This week, algae-biofuel startup Sapphire Energy announced it has received $144 million in new funding, which brings its total to over $300 million.

The company, which is less than five years old, has been moving quickly to build a 300-acre algae farm as a large-scale demonstration of its process for making algae oils. The U.S. government has supplied over $100 million of the investments, including a $50 million Recovery Act grant designed in part to spur job creation.

But Sapphire’s rapid expansion raises the question of whether it is scaling up its technology too soon. Some of its ideas for reducing the cost of algae fuels are at too early a stage to be implemented at the new farm. Yet these technologies might prove vital to making its fuels competitive.

Knowing when to move technologies out of the lab and into large-scale demonstrations is a perennial challenge for energy startups. According to some experts, Range Fuels, a startup founded to produce ethanol from wood chips, foundered because it built a large-scale plant too soon, before the bugs had been worked out of its technology at a smaller scale. As a result, the plant didn’t work well enough to be economical.

The new funding will allow Sapphire to finish building its algae farm, near the small town of Columbus, New Mexico, just north of the U.S.–Mexico border. A 100-acre segment of the farm has already been finished, and when the whole project is complete, by 2014, Sapphire will have the capacity to produce about 1.5 million gallons of algae crude oil, which can be shipped to refineries to make chemicals and fuels such as diesel and gasoline.

Algae is attractive as a source of fuel because the microörganisms naturally make large amounts of oil and can be grown in ponds filled with brackish or salt water, so they don’t use up fresh water supplies or quality farmland. But algae are expensive to grow and harvest, so previously they’ve only been used commercially to produce relatively high-value products such as cosmetics and nutritional supplements.

Sapphire hopes to lower the cost of producing algae fuels by changing every part of the production process. That includes increasing the quality and the amount of oil produced, reducing the cost of building ponds, and developing low-cost ways to harvest the oil. The company aims to have a product that’s competitive with oil priced at $85 per barrel, and it expects to meet this goal once it reaches full-scale production in about six years. Oil costs over $100 a barrel now.

Achieving these cost targets will require significant innovation. Last year, a pair of studies from the National Renewable Energy Laboratory in Golden, Colorado, concluded that algae-based diesel made by scaling up existing algae technologies would cost several times as much as conventional diesel. According to one of the studies, it would cost about $9.84 per gallon to make algae diesel, as opposed to $2.60 per gallon for petro-diesel, at January 2011 costs. Other studies have estimated even higher costs.

Increasing the amount of oil that algae makes is one of the most promising ways to reduce costs. A number of other algae-biofuels companies are genetically engineering their algae to increase production, but Sapphire, instead, has developed a fast way to breed algae, select those with traits that can improve oil production, and make oil that resembles crude oil closely enough that it can be processed in ordinary refineries.

Sapphire has also bred algae that can flourish in open ponds. Other algae-biofuels companies use closed containers, which are more expensive but can help protect the algae from predators, fungal diseases, and other strains of algae that might take over a pond. Sapphire has bred disease-resistant algae that can grow under harsh conditions, such as high pH or salinity, that most other organisms can’t tolerate, reducing competition. It has also made them resistant to certain chemicals that inhibit the growth of other organisms.

Another major challenge is harvesting the algae. It takes about 1,000 grams of water to grow 1 gram of algae, and separating the two efficiently and extracting the oil can require a lot of energy. Borrowing techniques from water-treatment plants, Sapphire treats the algae with chemicals that cause them to clump together. The algae can be “squeegeed off the surface” says Tim Zenk, Sapphire Energy’s vice president of corporate affairs. The result is wet slurry that still contains a lot of water. Sapphire treats that with solvents at high pressures and temperatures to make three streams of products: algae oil, nutrients such as phosphates, and the leftover biomass. The oil goes to a refinery, and the nutrients and biomass are used to feed more algae.

The company is finding ways to reduce other costs. Rather than building concrete ponds, it is building cheaper ponds out of dirt and waterproof liners. It plans eventually to do away with the liners and make ponds that resemble rice paddies. Sapphire is also replacing energy-intensive paddle wheels used to circulate the algae with more efficient pumps, and is planning to design systems that use only the wind that sweeps across the New Mexico deserts for circulation.

The company is working with Munich-based Linde Group to develop a low-cost way to supply the algae with carbon dioxide, which is key to high productivity. Linde has developed systems for supplying greenhouses with carbon dioxide from a refinery.

Finally, Zenk says, the company may eventually turn to genetic engineering to further improve the performance of its algae.

When complete, the new 300-acre algae farm project is expected to produce about 100 barrels of algae crude per day, or 35,000 a year. Zenk says the process won’t be commercially viable without the economies of scale that will come with much, much bigger farms—1,000 to 5,000 acres.

Sapphire is a major beneficiary of the U.S. government. It received a $50 million grant connected to the 2009 Recovery Act and a $54 million loan guarantee from the U.S. Department of Agriculture. Its first customers may be the U.S. military, which is evaluating its fuels. Sapphire’s early funders included Bill Gates and a Rockefeller family fund. Monsanto is another major funder. It has an R&D agreement with Sapphire to identify genes in algae that might make corn, cotton, and soybeans more resistant to drought and other stress, and increase their yield.

Phil Pienkos, a research scientist at the National Renewable Energy Lab, says that Sapphire is doing a number of good things to reduce costs. Yet he says making algae fuels competitive will be a challenge. “It takes a certain amount of faith that there is going to be a business there,” he says.