Losing its sparkle

Last year Israeli venture capital funds raised a total of US$1.1bn, up by 21% from 2006. High-tech capital raising from local and foreign venture investors was the highest in six years, at nearly US$1.8bn, according to IVC Research Center. In 2007 462 Israeli high-tech companies raised US$1.76bn, nearly 9% above the previous year and 32% above 2006 figures.

IVC also reported that last year 27 Israeli high-tech companies raised US$701m through IPOs on US, European and Israeli exchanges, a figure relatively similar to previous years. There was also significant M&A activity, with 75 deals totalling US$3.2bn – the second highest number of M&A deals in any one year to date. Of this figure, US$1.9bn involved VC-backed Israeli companies.

For a country of not much more than 7 million people, these are impressive figures and show a venture capital market that has mainly thrived since a government programme kick-started venture in the country in the early 1990s. In the past 10 years Israeli VCs have attracted a total of €10.6bn and currently about US$2bn is available for investment, of which 60% is for first investments in high-tech companies and the rest reserved for follow-on investments.

But despite this activity, Israeli VC funds face challenges. One of the biggest currently is the 20% depreciation of the dollar against the shekel. Given that most funds are denominated in dollars, this currency slide means that portfolio companies are, effectively, getting 20% less cash than they expected. It also means that Israel is 20% more expensive for US investors as a place to develop innovative technology.

“The currency situation does have implications for Israel’s competitive advantage, as it used to be seen as midway between the US and India in terms of cost, but now it’s much closer to the US,” says Adi Pundak Mintz, managing partner at Gemini Israel Funds, one of the earliest funds.

Gemini was founded in 1993 and was among the funds that emerged out of the government’s Yozma (‘initiative’ in Hebrew) programme. The government subsidised the establishment of 10 VC funds, in partnership with foreign VC investors. An attractive part of the programme was that the investors had the right to buy out the government’s share at a pre-agreed price within five years.

It’s quite unusual for a government programme like this succeed in the long term, says Pundak Mintz, but he says the government was able to withdraw at the right time and leave the private sector to manage investments. It also helped that other elements were in place that favoured a venture capital culture, such as strong universities, a well-educated workforce and among the highest per capita number of doctors and engineers in the world.

Cultural difference

So why has Israel succeeded, while the European VC industry seems to be struggling? Many Israeli VC directors put the main reason for Israel’s success down to its entrepreneurial culture and some question whether Europe lacks this risk-taking attitude. “The whole country is a start-up; perhaps the youth of the country, compared with Europe’s long history, partly explains some of the entrepreneurial culture here,” says Mike Eisenberg, a partner at Benchmark Israel. He adds: “My sense is that there is less entrepreneurship in Europe, but that may be changing, with companies like Skype and some of the new Russian businesses emerging, such as the search engine Rambler.”

Dr Avi Ludomirski, founder of med tech fund SCP Vitalife, says: “Israel has a very strong academic environment and the last wave of migration from Russia was high quality, with a lot of scientists with good technical skills.” This academic and research culture is demonstrated by the fact that Israel has the highest number of medical technology patents per capita, says Ludomirski. “We look at about 250 companies a year and it seems that the entrepreneurial culture here keeps growing. There seem to be countless physicians and engineers coming up with ideas, as well as people without medical experience but who feel they have a product that could be commercialised.”

Part of this entrepreneurial mindset is that failure is not automatically seen as a bad thing, according to those in the venture capital industry, and this attitude encourages risk-taking. Jack Levy, general partner at Israel Cleantech Ventures, says: “This is a risk-taking culture and you won’t be written off if you’ve started a company that didn’t succeed. Because people aren’t afraid to fail they’re more willing to think outside the box.”

In addition to this risk-taking culture, the venture capital industry also benefits from the strong work ethic among Israelis, says Adi Pundak Mintz: “Israeli employees are very loyal and hardworking. There’s not much churn among staff in businesses here. An indication of the hard work culture is that many multinationals, such as Intel, have found that their Israel operations are the most productive in their global network.” He adds that because of the long waves of migration, Israeli workforces tend to have a global perspective, which can help businesses find new markets overseas.

The strong academic environment in the country reflects a high value placed on education. Pundak Mintz argues that there is a relatively high level of social mobility, which means that anyone who gets a good education and works hard is likely to succeed and that this widens the horizons of Israelis from all social classes.

The more troubled history of the country has also contributed to its innovation. For example, because of arms embargos and external threats, Israel has developed its own defence industry, which has fed into commercial technologies. SCP Vitalife, for instance, is backing MediGuide, whose technology provides “body navigation solutions” so that keyhole surgery can be performed. The product is based on military GPS technology.

Dalia Megiddo, managing partner at life science fund 7 Health Ventures, says: “In the medical device area Israel enjoys competitive advantage and is actually considered the second most important source of new technologies after the US. This advantage stems from the large technological basis of military technologies (both communication and software) and some interesting technologies that were brought in from the former Soviet Union by immigrants in the 1990s.”

She says that most European funds have a different investment angle, when it comes to life sciences, and focus on biotechnology and pharma rather than healthcare technologies and services. The former is an area of drug development that carries a much higher technology risk and requires larger investments, she says: “The different investment focus of European firms stems from the deal flow that exists in Europe: mostly new drug development. As a result, the risk/return profile will be different. The 2000 funds in Europe were very much involved in biotech and the returns were not high enough. Because of this many firms were not able to raise additional new funds.”

Megiddo points out that, while the life science opportunities in Israel are very interesting, most of the projects available are at an early stage. “Having said that, there are many more good projects than available VC funding.” She believes that this could be a good opportunity for non-Israeli VCs: “Unfortunately, we rarely see a European fund investing in Israel. This could be due to factors such as the challenges in investing in a far away country, differences in mentality and the natural interest of VCs in being close to their portfolio. I believe, however, that European venture funds should try to be involved in the fantastic deal flow in Israel, perhaps by forming alliances or investing with local firms.”

There certainly seems to be strong levels of activity, according to the IVC Research Center. Capital raising in the Q4 2007 was the highest in five years, although it included an especially large fundraising round of more than US$100m for Jerusalem-based vehicle safety company Mobileye Vision Technologies. The Israeli VC share of investment in Israeli high-tech companies was just under 40% in 2007, with the rest coming from overseas funds. The communications sector was the leading recipient of funding, with 21% of total capital raised, followed by life sciences at 20%. The semiconductor and Internet sectors received particularly high investment.

Funds raised last year included Pitango’s fifth fund, which closed at US$330m, Pontifax II, which raised US$85m and funds from 7 Health Ventures and Wanaka Capital Partners. Six Israeli VC funds announced first closures last year, including two new cleantech funds and two funds set up in partnership with foreign investors.

The IVC believes that both investments and exits in 2008 will depend, to a large extent, on the US economy. A possible crisis on the NASDAQ would mean fewer IPOs and lower acquisition values, which would impact on the Israeli high-tech industry.

“IPOs are not viable probably for the next 18 months or even longer, but M&A activity is strong with companies like IBM, Oracle, Microsoft and Intel often on the lookout for acquisitions,” says Gemini’s Pundak Mintz.

Shekel squeeze

As well as a volatile IPO market, VC funds are facing problems the current exchange rate with the dollar. The weak dollar means that the shekel has appreciated by over 20% against the greenback in the past year. Because Israeli VC funds are dollar-denominated it means that the channel of investment to portfolio companies is being cut back by 20% compared with the original budgets.

“The exchange rate changes mean that portfolio companies have to cut their spending or investors will eventually have to put in more than they thought they would have to,” says Hillel Milo, co-manager of cleantech fund AcquAgro. Mike Eisenberg of Benchmark Israel says the depreciation of the dollar makes Israel a more expensive place to develop new products: “It’s almost as expensive now to R&D here as in Silicon Valley. It also affects many Israeli companies in their sales, as they look to the US market, given the small domestic market.” Eisenberg says VC funds and their portfolio companies will have to innovate more in order to meet this challenge and focus more on selling in countries other than the US.

The implications of the dollar’s fall can be seen in the shift in Israel’s comparative cost advantage, says Eisenberg. Today, it costs about 30,000 to 35,000 shekels a month to get a good software engineer in Israel, he says. That now converts to around US$10,500 a month plus about 30% for social benefits. An equivalent engineer in Silicon Valley, says Eisenberg, would be slightly less. “Israel is no longer a place for price arbitrage on engineers, which means that Israeli high-tech companies need to raise their game and lead on innovation.”

Eisenberg says he would like to see an increase in the number of software engineers in Israel, with companies and the government investing in incentives and retraining to create a larger supply of engineers. “The larger the supply of engineers here, the less pricing pressure there will be on engineering salaries,” he adds.

In terms of links with VC funds from outside Israel, Gemini’s Pundak Mintz points out that a number of US VC funds have set up shop in the country and that this competition has helped Israeli funds sharpen up their act. “As in Europe, the market has consolidated. There were about 70 Israeli funds five years ago but about 20 today and I’d like to think those that have survived are all the better for it.”

But Pundak Mintz says he would like to see more involvement by European funds in Israel. “We’ve seen some, such as Index or Wellington, make investments here but they’ve tended to be one-offs. I believe there’s a lot of potential in working more closely together.” Such partnerships could perhaps, he believes, help Israel develop billion-dollar companies. “We’ve been able to develop US$200m companies but LPs are concerned about the lack of a billion-dollar exit. We need to think why this is.”

One of the probable reasons for the lack of larger exits, he says, is that Israelis have a short-term focus, due to having been almost constantly under threat. This short-term focus has meant Israelis are excellent at improvising and utilising limited resources, but not so good at planning for the long-term and scaling up venture businesses. “You see a lot of successful companies built up in two or three years because Israelis are good at developing the technology and in building relationships with customers and partners, but you don’t see a lot of long-term thinking relating to these businesses.”


Fire and ice

As with everywhere else in the world, the field of cleantechnology is proving a popular destination of VC money in Israel as well, with the country taking a lead in solar and water power.

An emerging area of venture capital in Israel is the cleantech sector. Some of the more established funds are now investing in cleantech, while there have also been funds set up specifically targeting this market. Apart from Israel’s tradition of technical innovation, the country’s climate means it has had to tackle particular challenges in areas such as water provision that are relevant to cleantech.

“In Israel there has been a lot of innovation over the years, through necessity, in cleantech, especially in areas such as water related technology and alternative energy,” says Jack Levy, general partner at Israel Cleantech Ventures. He points out that the country has exports totalling around US$1bn in water-related products and services. It is particularly strong in purification and treatment technologies, flow control devices and monitoring systems.

The country also has a strong history in solar power, he says, thanks to its climate and its need to overcome an import-dependent energy sector. The country has particular strengths in energy technology niches such as geothermal energy, fuel cells and power electronics. In the 1980s Israeli company Luz International built nine solar energy-generating stations in California, generating a total of 354 MW. The company’s follow-one business, Luz II, is now involved in plans to produce 900 MW of solar power in California.

Israel’s strength in cleantech, the demand for new capital from companies in this sector and the country’s entrepreneurial culture are all attractive, says Levy. The waves of immigration from the Soviet Union have also brought engineering talent in areas relating to energy technology, he adds.

One of the funds specialising in cleantech is AcquAgro, which had a US$40m first close in December and is aiming for US$100m by mid-2009. Funding has come so far from Israeli industrialists and overseas funds, with 90% of the investment from outside Israel. It will invest in water and agriculture, as well as other innovative clean technologies and will focus on mid to late-stage investments.

“There are huge challenges globally in providing water, energy and food, which means there are tremendous opportunities from innovative technologies that can provide solutions,” says Hillel Milo, who co-manages the fund.

He says that one of the main challenges in cleantech venture capital is that the business model is different to more established venture sectors like communications or IT. This is reflected in the fact that it generally takes a lot longer to go from the initial idea to a commercial product, with years of research, then laboratory testing, followed by the prototype stage and then non-commercial and commercial pilots.

“We’re looking for companies that have gone beyond the technical risk and, at a minimum, can demonstrate a proven technology in an industrial setting and that the industrial, engineering and price points have been verified,” says Milo. One of the key benefits he says he will be looking for in technologies is cost-reduction opportunities: “If you have a technology that, say, reduces the cost of a cubic metre of desalinated water then that has the potential to be a very attractive investment.”

AcquAgro has so far made two investments. The first was in Advanced Desalination Technologies, which has developed a technology that improves the efficiency of desalination. “It can reduce the costs of desalinating water by 25% to 33% and the main benefit is that it makes small-scale desalination projects feasible,” says Milo.

The other investment was in Computerized Electricity Systems (CES), which has technology aimed at replacing the household electricity box and thus enabling the electricity utility to reduce the supply on the grid at peak hours and reduce the risk of blackouts in neighbourhoods.

Milo says that the aim is to hold portfolio companies in the fund for between two and four-to-five years. “We’re aiming to build companies that can be floated on leading exchanges such as NASDAQ or London Stock Exchange. If there is an M&A exit available then that would be fine, but we feel we have a little more control over an IPO process, assuming the broader market is favourable.” He expects the fund to reach 12 to 13 investments in total, assuming US$100m is raised, with no single investment absorbing more than 10% of the entire fund.

Another fund targeting this sector is Israel Cleantech Ventures, which had an initial close of US$30m last August and is soon to announce a final close. Among the investments made so far is Pythagoras Solar, which develops photovoltaic technology. Israel Cleantech led a US$10m Series A financing round in February, with financing also from Evergreen Venture Partners and Pitango Venture Capital. The company has an R&D centre in Israel and a US office in California.

Other investments made by Israel Cleantech include AqWise, which develops innovative wastewater treatment technologies, CellEra, which aims to turn fuel-cell power into a mass-market commercial product, and Citrine Renewable Energy, which develops systems to covert biogas produced by landfills and other sources into high-value natural gas. The fund was also among the backers of Project Better Place, an initiative to convert transportation systems toward electricity and away from fossil fuel.