Israel’s cutting edge with VCs

Israel’s high tech industry is growing up, confidently promoting itself to investors as an alternative to Silicon Valley rather than as an appendix to the US market.

And investors are attracted. Last year, more than 400 Israeli high-tech companies raised $1.6bn in funding, the highest amount in five years. During the first quarter of 2007, another $406m was raised, up 13 per cent year-on-year, indicating this year could exceed 2006.

Today, Israel’s innovators are focused on what they do differently from US technology firms. They believe that the country’s Jewish immigrant culture and geographic location, along proven engineering prowess, give Israel an edge when doing business in Europe and Asia, providing investors with exposure that North American start-ups rarely provide.

For many years, Israeli entrepreneurs followed a set sequence that had them develop cutting-edge technology at home, market it in the US and then list the company on the Nasdaq before it outgrew their management skills. Many deftly repeated the process again and again.

Some 75 Israeli companies are now listed on the Nasdaq, and last November the exchange created an index tracking these stocks, its first for foreign companies.

The dotcom bust damped the Nasdaq track but a revival is underway.

Semiconductor maker Mellanox Technologies and networking vendor BigBand Networks both listed recently, and telecoms vendor Veraz Networks plans an offering this year. Another 10 to 15 Israeli tech companies are considered likely IPO candidates.

Having lived through a complete business cycle, Israeli tech entrepreneurs have emerged wiser if not stronger than before. One sign of this is their shift in focus to markets in Europe and Asia. No longer are they moving their headquarters to the US at the behest of their American investors.

”In many sectors, the centre of gravity has shifted from the US to Europe or Asia Pacific,” says Rami Kalish, managing general partner at Pitango, Israel’s largest venture capital firm. Wireless telephony technology in Europe and consumer electronics in Asia are two such cases.

Telecoms software company cVidya built its business in Europe and is closing deals in Asia and Latin America, with the US market only now becoming attractive.

”VCs get their money in the US so they expect the company to sell in the US. But if we had started there, we would not exist today,” says Alon Aginsky, cVidya’s founding chief executive.

Zeev Holtzman, chairman of Giza Venture Capital, adds: ”The appetite of US funds and the capital they have can pressure early stage companies towards plays that are not Israeli strengths. We need to be disciplined not to follow the US push. We respect and suspect them.”

”Most successful Israeli companies are based here or have Israeli management,” says Yehuda Zisapel, a serial entrepreneur and co-founder of the RAD group.

Erez Shachar, managing partner of Evergreen Venture Partners, an Israeli VC, believes this geographical shift in market focus could break the Israeli venture sector’s close correlation with US venture trends. ”This will give us a real competitive advantage, it would be a big boom for Israeli venture.”

Meanwhile, over 90 per cent of venture money comes from investors outside of Israel, mostly from the US. Only about 40 per cent of this money is managed by local VC funds, with the rest being channelled in directly by funds run in the US and Europe.

”The Israeli VC fund investment level [in the first quarter of 2007] is almost the same as in previous quarters, but the relative Israel VC share is less. This indicates a shortage of capital and a very cautious pace of investments by the Israeli VC funds. Other investors – mostly foreign VC funds – have increased their investments.

Interestingly, many of these investments were made without the involvement of the Israeli VCs, effectively increasing competition for good deals,” notes Mr Holtzman.

But Mr Shachar sees local and foreign funds meeting different needs.

”We do the early deals with the entrepreneurs, then the US funds come in at a later stage. This is the typical Israeli model of funding. We get in as early as we can – even from just having two founders and a business plan.”

Foreign investor interest is largely driven by the promise of steady deal flow. ”They are looking for an innovative technology play as well as an early stage play,” says Mr Holtzman.

But they also need to increase international exposure. A recent survey by Deloitte, the accounting firm, shows that over half of VCs worldwide are seeking to expand their investments internationally.

”Big investors in the US realise they have to go outside. They have to have some exciting assets in their portfolio,” says Pitango’s Mr Kalish.

Israel can be an accommodating way to gain this international exposure, particularly when measured against other emerging markets like India or China. ”In Israel, it is easy to do business, it is transparent and smooth,” says Mr Kalish.

Zohar Zisapel, chairman of RAD Data Communications and founder of nearly 30 companies, says Israeli start-ups are measured by US benchmarks: ”The [VC] term sheets are the same here as in Silicon Valley.”

Many US venture capital firms themselves are moving into Israel. ”Over the last five years, Israel has really caught the eye of US VCs. They’ve been setting up offices here or at least sending scouts,” says Erez Ofer, who left EMC, the data storage company, to help run the Tel Aviv office of Greylock Partners, opened last year to manage a dedicated $150m Israel fund.

But VCs are not the only ones pumping money into Israeli high tech. Most start-ups are bought by global technology companies rather than floated.

”Israel is where people go shopping for technology,” explains Edouard Cukierman, head of Cukierman & Co, a full service investment bank.

Indeed, 57 Israeli technology companies were sold last year to overseas buyers for a total of $9bn, nearly four times the dollar value in 2005 and nearly six times that of 2004.

The largest deals were HP’s acquisition of software developer Mercury Interactive for $4.5bn and the sale of flash memory maker M-Systems to SanDisk for $1.6bn. Microsoft bought Gteko and Whale Communications for a combined $196m.

”International companies come to acquire Israeli technology because of the time-to-market advantage and the cost advantage. The time to success is shorter here,” explains Kfir Luzzatto, a patent attorney and investor in early stage technology.

And like certain investors, they also come looking for market access. Last year, for instance, chipmaker PMC-Sierra paid $300m for Passave, which sells its broadband chipsets almost entirely in Japan.

But Tali Aben, a partner at Gemini Israel Funds, says buyers value the people as well as the technology. ”Acquirers want to build the company, to expand the Israeli engineering group after acquisition.”

Government makes the most of foreign venture capital partnerships

Rafael, the Israeli government's arms manufacturer, is trying to make better commercial use of its intellectual property, writes Ian Limbach in Tel Aviv.

In 1993, it created RDC to transfer relevant technology to the civilian realm. Since then, it has established some 15 companies in microelectronics, medical devices and satellite communications, many of which have been taken public.

Avi Ginzburg, head of R&D at Rafael, says: "It is a very unique way to do that," noting that the US government's similar attempts have largely failed.

The government played a more direct role in the high tech industry through the Yozma initiative in 1993, aimed at creating an Israeli venture capital industry from scratch via a publicly funded $100m fund of funds.

Ten $20m-$25m funds were established with leading foreign VCs, with the government's share limited to 40 per cent. After five years, the private partners bought out the government's stake. Many Israeli VC funds started this way.