The drying font of Israeli high-tech
There's less money for fewer firms and the appetite for sexy but risky ventures has evaporated. Angels abound but cold-eyed capitalists with bigger money are in a funk.
For Israel's high-tech industry to stay healthy, it needs to have a full value chain, from embryonic start-ups to maturing companies to multinational giants with local research and development centers. As part of the natural life cycle, start-ups that reach maturity are sold and their founders go on to build new companies.
A broken link in this chain endangers the future of Israeli high-tech, and it seems at least one already exists. A problem has developed at the critical first financing stage as investors shy from risk in the frightening economic environment.
In 2011, the number of start-ups established in Israel was the smallest in a decade, dropping 40% to 360 new companies from 2010, according to IVC, which analyzes and monitors the local high-tech industry.
At the same time, the amount of capital directed to fledgling start-ups has decreased. From January to June this year, venture capital investments in Israeli start-ups were 11 percent lower than in the first half of 2011, dropping to $936 million.
The fuel of the high-tech industry is a critical mass of companies and financing. Without it, the high-tech engine will stutter. Huge exits will become a thing of the past.
Of course, the immediate beneficiaries of selling a company are its founders and investors. But the Israeli economy also benefits through the creation of high-paying jobs in a field in which Israelis have a competitive edge.
Israel made a name for itself as the "start-up nation." But if healthy trends fail – if enough new companies aren't launched each year - the pool of innovation will dry up, and a key source of exports will diminish.
Angels with clipped wings
The life cycle of a high-tech startup begins with investment by "angels," who typically place small sums to get the idea on its feet in exchange for a decent equity stake.
Next often come investments from venture capital funds. They, too, invest money in exchange for an equity stake. Some target early-stage start-ups. In all cases their entire strategy is the exit – the start-up's sale to a bigger firm, at which time they sell, hopefully for profit. Alternatively, the maturing start-up could be floated on the stock market, at which time early investors can exit too – selling their shares on the market.
Israel has problems in two parts of this cycle: in early–stage funding from venture capital funds and at the flotation stage, says Lior Aviram, head of the high-tech and venture capital practice at Shibolet, a law firm providing legal counsel to start-ups.
Israel isn't unique. Venture funding is short worldwide, including because the big money in pension funds and the like have slashed back investment in young start-ups, which are high-risk and have been generating mean returns over the past decade.
For example, CalPERS, the pension fund for the State of California's employees and once a major investor in Israeli funds, scaled back its investments in venture capital funds around the world to $340 million per year, compared with $2.1 billion this year.
According to Aviram, though, what has most affected local start-ups is that Israeli venture capital funds have scaled back investments and drifted to safer, later-stage investments.
Also, foreign venture capital funds prefer companies in which Israeli funds already invested.
"It's hard for an Israeli start-up with no backing history to compete for investments from a California fund because it has no performance history to present at that stage," explains Aviram.
Investments in Israel have changed in recent years. For example, angels – often former entrepreneurs who sold their companies and went on to become private investors – have become a dominant force, but their contributions mainly affect early-stage investments. The difficulties in raising venture capital generally crop up later, when the start-ups require more money. Angels often aren't in a position to provide hefty later-stage investments, Aviram says.
This “Death Valley” of investments had been the bane of biotech, but the situation has stretched to other fields, including security, computer chips and communications.
Frightening signs of shrinkage
The uneven distribution of investments over company life cycles is starkly demonstrated in a recent survey by Shibolet. In the first half of 2012, only 29% of venture capital investments in Israel involved early-stage start-ups, which is up from the previous three years, but a 12% drop from 41% in 2007, and also down from about 35% in the second half of 2008.
The survey, conducted by Aviram and attorney Limor Peled in collaboration with the Fenwick & West law firm of Silicon Valley, examined about half of the venture capital transactions in Israel.
When the industry is stable, first-round investments should exceed subsequent funding rounds, argues Aviram. "But subsequent investment should only go to the best companies. Since the second half of 2008, the first round of investment hasn't been the largest, or in other words, the industry is shrinking and that is a serious problem. We have to find a way to increase the number of first-round investments if we want to restore the industry to its previous size."
Actually, the number of early-stage investments in the first half of 2012 did increase from last year. But Aviram's concern isn't assuaged.
A similar survey conducted in Silicon Valley found that the greatest proportion of venture investment is indeed made during the first round. “In Silicon Valley, there was a temporary situation in which a smaller proportion of investments went to first-round funding, because of the economic downturn. But in Israel, this has been the case since 2008,” he says.
Another temporary effect of the dearth of investments is that local companies are appraised as worth less than peers in Silicon Valley. “Appraisals for companies we represent can be 30 to 40 percent lower than similar American firms. But while American firms raise more capital, they also spend more,” says Aviram.
Part of Shibolet's service involves connecting between American investment funds and Israeli start-ups. “We show American funds that in Israel, they will be getting companies that have just as much innovation, experience and talent at lower values and for smaller investments. They can do more with the same amount of money,” Aviram says.
'We've emerged from a slump'
Despite the difficulty in obtaining early-stage investments, the Israeli companies that manage to do so are in a good spot. According to Shibolet’s survey, more of 80% of the companies that raised funds in the first half of 2012 did so at a higher company value than was ascribed to them in previous financing rounds. In recent years, as the world economy growled, a reliable increase in value over time couldn't be assumed.
However, over the long term, dwindling investment in new ventures will empty the pool of start-ups, which also means fewer splashy exits.
That, in turn, will mean fewer repeat investments and fewer jobs.
“A significant number of Israeli companies have matured,” Aviram says."They are showing good sales and even profitability, becoming attractive prospects for mergers and acquisitions by large multi-national firms or for foreign private equity funds. Over the long term, these companies will be acquired, and they will leave Israel," he says.
Aviram goes back to describe the healthy life cycle of the high-tech industry: "Companies were sold, the entrepreneurs started new companies that grew, and this created a healthy industry. If this chain breaks, we could see a situation in which companies that have matured are sold without new ones emerging – and that will be a disaster.”
It's already starting to happen. The year 2012 began with a series of impressive exits, sustaining momentum from 2011. But the deal flow has been dry for months. The companies that did score an exit represent only a tiny proportion of the firms with revenues of more than $20 million – which reflects the maturity of Israel’s high-tech industry.
According to analysts Oren Raviv and Dan Yachin from market research firm IDC, there is a mid-stage problem: fewer new companies are being created in proportion to those being sold.
For his part, Aviram says that the solutions the state proposes, such as the Competitive Advantage program to boost the high-tech industry, are insufficient. “We’re very late in dealing with this problem, and time is not on our side," he says. "Solutions suggested by the Ministry of Industry and Trade, such as state guarantees covering 25% of any eligible investment by institutional investors in venture capital funds, aren't attractive enough and won't work.”
Nor does it look like salvation will come from micro venture capital funds, which have some tens of millions of dollars under management. Some even call for government intervention.
Could the solution come from unexpected directions? “In Russia, there is a lot of wealth looking for investment opportunities," Yachin says. Potential investors from Singapore have also been scoping out the Israeli scene, and Chinese funds and firms dealing with computer chips and communications are trolling for opportunities.
That said, Yachin points out, no Russian venture capital fund has earmarked money for the Israeli market. There have been a few isolated investments, no more.