BloGiza

The Government Rides to the Rescue (?)

The last couple of years have not been particularly kind to the local high-tech industry. Although Israel was spared the worst effects of the global crisis, the local economy and especially the local tech-based economy has had to deal with knock-on effects of the general meltdown.

Specifically, we have seen a dramatic reduction in capital available for both VC funds and startups. Since the beginning of 2009, only one VC in the local market has managed to raise a new fund, and this was Sequoia Israel who could leverage Sequoia’s international positioning.  Many of the local VCs who had managed to raise new capital prior to the crisis are working with smaller-than-planned funds.

Unsurprisingly, this has affected that amount of new money flowing into startups here, which is at one of its lowest points in a decade.

Over the past few weeks, the Government has unveiled a number of new initiatives which Prime Minister Netanyahu and Finance Minister Yuval Steinitz hope will help save Israel’s high-tech economy. Steinitz, working with his Director-General, Avi Shani, and a Knesset subcommittee dedicated to the issue have come up with a number of ideas designed to address the problems of Israel’s high-tech sector at all levels.

The measures that have been announced are: 

1. Encouraging local institutionals to invest in VC funds instead by providing a financial safety net
2. Provide tax benefits and breaks for investors in seed-stage companies (the so-called “Angel Law”)
3. Attempt to establish Israel as a leading center for the development of technology geared towards the global financial sector, in the same way that Israeli high-tech companies became leading players in the Communications space over the last 15 years
4. As part of this repositioning, encouraging multinational financial institutions to establish R&D centers for financial technology within the framework of the CSO
5. Encourage Israeli companies to grow instead of selling themselves out early. The idea is to provide tax incentives for medium- and large-size local tech companies to acquire smaller tech companies and in this way to establish themselves as large growing concerns.
6. Create additional exit opportunities by encouraging companies to go public on the Tel Aviv Stock Exchange
7. Focus government R&D spending towards specific areas of interest
8. Improve the quality of science and technology teaching at the high-school levels by creating programs to train teachers in these subjects, re-training ex-high tech employees as teachers, and encouraging current high-tech employees to teach on a part-time basis in the schools
9. Encourage additional sectors of society (e.g. the ultra-orthodox and Israeli Arabs) to participate in the high-tech economy by subsidizing part of their salaries in high-tech companies
10. Encourage academics who have left Israel to return by providing tax breaks from future earnings based on technology that they develop

It’s an ambitious plan and one that addresses a lot – if not all – of the main problems facing Israel’s high tech sector. Whether or not it will work is another question.

My gut feeling is that the plan will be only partially successful at best. Without going into a point-by-point critique, some thoughts:
 
Regarding incentives for local institutional investors to invest in Israeli VC, this is one of these “yes, but…” things. On the one hand, Israeli institutionals are indeed an untapped source of LP potential. This is increasingly important, since institutionals in the US and Europe are both more hesitant to invest money in the asset class and more inclined to put their money in funds targeting other emerging markets such as India and China.

However, the local pension and insurance funds are not currently geared for significant investments in VC and it would take significant incentivization on the part of the Government to get them there. Even then, the amount of money that they could theoretically put into the asset class is limited. This by itself won’t solve the funding crisis for local VCs looking to raise new funds.

Regarding the re-focusing of Israel’s R&D efforts towards financial technology, again “yes, but…”. Other emerging countries, for example Taiwan, have had success in steering their high-tech industries towards government-defined areas of interest such as semiconductors and biotech. I have two issues here, one philosophical and one practical.

On the philosophical side, one of Israel’s great strengths as a high-tech superpower has been in the creativity of our entrepreneurs and technologists. If a large portion of government and specifically OCS funding is directed towards financial technology, might that not stifle a lot of this creativity that might lead to other large opportunities?

On the practical side, encouraging the establishment of R&D centers, as well as the other components of the plan based on providing tax breaks and benefits are all great in theory. However, they all have a good chance of falling apart in the execution phase especially if the tax authorities are not re-tooled to handle these changes.

After all, the government already provides tax incentives for high-tech today but it makes companies and investors go through 12 levels of bureaucratic hell in order to enjoy them. If this continues to be the case, will multinational financial institutions feel that it is worth the hassle of setting up R&D centers here?
 
The relative lack of large-scale local tech companies has been a key concern for the better part of a decade. We have talked endlessly about whether Israel needs or can establish more “Israeli Nokias” to stand alongside Amdocs and Teva, and the complexities involved. I’m not sure the current plan offers strong enough incentives to do so.

The idea that you can encourage medium size Israeli tech companies to grow into large size tech companies, and large companies into global leaders all by helping them acquire smaller companies is at the very least out-of-the-box thinking. However, it still doesn’t address the main reasons that lead medium-large companies to and M&A exit before they can become large.

Companies usually sell out because they have funding concerns. Either they start to run into cash-flow problems or else are need a relatively large amount of financing in order to ramp up into major-size IPO-able international leaders.

The current government plan as formulated does not provide real solutions to this issue. Encouraging more IPOs on the TASE is nice. However, the TASE is a relatively small exchange with some liquidity issues. The plan might help companies that would ordinarily be sold for the low tens of millions IPO for mid-ten to millions. But in order to IPO in a manner that can establish a large sustainable company, you need to go public on NASDAQ.

Which brings us right back to the funding issue. As Giza’s Managing Partner Ori Kirshner noted in this piece on The Marker TV, one of the real problems facing Israeli VCs and startups is the lack of available late-stage funding. Israeli funds are relatively small in global terms, and those funds who have the capital to invest will look just as actively at investments in India and China.

The issues of reversing the brain drain and improving the quality of technical education in the schools are both good ones, but they will struggle if not handled in the broader context of problems facing Israel’s education system as a whole. (Which is a whole other blog post, if not a series of blog posts). Short version: in order to provide a more educated and effective high-tech workforce, it’s not enough to concentrate on high-school science training. Israeli students need much better training in math, science, and English from the elementary school level onwards.

I’m not saying the government plan is a wash. It addresses a number of key social concerns (especially the low participation of large sections of the work force) in a logical manner. And, if the plan doesn’t get mired in a bureaucratic morass, stands to introduce a bit more flexibility into the local high-tech market and perhaps even end up as a net gain for the Israeli economy.

But without a significant increase in the amount of capital flowing in from overseas – both from LPs and global venture funds – the local high tech industry will continue to face serious challenges, despite the best intentions of the government.

Duck and Cover

The other day, I was talking to a friend of mine in New York who works in the financial services industry. I asked him how things were going there. His (sarcastic) answer, “Everything’s great! The dollar is strong, oil is cheap, Wall Street is looking sound, we’ve got a morally upstanding governor, and I just bought a large position in Bear Stearns. What could be better?”

Indeed, these are scary-type times for those of us in the finance world. This last month has been turbulent. The US economy is teetering at the moment, as the subprime mess starts seeping into many areas of the financial world not directly related to mortgages. At the same time, the dollar is weaker than it has been since the mid-$80s.

This last fact is especially striking when you compare the dollar to the state of the shekel. Sometime over the last couple of years, the humble shekel has transformed itself into an international monetary powerhouse. Since the beginning of the year, the dollar has lost more than 10% of its value relative to the shekel.

So, what does this mean for those of us who ply our wares in the local venture capital trade? Mostly bad news, but there may be a thin silver lining hiding in there somewhere.

The bad stuff: With the financial markets currently in a state of chaos and the US economy slipping (if not already slipped) into a recession. From our perspective, this has three main ramifications:

1. It will be very hard to exit portfolio companies in the States this year. A lot of big players will likely hold off on M&A activity while everything settles. At the same time Wall Street will also take a while to get over its jitters, meaning a rougher environment for IPOs.
   
2. Portfolio companies, especially those in the IT/Software space who sell to financial institutions are liable to miss their revenue forecasts as these institutions implement cost-cutting measures.
   Funds who have recently started fundraising may encounter problems with LPs getting cold feet.
   
3. The dollar-shekel situation presents a host of different problems for portfolio companies in Israel. This from the simple fact that they raise money in dollars but a lot of their expenses are in shekels. Which makes these currency fluctuations a big deal. Just to give an example, one of the portfolio companies I am involved with “lost” nearly NIS 750,000 shekels from the time the investment process started based on the amount they raised and the difference in the exchange rates over the last few months.

All this means that we need to help portfolio companies operate as lean as possible for the foreseeable future.

So, is there a ray of hope anywhere in here? Presumably, the new situation presents an opportunity for companies who can provide real cost savings to customers and present a compelling ROI in a relatively short time frame. As in all times of crisis, these companies can prosper.

From the VC front, all we can do is content ourselves with a bit of schadenfreude. For the past few years, as the markets soared, we VC types watched in envy as private equity and buyout funds posted huge returns. Now, as things swing the other way, we can smile to ourselves.

The online year that was

As today is the last day of 2007, it’s a little hard to resist looking back at the past year and trying to sum it up. So, I won’t resist. Unlike last year, 2007 is hard to summarize with one handy tag such as “the year of online video” or “the year of social networks”. There was a lot of activity in a number of different areas, the rise of a major player in the social networking space, and the rise of a new form of communication.

So, herewith a few highlights IMHO of the online industry in 2007

Story of the year: The consolidation of the advertising industry
Y’all thought I was going to say Facebook, right? Now, while the rise of Facebook is certainly the most hyped story of the year, my vote for the most significant development  (not to mention the biggest source of M&A activity) is the rapid consolidation of the online advertising space.

During the last 12 months, Google bought out Doubleclick for $3B. Shortly thereafter, Microsoft acquired aQuantive for a staggering $6B. AOL bought out targeted ad firm Tacoda, as well as Quigo which. Yahoo acquired Blue Lithium, as well as a majority stake in Right Media. WPP bought 24/7 Real Media. And the list actually goes on.

The M&A hyperactivity in this sector is an indication of the fact that online advertising has reached a certain stage of maturity. Beyond that, the consolidation is likely to have long-term ramifications, especially in regards to the rise of Google as the behemoth of the information age as well as the development of new business models online. And that’s what makes this, at least for me, the biggest development of the year.

Phenomenon of the year: Facebook
Obviously, I couldn’t not mention Facebook which gained momentum extremely rapidly this year and became the go-to social network for those of us who aren’t musicians, 14-year-olds, or skeevy perverts. Facebook only opened itself up to the world outside the university sphere towards the end of 2006. I joined up early this year. Before long, almost every high tech-ist I knew (and many I didn’t) was on it. Lately, the sphere has expanded further and everyone, their parents, and their parents’ friends are connected. Clearly we’re on to something.

Of course, it will be interesting to see whether Facebook will be an ongoing concern for most people or just a passing fad. I like it for business purposes, as a tool for microblogging, and as the communications platform of choice for a number of my friends. On the other hand, I have a hard time answering those who complain that there’s nothing to do there. We shall see.

New technology: Microblogging
The rise of Twitter and its clones provided us with probably the only real new media form we’ve had in a few years, viz. microblogging. At first, the concept seemed a bit stupid. After all, why would I want to blog in tiny, one- or two-sentence bursts? But then you start getting into it and discover that Twittering (or updating your Facebook status, which I tend to do more) is a nice complement to blogging for those times when you have something small and/or clever to say but which doesn’t warrant an entire post. Plus, it’s the first Internet app that makes perfect sense for the mobile. It’ll be interesting to see who snaps up Twitter and for how much.

Interesting development in local tech: The renaissance of the Israeli internet scene
Three or four years ago, it seemed that the Internet industry in Israel was close to dead. During the days of the ’99-’00 bubble, the high tech scene was awash in Internet startups looking to be the next ICQ. Then the bubble burst and most of the companies went under. Worse, the VC industry was burned on the subject and it subsequently became almost impossible to get a new Internet startup funded.

As recently as two years ago I regularly had colleagues in the VC world lecturing me that Israel was incapable of producing Internet companies and, besides, these types of investments weren’t suited for VC anyway. What a difference a few years and a YouTube (and a Facebook) later make.

Once again, we are seeing dozens of new Internet companies each month. What’s more, there is a real feeling of an Internet scene here, helped along in no small part by Facebook, the work of groups like the Co.ils and the Geek Garage, and of course Jeff Pulver’s social activities. Let’s hope this continues to develop and mature.

Case of possible overhype: Online video
I’ll catch some crap from friends about this, but the online video space has become somewhat overhyped in the last year. Actually, that’s kind of unfair. What has happened is that in the post-YouTube age, online video has become ubiquitous. This has led to a lot of noise and a sense of, “Ok, what do we do now?”

Towards the end of last year, it looked like the field of mid-tail, independently produced video content (e.g. Ask a Ninja, Rocketboom, Ze Frank) would be the next big thing. As of now, that has failed to happen. There haven’t been any real breakthroughs this year. Even projects as big and as hyped as Joost have yet to take off as a mass-market application.

I still have big hopes for this sector, but it may have to wait until sometime in mid-2008.

Predictions for 2008
You’ve got to be kidding me. Only fools make predictions in this online age where what you write will forever haunt you. Still, I’ll make some safe and predictable ones for the upcoming 12 months:

• There will be a number of huge-size Internet exits that will have people scratching their heads
• The whole notion of privacy will continue to erode as Google finds out more and more about you
• Mobile internet will remain where it has for the last three or four years, i.e. tantalizingly around the corner as the Next Big Thing
• Some technology or company that you’re not thinking about will be the big story of 2008

So, for all my celebrating friends and colleagues out there, I want to extend best wishes for the new year and hope that 2008 brings health, happiness and success to us all.

The return of Gary Snoman

He's baaaaack!!!

As they've been doing the last couple of years, the guys at Blueprint Ventures have sent out an animated clip for the holiday season featuring Gary Snoman, everybody's favorite ice-based VC. This year, Gary takes a trip to all the major international high-tech hot spots, including... Israel!

"Forget Silicon Valley, this is Technion search technology. You guys can't compete, I mean, you don't even have compulsory military service." Hee.

Explaining VCs part 3 - The Investment Process

Last time we looked at the investment parameters that VCs look at in general. Now let’s look at the actual process of how an investment gets made.

You can envision the VC investment process as multi-leveled pyramid. At the bottom of the pyramid are all the companies which pass through the fund each year, be it at the level of sending a business plan, pitching to a VC at a conference, or being contacted by us. At the top of the pyramid are the small handful of companies that receive investment in any given year. At every one of the levels in between, the fund will decide to pass on the majority of the companies coming in.

The numbers can be pretty daunting. To give you a rough idea, in any given year, something like 1,200-1,500 companies enter the process with a fund like Giza. We will actually meet with maybe half these companies. And the number of new investments that the fund will actually make is something like 6.

Roughly speaking, the process can be broken down into the following stages:

1. Locating potential investments – it all begins with what we call deal flow: finding the companies that are looking for funding. This comes from a wide variety of sources.

   Giza has a full-time investment manager (Aaron Rothenberg, who many of you already know) whose job it is to find companies and contact them. Other new companies come in via our personal networks. Still others contact us, occasionally submitting their business plans to the Giza website.
   
   In addition to identifying new companies, we also spend a lot of time re-evaluating companies that we have seen in the past and who have made progress with their technology and/or their business development.
   
   We drop a certain percentage of companies at this stage which are clearly not suitable for us (sectors that we don’t invest in, not high-tech, etc). Those that pass go to the next level.

2. Screening and reevaluation – Each week, the fund holds a screening meeting where the investment professionals discuss new opportunities. We look at 20-30 companies, discussing the main points of their business plan or presentation. At this meeting, team members request to meet with those companies that seem interesting.
   
   About a third of the companies make it through the screening committee and actually meet with the investment team.
3. Initial meetings – Following screening, Giza team members (often in teams of two or three) will hold an initial meeting with the company. This is usually a 90-minute meeting where the entrepreneurs present themselves, their idea, and their vision. At the end of the meeting, the VC team will discuss whether the company is worth moving forward with.
   
   About a quarter of the companies that make it to initial meetings willpass this stage.
   
   
4. Due diligence - This is the longest and most involved part of the investment process. Depending on the type of company and the complexity of its   technology, the due diligence process can take anywhere between a month   (in the case of companies going through Giza’s fast-track “Ofek” program)   to four or five in the case of companies with more involved technology.
    
     During this stage the company will be called in for more meetings at the   fund to delve further into its technology and market. Often, the VC will   call in outside experts to help the fund evaluate a company’s technology.   The company will also make a presentation to all the investment   professionals in the fund to allow them to decide whether or not to   invest. At the end of this stage, if the investment still looks good, the   VC issues a term sheet.
    
     About 5 percent of the companies which enter the due diligence process   emerge with a term sheet in hand.
    
    
5. Closing   process and investment – The final stage of the investment process   involves negotiations about the terms of the investment. The VC will   perform additional legal and financial due diligence on the company. Some companies will still drop out of the process (usually due to the company   deciding to reject the term sheet) but the rest emerge as the winners of   the VC sweepstakes.

It’s a long process, and it can be an arduous one. As one startup-ist once said, the odds of becoming a pilot for the Israeli Air Force are better than these. However, we would like to think that the results are worthwhile.

Explaining VCs part 2 - The VC Model

Last time around I gave a general introduction to what venture capital is. This let’s look at how VCs make money, which in turn influences which companies we choose to invest in.

I’m talking about the infamous “VC Model” which (if you’ve been reading the blogosphere in recent months) a lot of people claim is broken.

Marc Andreessen explains the model very succinctly:

The whole structure of how the technology industry gets funded -- by venture capitalists, angel investors, and Wall Street -- is predicated on the baseball model.
Out of ten swings at the bat, you get maybe seven strikeouts, two base hits, and if you are lucky, one home run.
The base hits and the home runs pay for all the strikeouts.

Say we raise a fund of $150-200M from our investors. With that money we will make, something like 20 investments averaging $8-10M over the lifetime of the company. In order to make the returns that our investors expect we assume that of the 20 investments:

•    Two will be huge successes and return 10X on the money
•    4-5 will return 2-3X their investment
•    The rest will either just return their investment or else get written off entirely

The successes, as mentioned above, need to be big enough to cover the inevitable losses from those companies that fail.

So how does this influence our investment decisions? For one thing it means that we need to focus on those companies which we believe at least have the potential to be home runs and return 10 times their investment.

One of the most common reasons we have for passing on companies – including a lot of companies where we think the team is great and the idea is solid – is that we feel that the opportunity is too small.

(How small is too small, you may ask. We don’t have any fixed rules, but if your total addressable market – in other words the total revenues that you could theoretically get if you cornered your target market – is less than at least half a billion dollars if not a billion, it’s probably too small for VC).

While the investment multiple is important, it’s not the only consideration. The actual amount of money which is returned is important as well. Small exits (let’s say under $40M) can be very good for a company’s founders but not so great for the VCs who invested in them. In other words, if a VC makes a seed investment of $2M and the company exits for $20M, this is not considered a big success even though it had a multiple of 10.

Why is this? Even if the VC held 30% of the company at exit (which is on the large side) it only got back $6M. In order for a $150M fund to make the returns is investors expect, it would have to have 30 or 40 exits like this, which is unrealistic. So, again, we look for exits we believe will be have the potential to be in the $100M range or greater.

Obviously we know that most companies will not have $100M+ exits. But since 7 out of 10 companies that we invest in are likely not to succeed as hoped, we need to know that the three who do at least have the potential to succeed big time.

So, why are we hearing that the model is broken?

There is a feeling that the size of exits has shrunk over the course of this decade. Fewer companies are going public, and the ones who do are doing so at a much late stage after much more money has been invested in them. With fewer IPOs, more companies exit by being acquired, which often means smaller exits.

It’s unclear to what extent these assumptions are true, but if they are then the number of exits that return a 10X multiple shrinks, which affects the model greatly. On the other hand, the costs of starting up a company, especially in the Internet world, are a lot smaller. Perhaps a larger number of companies will produce moderate exits, which will cover the ones that don’t.

So we may find that the VC model will have to be adapted. If it’s not broken, it may yet have to bend.

Explaining VCs - Part I

In the world of high-tech in general, and Israeli high tech particularly, venture capital is the main avenue for funding new technology companies. This remains a fact even today when startup costs are lower than they’ve ever been and where angel investors can provide alternatives to a lot of deals. However, despite the prevalence of VCs in the startup world, I find that there are a lot of misconceptions about the field. A lot of entrepreneurs don’t quite understand who the VCs are and how we operate.

Although the subject has been covered before in many places, I think it’s worth reiterating with a multi-entry series about how VC works.

Let’s start with what VCs are and what we aren’t.

Quite often, I hear complaints along the lines of, “You VCs say you like risk, but you’re really only looking for the next Google and other sure things.”

Contrary to popular opinion, we are not wild-eyed gamblers nor do we particularly “like” risk. I think part of the confusion here is local and comes from poor translation. In Hebrew, the term “venture capital” is hon sikun, which literally means “risk capital”. (A more accurate translation into Hebrew would be something like hon yozma.) In other words, we are in it for the venture, not the risk.

Venture capitalists are first and foremost financial investors who specialize in investing in technology companies. All startups carry some degree or another of risk. The earlier you invest in a company, the greater the risk. The risk is just part of the business.

It’s also inaccurate to say that we are looking for “sure bets”. While it would be terribly nice to invest in the next Google, who can tell what the next Google is. (As the old cliché goes, back in 1997 who would have thought that the world needed another search engine?)

Another big misconception: although we are seen as haughty, we are not the masters of our own destinies. To paraphrase an old Bob Dylan song, we have to serve somebody. And that somebody is our investors. The majority of money in VC funds comes from large institutional investors such as pension funds which manage tens and sometimes hundreds of billions of dollars. These investors earmark a certain part of the money to high risk/reward vehicles like venture capital. In return we try to provide a high rate of return.

What does this all mean?

First, this setup dictates our business model and what types of opportunities we tend to invest in. More about this in the next part of this series.

Secondly, it means that every few years VCs have to go hat in hand to our investors and try to raise a new fund. Yes, we do know what it feels like to be the ones asking for money. We also have to sit through endless series of meetings, go through a rigorous due diligence process, and then wait around impatiently for an answer. This probably won’t win us any sympathy points with the entrepreneur community, but it’s worth mentioning anyway.

So, that’s us. Next time: the VC model and how it affects our decision-making.

The art of picking winners

Guy Grimland wrote a piece (Hebrew link) in The Marker the other day about highly promising Israeli startups not backed by Israeli VCs. The piece came after reports that targeted ad serving company Quigo has been bought by AOL for around $300M. (Quigo founder Yaron Galai, it should be mentioned, strongly emphasizes that this is still a rumor).

Alongside Quigo, the piece looks at a couple of other high-flying Israeli startups like Oberon Media, Mobileye Vision Technologies, and SuperDerivatives. These have variously raised extremely large financing rounds and/or have significant revenues. And, like Quigo, each managed to make something of itself initially without VC financing.

The question is whether there we can learn a lesson about the structure of the Israeli high-tech market -- and specifically about the way VCs work within this market -- from the success of these companies. I'm not entirely sure.

First off, I think Ori Kirshner (my boss) gave the best answer in the article by pointing out that while Israeli VCs did miss the ball on Quigo,  there have been quite a few other success stories recently that were VC backed.

Beyond that, to say that VCs dropped the ball on Quigo, Oberon, et al. is oversimplifying the case. VCs look at many hundreds of companies a year. Each rejection is its own story. Sometimes, the companies themselves reject VCs, because they find they get what they need from angels or they have chosen to bootstrap it.

If there is a lesson to be learned here it might be one of broadening our horizons. Each of the companies mentioned above operates outside the "traditional" realms like communications technology or enterprise software that Israeli VCs historically invested in. Quigo and Oberon are Internet/gaming plays; Mobileye does technology for the auto industry; and SuperDerivatives provides a software solution for the financial world. The fact that most of them were set up in the post-bubble period (during which a lot of VCs became more conservative in their decision-making process, especially with regards to Internet companies) probably contributed as well.

At any rate, I hope the rumors surrounding Quigo are true. Not only because I wish the founders well (which I do), but also because it will help further establish new sectors in Israeli high tech as "interesting" from the financial perspective.

Early exits

A little while back, Aner Ravon wrote a heartfelt post about the state of Israeli high tech, specifically the fact that Israeli startups tend to exit too early (generally via acquisition) instead of developing into large, mature companies.

The Israeli high tech scene fails to produce sustainable, ongoingly growing, companies. The problem is not the Israeli landscape, the problem is probably with having a wrong dream.

When it’s all about the Exit, focus shifts from succeeding as a company to succeeding as investors, speculators. From creating to trading. Operational record is overlooked for dream weaving. This is why Boaz Eitan walks out with $100M for having successfully sold a multi billion dollar balloon to investors despite having no operational evidence at any point.

The question why this is so often comes up for discussion by people inside the country’s high-tech industry. (Daniel Cohen addressed it in a piece about “The Quest to Create an Israeli Nokia”). While Israel has shown itself capable of creating international category leaders – Teva, Check Point, and Amdocs spring to mind – the actual number of these is small, and none have really sprung up for nearly 15 years.

Aner lays most of the blame with the money guys:

Most Israeli startups are funded by VCs, Israeli and American, who in turn get most of their funding from out of Israel investors. This is good and bad. The VC model is based on selling their share for the highest amount in the shortest time. The fundamental focus of a “business” is to create a profit. Unfortunately, these two foci’s correlate less often then they do. An IPO may mean such correlation, as the VC can sell it’s share and the company can grow. However, very few companies fit the IPO model, and most companies are forced to think about their “business” in different terms. Terms such as “comparables”, “size of the (exit) opportunity”, “exit strategy” and “fitting the investment portfolio” take precedence and management attention away from real business decisions. Innovation becomes more important than operations because ideas can be sold earlier in the lifecycle. This means the company must be sold to a company who believes it can turn innovation to operations. Sold to, not become one.

I don’t want to argue that he is wrong, because a lot of these points have merit. The venture capital model does present certain problems (mainly the time horizon) when it comes to growing a big company. There have certainly been cases where investors have pressured companies to exit when they had the potential to become much larger. And yet, at the risk of being an apologist for the VC industry, the situation is a lot more complicated.

Other factors contributing to the relative paucity in the development of large-scale tech companies in Israel include:

• The entrepreneurs themselves – In some cases, as mentioned, investors will push entrepreneurs into exiting too early. But in many other cases it can be argued that VCs try to keep entrepreneurs from going for exits in the mid- ten million range that might be good for the entrepreneurs but lousy for the investors.
  
  To put another way, it is the rare entrepreneur (especially in Israel) who won’t give in to the temptations of a $200M exit. Very, very few people have the cojones of a Mark Zuckerberg.

• The lack of a local market – The fact that Israel has managed to grow a tech industry at all is impressive given its basic situation. We are a tiny little country, whose inhabitants speak a native tongue that nobody else does, cut off geographically from all of its potential markets. All this means that Israeli companies need by definition to be oriented towards overseas markets. As a result, a lot of non-technological functions end up being shipped off overseas instead of staying in Israel. This leads to…

• Management issues – Israel has traditionally had problems growing management capable of making the jump from a $100 million-level company to a $1 billion level company. The situation has improved in recent years, ironically as more Israeli executives have served time in international companies. But there are still way too few international-grade managers to go around.

• The financial environment – You should also remember not to discount the general financial environment. The wild IPO environment in the late ‘90s and beginning of this decade has been dampened for years. And while the TASE is growing continuously, it is still considered a backwater financial market. Meanwhile, investment banking and other financial services are still relatively primitive. All this has led to greater M&A (well, A) activity rather than IPOs.

It should also be pointed out that Israel doesn’t necessarily want a Nokia, in the sense that Nokia completely dominates Finland’s technology industry.

The question is whether this is all leading in one direction – as Aner suggests – that direction being downwards. But that is a question for another day.

On the Changing Web Investment Landscape

A recent blog post by Y Combinator’s Paul Graham has caused a fair deal of buzz around the VC end of the blogosphere. In his essay, Graham points to a number of trends that he sees in the software/internet startup world and makes a number of predictions as to where the industry is headed.

In Graham’s view, we can expect to see a lot more startups founded by younger entrepreneurs needing a lot less funding; a standardized process on the part of investors to streamline the investment process; a more sophisticated attitude towards acquisition by major players; as well as a decrease in the importance of a college degree compared to technical skills and experience.

On the heels of the piece, we’ve seen numerous blog posts analyzing Graham’s points, focusing on the changing landscape (when it comes to Internet companies), and openly suggesting that the traditional VC model is broken and that we need to adapt ourselves to the new world order.

Graham, I believe, is spot-on with a lot of his analysis even though I don’t fully accept his conclusions. Here at Giza we’ve seen the local Internet scene develop greatly over the last couple of years. Our deal flow is filled with the types of companies Graham describes: young guys (and gals) with great ideas who don’t need a lot of funding to get started.

Our Ofek seed-stage program is designed for this environment: provide the relatively small initial sums for a company to reach pre-defined milestones and then decide whether to continue on to a major Round A. So far, we have made four investments this year under the auspices of the program, with Koolanoo Group having already graduated into a full portfolio company.

Like I said, I have a couple of caveats about Graham’s piece and the Y Combinator approach in general. A big part of it is the model and the potential scale. Y Combinator’s business model (also shared by investors such as First Round Capital) is predicated on making small investments in each particular company, then enjoying potentially good returns even on small-scale exits.

In theory, this should work fine. In practice, it runs up against issues of scale. Again in theory if you fund enough startups like this, one or two of them might be classic VC-grade home runs (say $100M plus exits). The question is how many you have to fund.

Graham talks about what happens when Y Combinator has to deal with 10,000 companies. Obviously, they’ll never be able to deal with 10,000 companies, let alone 1,000. Unless you’re planning on being a source of capital c’est tout, you need to provide some management attention to each of your portfolio companies. This is feasible for 20 or 30 companies at a time, depending on your staff size and the amount of streamlining you are able to do. It becomes increasingly hairy after that.

So you have to then wonder what types of returns – not multiples, but actual objective money – you can get from a strategy based on a few dozen companies with relatively small exit avenues.

And then there is the matter of follow-on funding: few are the companies that grow into significant Web properties without some degree of marketing. Which means that you go from investing a few hundreds of thousands of dollars to investing two or three million.

In short, big questions indeed. As a rule, I think that seed-stage investment approaches like Ofek are the right way to go for many of the Internet companies that we see. (And even then, I should point out that since the model is relatively new we have little data on the actual outcomes). Whether it will completely take over the VC biz, count me skeptical.