Israeli Venture Capital: Between a Rock and a Hard PlacePublished: January 11, 2011 in Knowledge@Wharton
This has been a bad year for Israeli venture capital funds -- but then 2009 was a bad year, too. That alone can go a long way to explaining the angst gripping much of the VC industry in Israel.
But the soul-searching now under way in Herzliya, the sleepy seaside town just north of Tel Aviv that has been transformed into the heart of the Israeli high-tech and venture sectors, suggests that something deeper is amiss. Perhaps the most dramatic public expression of this growing groundswell of gloom and doom came in a letter sent in May by Ze'ev Holtzman, founder and chairman of Giza Venture Capital and former chairman of the Israel Venture Association, to Prime Minister Benjamin Netanyahu and Minister of Finance Yuval Steinitz. Holtzman's message was blunt: "Israel's venture capital and start-up industry is heading for collapse.... The industry, which is the economy's growth engine, is liable to be irreversibly damaged."
Nor is Holtzman a lone voice. A growing number of experts, inside but especially outside the industry, believe that Israel's VC funds are an endangered species and, if they are to survive at all, their accepted business model must be scrapped and replaced with something more suitable to today's business and financial environment.
A Major Success Story
The "history" of Israeli venture capital effectively began in 1992, when the Israeli government kick-started the domestic venture sector by launching a prototype government-owned fund called Yozma (it seeded other funds, which were privately owned, and was itself ultimately and successfully, privatized). Since then, the VC-driven business model has dominated Israeli high-tech and become firmly implanted in the public mind as a major success story.
The model works like this: A seemingly endless stream of technology entrepreneurs -- encompassing nerdy high-school kids, highly qualified scientists and academics who had immigrated to Israel from the former Soviet Union, and graduates of elite military intelligence units -- generate a flood of ideas for products, programs and systems. They market these ideas to Israeli venture capital funds, and those that the funds choose to back receive financial -- and often managerial -- support which, typically, requires several rounds of investment. Often, the original fund will bring in others along the way to share the burden and the risk -- and also the profits, if all goes well.
Typically, "going well" means going public, preferably via an IPO on the Nasdaq market in the United States. This path became so well-trodden that between 1985 and 2003, some 120 Israeli companies issued shares on Nasdaq -- more than any other foreign country except Canada. (Prior to 1992, Israeli start-ups largely sought funding from VCs and individual investors in the United States, who continue to be a significant source of financial aid.) Additionally, several larger Israeli companies were registered on the New York Stock Exchange and many smaller ones went public via issues on European "wannabe" Nasdaqs, such as the Alternative Investment Market (AIM) in London.
Problems with the Model
What has gone wrong with this model? David Rosenberg, a veteran journalist covering Israeli technology and author of the forthcoming book, "Israel: The Knowledge Economy and Its Costs," says the villain is a "two-sided squeeze" of the VC funds. At one end of the VC activity cycle, the firms cannot raise money for new funds, while at the other end, they can't exit their investments via IPOs because the global financial crisis of the last two years has largely shut down the market for new issues.
Raphael "Raffi" Amit, a Wharton management professor, notes that although this year has proven to be much better than 2009, that's because 2009 was the worst year for IPOs in more than 40 years. The improvement in 2010 was from such a low base that it still left this year weak by historical standards, he says.
Amit, who sees strong parallels between the state of the Israeli VC sector and that of the sector in the U.S., questions whether the IPO market will ever return to boom conditions. Given the statistical fact that most IPOs of technology companies generated poor returns for the investors who bought the shares, he says he is very doubtful that it will. Right now, many companies are sitting on prospectuses for share flotations that they have prepared, but market conditions have prevented them from activating those, Amit notes. This overhang of supply acts to depress prices and will continue to do so for a long time -- hardly good news for VCs eager to exit from their successful investee companies.
The tough market conditions raise the question as to whether the VC funds are victims of circumstances or the cause of their own problems, experts say. In other words, has the model been undermined by developments outside the venture sector, or is it inherently flawed? Not surprisingly, opinions vary depending on where you sit. Many VC fund managers see themselves as victims, although there are those who are prepared to admit to systemic problems and who also propose solutions, some of them radical.
But people outside the industry tend to be more critical. Andrew Fine, who has worked with numerous venture-backed start-ups both as a CFO and as an outside consultant, believes that the problems with the business model begin with the accepted fee structure. This structure typically awards funds a fee of 2% per year of money under management, irrespective of their performance, and a hefty success fee when they realize a profit from an investment. However, the poor -- in some cases abysmal -- record of the VC fund industry over the last 10 years, since the Internet/telecom boom collapsed in 2000, has forced even the most apathetic and gullible investors to ask whether the fees are justified, Fine notes.
By the same token, the entrepreneurs in the investee companies who sell the VC funds large equity stakes in return for their cash feel that they are also getting a raw deal. Money is essential for start-ups, but it is not sufficient: They need professional and managerial help, contacts and guidance, and they expect their investors to provide them. Many funds have failed to do so, experts point out.
Just a Cyclical Downturn?
That these are hard times for VCs is uncontested -- and just how bad things are can quickly be ascertained from some key statistics: Capital raised by Israeli high-tech companies from venture capital funds fell last year to $1.12 billion -- some 55% less than 2008 -- and ran at a similar annual rate in the first half of 2010, when it totaled $577 million. These are the lowest levels of capital raised since 2002-2003, when the aftermath of the dot-com bust saw a collapse of high-tech investment flows.
More critically, the percentage of the investments being made in these Israeli start-ups specifically by Israeli VC companies has fallen dramatically. Between 2000 and 2006, Israeli VCs were responsible for 40% to 45% of total investment by VCs, with the 49% level recorded in 2005 marking a high point, according to the IVC Research Center, an arm of the Israel Venture Association. From 2007, their share eroded at a steady one percentage point per year, reaching 37% in 2009. But in January-June 2010, the share plunged to an unprecedented low of 29%
The critical question is this: Is the weak period that the sector is going through merely a cyclical slowdown, or is it something more fundamental and hence more far-reaching?
Observers inside and outside the industry have diverging views on the issue. Len Rosen heads the Israeli office of Barclays Capital and, in both his current and previous positions (at Lehman Brothers), has been a leading player in the involvement of foreign investment banks in Israeli high-tech. He suggests that the sector's current state represents a cyclical downturn -- and he even identifies a silver lining around the current black cloud. "There is a general problem in high-tech, which is especially acute in Israel, of start-up companies that want to go to market too early in their development path," Rosen says. "If an exit option exists, companies take it -- whether because of pressure from their VC investors or because the entrepreneurs want to 'meet cash.' But we have found that the best IPOs were those made after an enforced hiatus when the market was closed to new IPOs."
According to Rosen, "the cyclical dynamic will continue and good IPOs will return." Indeed, recent months have seen the IPO window opening and the first Israeli IPOs since 2007 being floated on Nasdaq -- although with decidedly mixed results. Yet even Rosen concedes that there are structural problems in the Israeli high-tech sector, such as the absence of funds specializing in "mezzanine financing," which employs a mix of debt and equity to help existing companies expand. An infusion of mezzanine money would enable start-ups to hold off from going public prematurely, Rosen says, noting that this structural issue reflects a cultural problem prevalent in Israeli business -- a lack of patience and an unwillingness to allow the natural process of development and maturity to run its course.
A Smaller Role?
Yossi Vardi, an angel investor and one of Israel's first high-tech entrepreneurs, maintains that Israeli start-ups can comfortably survive an existential crisis in the VC industry, because their future financing will come from angels and from larger companies, with VC funds playing a much smaller role than in the past.
Vardi's view of high-tech's future resembles a barbell: At one end are the hundreds of start-ups operating in the Internet and mobile sectors. At the other end of the corporate spectrum are the major multinationals such as Intel, IBM and Motorola -- all of which have large facilities in Israel for R&D and, in Intel's case, for manufacturing as well -- that each employ thousands of people.
He dismisses the idea that there is a shortage of financing available for start-ups. There is indeed less money available than before the financial crisis, he notes, but the sums that are required for seed financing and for later rounds have also shrunk. "I see an endless flow of new ideas being generated here, and an ongoing parade of foreign companies coming to Israel to find the ones that meet their needs."