Taking stock / Seven myths about high-tech and venture capital
There are some grains of truth, but not many, in the axioms that the public believes about the high-tech sector.
It's all but axiomatic, at least among the public that reads the papers. One: high-tech is the main growth driver of Israel's economy. Two: High-tech is in trouble because of the global economic crisis, the scarcity of funding and the reluctance among Israel's institutional investors to invest in it. The high-tech industry is drying up. Soon startups will starve for cash. Big companies don't grow here anyway. In the years to come, the only branch in which Israel has excelled in the last decade will wither away.
There are some grains of truth in that litany of drivel, but not many. Most of that is based on myths that are light-years away from the economic reality. Here are seven of these myths, and the reality.
1. Venture returns have shrunk because once companies could be sold for hundreds of millions of dollars. Today at best they sell for tens of millions. Israelis can't build serious companies.
It's a good story that complies with the thesis that Israel is incapable of growing big companies a la Finland's Nokia. But the facts don't support it. Investors in Israeli startups and venture capital during the 1990s did reap extraordinary returns, certainly compared with their yields in recent years.
But the reason isn't the prices that good Israeli companies commanded, it's the amounts invested in them before their sale. In the 1990s, investment before an "exit" (sale of a company ) averaged about $10 million. In recent years the average investment in startups is more like $40 million before the exit.
The average value at which startups sell remains about $120 million - in other words, the returns are roughly 12 times investment in 1990s terms, and three times investment in the terms of this past decade.
Ergo, the reason for the huge difference in returns is the initial investment, not the selling price. Which leads us to the next myth.
2. The drop in the returns investors reap on investing in startups and venture capital is because salaries rose to the skies. So has the cost of doing business.
If the investment in a startup before exit has increased fourfold in 10 years, we may assume that the cost of building a big company has, too. But even if we assume that the average salary in high-tech doubled in 15 years, that couldn't explain fourfold investment.
A more prosaic explanation is that the average investment in startups grew because venture capital funds became bigger. The number of partners in the funds did not increase commensurately, so each had bigger sums available for investment than in the past.
The result was that when they found a company they liked, they could pour more money into it. At some venture capital funds, glutting favorite startups with cash became practically an ideology; they figured it would shorten processes, or so they told the entrepreneurs and investors.
In practice, too much money was lavished on too few companies, which led to bloated startups and shrunken returns on investment.
3. Israeli startups can't break the glass ceiling because their management is provincial. They need to learn international management or hire an American CEO. Israelis don't know how to build big companies. They cut too many corners.
Israelis have many weaknesses, but they have advantages, too. Usually attempts to hire an American CEO have ended in tears. More than 80% of Israel's startups that made it to a major exit (meaning, they were bought for a lot of money - more than $50 million ) were led by their Israeli founder until their sale.
It's true that Israelis take shortcuts, but the main way American companies reach critical mass isn't through organic growth. It's through acquisitions. What Israeli business culture lacks is M&A. Most American companies reach an exit after they've acquired at least one other company, while here, maybe because of the Israeli ego (or tax issues ), that doesn't happen, though it is crucial for creating value and critical mass.
4. The venture capital funds don't have enough money. They stopped investing in startups because of the global economic crisis.
Israel's venture capital industry badly wants taxpayer subsidies. So it whipped up a frenzy with wails to "rescue the Israeli high-tech industry". Let's put things into perspective. First of all, the amount of money invested in Israeli startups during the last two years has been declining sharply.
But the number of transactions has dropped only moderately. It isn't much different from the 10-year average: about 450 investment transactions a year.
In other words, the venture capital industry has become more efficient. Less money is being put into the same number of deals. If anything, it could mean that returns will increase in the future (see Myth No. 2 ).
Also, the number of new high-tech companies established in 2009 isn't any lower than the long-term average, ergo, the entrepreneurial spirit was not crushed by the global economic crisis.
Second, Israel's venture capital funds still have a billion dollars sitting around waiting to be invested.
The main problem of Israel's venture capital industry today is financing advanced companies, especially medical technology and clean-tech companies. Good entrepreneurs with good ideas can find the money.
Not only Israeli venture capital funds operate here. In the last seven years, foreign funds have provided 55% to 70% of venture investment in Israeli startups. Despite the post-crisis sentiment of stress, the American venture capital industry still has $150 billion seeking investments.
5. Israeli institutional investors don't invest enough in Israeli high-tech.
It's true that the institutional investors place no more than 2% to 3% of their portfolios in venture capital funds and private equity funds. But that's how it should be, if you want to diversify. Anyway, as we showed above, pouring more money into the industry simply means bloating the companies and generating losses for savers.
Yes, Israel's institutionals should step up their investment in venture capital and alternative investments, but not in Israel. They should target overseas opportunities. They should stop slipping money to buddies and use international gatekeepers to bring them investment opportunities with the best managers in the world, most of whom are not in Israel. Also, institutional investors should invest more in top-notch international funds, with the long term in mind.
Israel's institutionals could increase their investment in local private equity and venture capital, but only after thoroughly inspecting past performance, management quality, and assuring proper disclosure of management fees. They need to study the funds' financial statements. Let them take CalPERS as a model for emulation - that giant pension fund for California state workers puts a lot of money into venture capital, but it enforces disclosure rules.
6. Big companies can't grow in Israel.
It's true. Very few big companies have developed here in the last 20 years, and among the five big ones that did grow in the last decade, two collapsed: Comverse and Gilat Satellite Networks.
But that isn't an Israeli issue. According to market research, out of 24,000 American companies that received money from venture capital funds during the last 10 years, only 3% reached a public offering or sale at a value of at least $100 million. So the great United States also has difficulty growing big companies.
Over here, during the last 20 years, a number of multinationals have set up shop in Israel, including HP, Intel and IBM. They employ thousands in the Holy Land.
Breeding giants like Nokia has its advantages. But it also has disadvantages, as Finland has been learning in the last two years as the iPhone bit into Nokia's business, leading to layoffs and other ills.
7. High-tech is Israel's economic growth driver.
Well, the high-tech industry is certainly the best thing to have happened to Israel's economy in the last 20 years. It's a terrific producer, which leads to jobs. It has improved living standards and led to the adoption of international business culture. In a country ruled by giant cartels and monopolies, high-tech has contributed greatly to making the economy competitive.
But Israel's economy can have growth drivers just as powerful as the high-tech locomotive. Right now these engines lie on the side of the roads, rusting. They aren't sexy, and cultivating them involves a lot of hard work. It's hard - politically and technically.
The main one is increasing the productivity of the public sector and local market.
How many articles have you read in the last year about high-tech and venture capital?
How many about measurement, productivity, efficiency, output, quality of service, computerization of transportation systems, the ports, the banks, education or services? Nobody writes about these things - they can't because there's no data for basing a serious public debate.
It's so much easier and tempting to focus on boosting high-tech and keeping it strong.
But the real way to improve Israeli living standards, not only inside the high-tech bubble, is by tackling the gigantic sectors that employ hundreds of thousands of people at very low productivity rates.
A last note: If the drought in venture capital financing persists for another two or three years, it's true that funding for high-tech will run short. But if anything, that will be a great time to invest. Returns will rise and the funds will be able to raise money again.