanol technologies include U.K.-based Green Biologics. In September, the company said it was seeking £3.5 million ($5.84 million) in funding and had signed a deal with India-based Laxmi Organic Industries to a biobutanol plant in Mumbai.

Unlike ethanol, biobutanol is less corrosive and can be transported via pipelines. Ethanol makers have to ship their products by trucks or trains. Biobutanol also can be blended at a higher percentage than ethanol for use in standard car engines today.

"It really fits seamlessly into the distribution network," Shevick said.

Challenges for biobutanol companies remain similar to its ethanol brethrens, including the ability to mass-produce the fuels at a low price.

Cobalt is looking for opportunities overseas, though the company isn't ready to discuss them.

Life Sciences Partners and Pinnacle Ventures co-led the $25 million funding, which also came from Vantage Point Venture Partners, the Malaysian Life Sciences Capital Fund, @Ventures and Harris and Harris.