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The Israeli venture story, a GP's perspective

High-tech venture capital activity in Israel, a country with a population of just six and a half million, is equal to half of that in the whole of Europe. Ed Mlavsky, chairman and founder of Gemini Israel Funds, explores the root of the Israeli entrepreneurial spirit and looks ahead to what the future may hold for the nation's venture industry.

People sometimes ask me whether the Israeli venture capital market really is different from other venture capital markets. Of course it is. If you are a fish swimming around with your friends in the ocean, you can bet the one thing you won't be talking about is where to find water. If you are an entrepreneur in Silicon Valley, you would be very stupid to wonder where your customers are - there are waves of them in front of your nose. You just have to come up with a product they need. Even the most insular Europeans can access plenty of customers in their own continent. But in Israel, we are fish out of water. We have the technologies and the products, but in order to become part of the food chain, we have to take them worldwide.

The early commercialisation of Israeli technology started in the late 1970s and gained serious momentum in the 1980s through the Israel-US Binational Industrial Research & Development (BIRD) Foundation, set up by Jimmy Carter, with which I was fortunate enough to be involved as Executive Director. That was when I first moved from the US to Israel, having grown up and been educated in the UK. The US and Israeli governments invested 50/50 in product development projects carried out by, in each case, a partnership between a US and an Israeli high tech company. During my 13 year stint with BIRD, we invested $100m in 300 such projects, leading to sales of some $3bn. But BIRD-type 'soft' loans are no long-term substitute for equity capital. By the early 1990s, the first venture capital funds were being raised, with encouragement from the Israeli government. Today, our venture capital funds are independent of any governmental support and attract sophisticated institutional investors and academic institutions the world over.

Because we have learned that technology can be commercialised, because of the fast tracking of bright young people through the Israeli army into technological development and management, and because of the myriad technical skills that have come with immigrants to Israel from the former Soviet Union, we have an exceptionally well-developed technology base. We just don't have the customers.

That is one difference. The other is that we have a much higher proportion of serial entrepreneurs than any other market. When an Israeli technology company has grown to a certain size, like its counterparts elsewhere it floats, usually on the NASDAQ (which lists more companies from Israel than from any other country outside North America), or is acquired by a bigger company in the US, Asia, or Europe. But the value of the Israeli company lies in its continuing to develop new technologies and components for Big Corporation's products. And Israeli technologists don't transfer that easily, so we end up with at the least the R&D entity still in Israel, as the core part of a subsidiary of a larger international business, as attested by companies such as HP-Indigo, Intel-DSPG, Veritas-Precise and CA-Memco.

The dynamic in our market occurs because the founders tend to move on after a period and start all over again with another new technology, rather than become managers of someone else's business - not so much from the desire to make money as from the sheer challenge of doing it.

In the US, it is estimated that of 12,000 entrepreneurs, only some 5 per cent are building a company second time around. In Israel, nearly 30 per cent of entrepreneurs are on their second or third start-ups. Few of them will have run even $500m businesses, but their expertise, honed over two decades, lies in starting and building businesses out of cutting edge technology. It's a feature of a small, intensely fecund and successful market.

Although at the height of the boom one could number 150 entities in Israel purporting to be in the venture business, today's figure is back to less than 20 local firms doing real venture capital, plus a few international or US firms like Apax, Benchmark and Sequoia who operate funds in Israel. It's a small ecosystem but an efficient one. There are also a number of firms doing expansion and later stage investment - and some, like Pitango, that do the whole range - but, while necessary, later stage is not the essence of our market.

As the Israeli venture capital market has matured, we have seen a degree of specialisation. Many local firms now concentrate on one or two technologies, reflecting the expertise of their teams, and focusing on quite specific stages of development. Carmel, Gemini and Evergreen, for example, each invest in certain technologies at the seed and early stage. So any investor looking at this market, as many are at the moment, would be wise to invest in two, maybe three funds covering different parts of the spectrum.

Having established that there are differences in our venture market, the next question I am asked is how we cope amid the political instability of our region. To most of us, it's not an issue. Investment in Israel has continued to grow over the years - in 2002 it was over $2.5bn up from $537m 1992. Most of this is technology-related. Leading multinationals such as Intel, Microsoft, Cisco and Motorola, maintain core development centres in Israel. Good returns are being made on investment and new businesses are being founded and built as they have been since the 1980s - over 1,000 in 2003. Just as they are in all parts of the world where commercial stability, fiscal incentive and light regulation exist. Crucially too, our customers are elsewhere so their purchasing decisions are only affected by the quality of our R&D, and the products derived from it, not by the politics of the Middle East. In practise, there has been no perceptible interference in any high tech activities in Israel, despite the notion that normal day-to-day life is somehow impeded.

But, as our industry comes of age, we should perhaps bear two things in mind. First, in our very particular market, we must not lose sight of the skills needed in our venture capitalists. To build successful businesses from seed or start up, you have to get in at the very start and really help mould the DNA of the nascent enterprise. We have to instil in the very genes of a start-up company an export or die approach to every piece of research and every piece of development. No venture capitalist in Israel failing to do this will make money for investors. For those firms investing solely or mostly in later rounds and stages, problems do arise in businesses that have grown up with, so to speak, faulty gene structure. It is extremely difficult to change the fundamental characteristics of a company's approach once embedded. Culture becomes rooted in the first two years.

With no internal or contiguous market big enough to justify the development of any one high tech product, Israeli start-ups have from day one to take into account the different specifications of the different external markets, have to establish a presence in those markets, to develop products in parallel with foreign buyers and will need funding and networks to find and establish early adopters and then sales abroad - much more so than in the case of a European start up. Someone needs to know how to do all that. So you either need a venture capitalist who has started a business for himself or herself - all of the top tier Israeli venture capitalists have some or all of their team in this category - or to bring in a manager who has been there before: a repeat entrepreneur. Many start-ups here do both. And the result is that Israel's high technology exports have tripled in the last ten years to $13.6 billion in 2002.

The other issue I would caution on is the business model of the fund manager. In Israel, as a country and as high tech incubators, we have thrived best working together for shared goals, not against each other. The business model I abhor is what I think of as the 'silos' of private equity - large groups in which each executive's motivation is driven by the profits they will derive from their own deals and in which innovation and dynamism are stifled by internal rivalries, with executives competing against each other. This is the very opposite of what the best firms in venture capital - not just in Israel but in Silicon Valley, East Coast and Europe - achieve. In our space of the market, the best returns are achievEd where the fund management team grows primarily from within, is smaller rather than larger, is imaginative, works together and where everyone's compensation depends on the whole portfolio, and therefore everyone's input to every company in that portfolio is an integral part of the operation. It is my hope that venture capital in Israel will long retain this model.

Since Israel is such a small country, most of the parameters used to describe the market are, for purposes of comparison, typically represented on a normalised basis - usually "per capita". But when one wishes to put the scope and impact of Israeli venture capital in context, absolute numbers reveal the facts. High tech venture capital activity in tiny Israel is equal to half that of the whole of Europe. For listings on NASDAQ, Israel leads all countries outside of North America. As a 2003 Morgan Stanley report on our market noted: "If Israel were a US State, it would rank second or third in terms of total venture capital investment". Doubters should come and see for themselves.

Copyright © 2004 Ed Mlavsky, Chairman and Founder, Gemini Israel Funds