1

The Israeli VC Industry: Emergence, Operation and

Impact

Gil Avnimelech & Morris Teubal

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Main Objectives

• Analyze the emergence of the Israeli VC industry in the 90’s: background, triggers, operation and growth.

• Analyze the emergence of Israel’s Hi-Tech cluster of the 90s (‘Silicon Valley’ Model)

• Analyze the role in High Tech emergence of R&D support & Innovation Technology Policy(ITP) more generally speaking (e.g Yozma Program)

• Policy implications for Italy VC industry

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Our Approach1. Our research focus on co-evolution as a factor in Emergence of the

industry; and through a better understanding of the contribution of the VC industry

2. For this purpose our analysis takes place at two levels-a VC industry level (meso-economic); and VC company/fund level (micro-economic).

3. At the meso level we emphasize the importance of background conditions for the successful emergence of the VC industry; and the crucial role of Yozma as a trigger to the process

4. At the micro level we distinguish between private and social performance/impact of VC companies/funds; we build indicators for each of these; and correlate private performance and social impact across a sample of 17 VC companies.

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Contents of Presentation

• Part A: Background- Phases in the Israeli High Tech Industry and Innovation Technology Policy

• Part B: Phases in the Emergence and growth of the Israeli VC Industry

• Part C: Micro-economic Statistics of a Sample of 20 VC Companies: Private Preformance and Social Impact

• Part D: Building Initial Hypotheses of VC Company Performance and Empirical Analysis

• Part E: Policy Implications for Italy

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Part A: Background- Phases in the Israeli High Tech Industry

and Innovation Technology Policy

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Background: R&D Penetration Period (1970-89)

• High Tech Industry and R&D

• Innovation and Technology Policy:

1. The Backbone ‘Industrial R&D Fund’

2. First Phase-Learning

3. Second Phase- Policy Restructuring

4. Impact of ITP

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High Tech Industry and R&D

•  During the 70’s and 80’s: Military R&D cooperation with US, Germany and France; Dominance of strong military industry; First foreign multinational companies establish R&D centers in Israel.

• High Rate of Growth of industrial Civilian R&D -from 26 M$ real to 347 M$ real between 1969 and 1987.

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Innovation & Technology Policy •1969: Establishment of the Office of the Chief Scientist (OCS) and creation of the “R&D Industrial Fund” program. This program directly supported R&D projects of individual companies, is the backbone of Israel Innovation Strategy. The OCS budget grew from $2.5M in 1969 to almost $400M in 1999.

• Implementation in 1977 of BIRDF which promoted joint R&D projects between Israeli and US companies.

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Silicon Valley Phase (1990-2000)

• Specific Background conditions & Events – Internal/External

• New programs

• The new High Tech Cluster

• Impact

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Specific Background Conditions & Events-External

• Beginnings of Globalization of US capital markets with respect to SU e.g under certain conditions foreign SU could undertake an IPO in NASDAQ

• The global growth of the IT industry in the 80’s and 90’s; & de-Regulation in the telecommunication market in the 90’s.

• The rapid growth of global capital markets (Nasdaq effect).

• Globalization of US investment banks & Private Equity Companies; and attempts at searching for new investment opportunities in Israel

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Table 1: Israel's high Tech Cluster of the 90s

99/00 90 80

Number of SU ~3000 ~300 ~150

Number of VC Companies ~100 2 0

Funds Raised by VCs: M$ 3400 ~49 0

Capital Invested by VCs: M$ 1270 ~45 0

Accumulated No of IPOs (hi tech): ~130 9 1

Accumulated VC-backed IPOs: ~70 3 1

% Foreign Sources in SU funding 67% NA NA

% IT Exports in Manufacturing Exports 45.7% ~33% ~20%

Mergers and Acquisitions : B$ ~10 NA NA

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Part B: Phases in the Emergence and Growth of the

Israeli VC Industry

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Yozma Program – Objectives• Generating a critical mass of VC funding/activity. This was estimated as being around 200-250 M$.

• Achieving a balance between Government’s contribution and that of the Private Sector; & ensuring minimum government intervention in Management of the VC companies

• Promotion of domestic VC industry capabilities through learning from foreign partners & through the creation of networks and links.

• Creation of stable VC industry which will survive after termination of Government Support.

• Fast learning of local VCs and creating added value to SUs.

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Yozma Program-Final Design

• Total government investment of $100M- in the 1+10 Yozma funds.

• In each of Yozma funds the government invested 40% of the capital raised by the fund up to 8 M$.

• Each fund had a 5 years option to buy the government share at initial value plus interest.

• All management companies were Israeli entities which included partners from both Israeli and foreign financial institutions.

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Yozma Program – Growth

• Most Yozma funds management companies has at least 2 additional funds.

• All but 2 of Yozma funds bought back the government share.

• The total sum managed recently by Yozma funds management companies is approximately $6B.

• At least 7 out of 11 Yozma funds management companies are among the top 20 management companies in Israel.

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Table 4: Capital Raised by the Israeli VC industry

1000

3288

1752

67572739715637437216058 0

500

1000

1500

2000

2500

3000

3500

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001E

Total VC Capital Raised

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Table 5: Capital invested in Israeli startups by Israeli and foreign VCs

440190

589259

1011

575

3233

1963

1600

850

0

500

1000

1500

2000

2500

3000

3500

1997 1998 1999 2000 2001E

Total

By foreign Entities

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Table 6: Foundation of SU companies

40 40 50 50100

200

350 350

550

850

150

0

100

200

300

400

500

600

700

800

900

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 E

First time VC Backed Startups

All new Startups

First time OCS financed

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Table 7: Number of offerings of Israeli companies in US and EU stock exchanges

16

8

12

24

1614

20

31

2

64 5

12

5 5

14

24

2

0

5

10

15

20

25

30

35

40

1993 1994 1995 1996 1997 1998 1999 2000 2001

Number of Offerings

Number of IPOs

Number of VC backed Offerings

Number of VC backed IPOs

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Table 8: Israeli high Tech companies which were

Targets in M&A deals 1994-2000 (M$)

2 2

5 5

8

3

11

5

23

7

17

11

29

18

75

0

5

10

15

20

25

30

1994 1995 1996 1997 1998 1999 2000 2001

High Tech M&A deals

VC backed M&A deals

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Stages of Evolution of the Israeli VC Industry

Pre-Phase1 (before 1993) – Pre VC age.

Phase1 (1993-1995) – Creation and Learning.

Phase2 (1996-1998) – Rapid growth and fast maturation process.

Phase3 (1999-2000) – Mature Industry; and bubble years.

Phase4 (2001-) – Confronting with the global slowdown and the global high tech crisis.

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Table 9: foundation of management companies investing in Israeli SU

810

1315

2

6

1618

29

7

0

5

10

15

20

25

30

35

Pre Phase1 Phase1 Phase2 Phase3 Phase4

Holding & Investment company

PE & VC Companies

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CONCLUSIONS PART 1 ISRAEL'S VC INDUSTRY & HIGH TECH CLUSTER

OF THE 90S

• Is an outgrowth of High Tech as it developed during 70s/80s

• influenced by additional Background Conditions/Events, both Internal & External

• Was Indirectly stimulated by existing Policies; & Directly triggered by a Targeted Policy --Yozma (since 1993)

THE VC INDUSTRY DID NOT GROW IN A VACUUM, BUT IN A CONTEXT IN WHICH A HIGH TECH INDUSTRY ALREADY EXISTED

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CONCLUSIONS PART 1THE ISRAELI EXPERIENCE SUGGESTS THAT

Critical Design & Timing Elements of Targeted Policies:

• Assurance of 'demand' for VC 'services’

• Strong 'supply' incentives, especially to the upside

• Active participation of reputable foreign Financial

Institutions

• ’Critical mass' of effort and Government role declining

through time ('catalytic policies')

• Attention to organizational design (LP form of

organization)

• Simultaneous implementation of other policies

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AT THE HEART OF EMERGENCE OF THE NEW HIGH TECH CLUSTER IS A STRONG VC-SU EVOLUTIONARY

PROCESS INVOLVING THREE PHASES

• Pre-emergence phase (1990-2): Very favorable. Market Forces already operating in the field•Emergence phase (1993-5): The first phase of the VC industry, induced by Yozma. It generated a 'critical mass' of activity which, together with Government R&D support, strongly stimulated SU formation. • Mature Phase (1996-2000): Steady growth assured by a 'cumulative process' e.g. early successes lead to imitation, entry & learning( 2nd and 3rd phase of VC industry). •Shifting Structure of Exits: Crucial role of IPOs initially, M&A gradually becoming important, both very important at the end of the decade.

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Part C: Microeconomic Analysis

Of A Sample of 17Israeli VC Companies

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Patterns Identified• Less co-investments in phase 3 than in phases 1&2 – Fits our

prior assumption.

• More co-investment in successful companies – this may have several reasons e.g 1) ‘good’ SUs have more sources & more rounds of finance; & more value added needs; 2) Top Tier VCs are invited to invest in good SU.

• Exit valuation grew with the number of prior exits for a specific VC and for the industry in general.

• Gradual movement to ‘Seed Investments’ (Phase 3) due to: stronger competition, larger fund sizes and greater capabilities.

• Increased specialization of VC companies.

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Direct & Indirect Indicators of VC-performance

• Average number of portfolio companies is 50 & average number of Exits is 10. This gives a Success Ratio of 20%(11% IPO and 9% M&A)

• The Success Ratio of Phase 1 is 30%.(20% IPO & 10% M&A).

• 7 VCs had at least 1 Very Successful Exit, and another 3 VCs had at least 1 Successful Exit.

• 8 VCs had leading strategic investors and 11 VCs had financial institutions as investors(leading private equity companies or investment banks)

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Part D: Exploring Characteristics associated with

VC Value Added and VC Success

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Linking Characteristics With the

Model of a Successful VC Company success is a function of four basic operations:

Deal flow- good SU who apply to the VC;

Scanning Abilities- Identifying a subset for Due Diligence; efficient due diligence process; and successful selection of SU;

Value added "operational' activities- ability to help companies during startup and early growth phase;

Value added during Exit- networks with Investment Bankers or with Strategic Partners; timing of exits, preparing the company for the exit, etc.

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Linking VC Characteristics to Performance-some Hypothesis

• Hypothesis I: prior Management Experience is a necessary condition for VC entry

• Hypothesis 2: Important Role of Founder Technology/Science Education combined with R&D Work Position --absence of the above is strongly associated with relatively weak performance.

• Hypothesis 3: Belonging to a Global Network is Strongly Associated with VC success.

•Hypothesis 4: Existence of Strategic Investor or Reputable Financial Institution is correlated with high performance

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Analysis of ‘Top Tier’ VCsSample and methodology

• Top Tier VCs are defined as having a) prior Management experience; b) Technology Background; and c) either belonging to Global VC network & having a Reputable Financial Institution; or having a Strategic Investor

• 16 out of Universe of 128 VC or VC-related organizations were classified as ‘Top Tier’.

• Sample of SU companies: all Israeli high tech companies that had IPO in US or EU since 1971(156); and all Israeli high tech companies that were the target side in an M&A deal since 1993(103).

• SU where classified into three groups – none VC backed companies, VC backed companies and ‘Top Tier VC’ backed companies.

• Variables compared according to: Sector, year of exit, age at the exit date and valuation at the exit.

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Table 12: Number of Israeli high tech IPOs according to technologies sectors and according to finance source

156

42

91511

3439

60

20

40

60

80

100

120

140

160

Biotechnology

Comm

unication

Electronics

Internet

Medical

Semiconductors

Software

Total

# of IPOs

# of VC backed IPOs

# of TT_VC backed IPOs

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Table 13: Average age of Israeli high tech IPOs according to finance source

0

2

4

6

8

10

12

14

16

Biotechnology

Communication

Electronics

Internet

Medical

Semiconductors

Software

All sectors

IPO Average Age

VC backed IPOs Age

TT_VC backed IPOs Age

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Table 14: Average valuation of Israeli high tech IPOs according to finance source

0

50

100

150

200

250

300

350

400

450

Bio Comm Electronics Internet Medical Semi Software All sectors

IPOs Average Valuation (M$) VC backed IPO Valuation

TT_VC backed IPO Valuation

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Table 15: Number of M&A deals involved Israeli SUs

0

20

40

60

80

100

120

Bio

Comm

Electro

nics

Inter

net

Med

ical

Semi

Software

All sec

tors

All M&A deals

VC backed M&A deals

TT_VC Backed M&A deals

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Table 16: Average valuation of M&A deals

0

100

200

300

400

500

600

700

800

Bio

Comm

Electro

nics

Inter

net

Med

ical

Semi

Software

All sec

tors

All M&A deals

VC backed M&A deals

TT_VC Backed M&A deals

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Table 17: Exit Ratios of Israeli Startup Companies (% of success)

Phase of SU foundation Pre Phase1 Phase1 Phase2

# HT SUs established in Israel ~200 ~250 ~1050

Companies that had an IPO 31 (15%) 37 (15%) 44 (4.5%)

Companies that were acquired NA 27 (11%) 77 (7.3%)

# HT SUs backed by VCs ~25 ~185 ~740

VC backed companies that had an IPO 12 (48%) 28 (15%) 40 (5.4%)

VC backed companies that were acquired NA 17 (9.2%) 40 (5.4%)

# HT SUs backed by TT_VCs ~10 ~65 ~195

TT_VC backed companies that had an IPO 6 (60%) 14 (22%) 28 (14.5%)

TT_VC backed companies that were acquired NA 11 (17%) 30 (15.5%)

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Conclusions Part C and D• There is strong evidence that the investment organizations in Israel are

not homogenous – there are significant differences in their value added abilities and success.

• Most value added of the Israeli VC industry is focused on a group of 10%-20% of the Israeli investment organizations.

• There are two critical elements of VCs’ value added abilities: 1) Reputable & value added investors; 2) science & technology education and work experience.

• VCs have different affects on SUs success in different sectors(Semiconductor-high; Software & Internet-low).

• While in the early phases of the Israeli VC industry most VCs created added value to their portfolio companies- as the Israeli high tech industry matured the added value of weak VCs diminished.

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Implications For Italy

Suggestions From the Israeli Experience

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Availability of VC resources - Italy

• Italy’s VC industry is not a young industry –it formally exists since 1986. However it grew slowly after the 1987-8 crisis and re-focused toward LBO investments afterwards.

• Growth re-started in 1996 with a significant growth in capital raised and in investments, with early phase high tech SU investments growing very fast in 1999-2000.

• Still only a small percentage of total VC resources is devoted to high tech and to the early phase Start Ups.

• Hypothesis: There is no problem of availability of capital to the Italian VC industry.However there are constraints to the growth of Start Ups including insufficient ‘intelligent’ capital which specializes in investing in such companies.

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VC Maturity - Italy• Hypothesis: The Italian VC Industry is an outgrowth of that country’s

financial sector, and most managers do not have prior high tech and R&D experience – this explains the late stage& non-high tech bias.

• Hypothesis: only a small number of VC companies are fully specialized in early phase high tech Start Up investments.

• The Italian VC industry accumulated experience in early phase high tech investments during 1999-2000(especially in Internet and Communications Services).

• Hypothesis: Global VC players (mostly European) came quite late in the evolution of the industry; also little cooperation between local and foreign VCs.

• Hypothesis: the high tech world crisis since late 2000 truncated what could have become a healthy growth of that segment.

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Specific PoliciesStimulate VC investments in early stage high tech Start Ups• Government Fund which co-invests with private VC in early

phase of high tech Start Up companies• Tax Benefits to VC companies specialized in early phase high

tech Start Up investments• Government R&D support/subsidies of early stage Start Up

companies• Government support of Technological Incubators

Note: Some these may require a specialized Government Agency with abilities to identify & distinguish early high tech activities of SU from non-high tech and non-early high tech activities

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High Tech Start Up Culture - Italy• It seems that the main problem of the Italian VC industry

is the demand side – few SU companies i.e. few opportunities for VC investments

• Risk aversion culture

• Institutional constraints to the development of University SUs relationships e.g. incentives to professors to found SU companies

• Hypothesis: as a result young engineering graduates and other potential SU entrepreneurs seek employment in large high tech companies or in the universities

• There are also few incentives to leave these organizations

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Specific PoliciesThe objective is to encourage SU foundation through

entrepreneurship

• Simplify the process of personnel spin-off from large companies to Start-Ups e.g assuring pension rights;labor laws and regulations;

• Simplification of process of creation of new Start Up companies

• Government underwriting of costs of establishing Start Up companies by Universities

• Simplification of University bylaws concerning foundation of Start Ups by Professors

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Exit Mechanisms - Italy• The dominate exit mode is accumulated earning. This is

not adequate for early stage high tech investments.

• Absence of links with global capital markets- Nasdaq and European markets.

• Small numbers of IPOs in those markets.

• Few M&A deals with global IT industry players.

• Main implication: Weak incentives to establish SU companies.

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Specific Policies

Stimulation of IPOs• Since Italy is not a leading High tech

country it is important for-- visibility, reputation, networking, attracting partners, experienced investors, etc- that Italian SU companies float at Nasdaq and to a lesser extent in leading European new enterprise, high tech markets

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Possible means to stimulate IPOs

• Tax Exemptions a) for a number of years to individual companies, b) for a period time of growth of the industry

• Government participation in Underwriting Costs: a percentage of costs; or covering the excess cost over the underwriting cost of US companies ( 7%)

• Capital gain exemptions to companies floating in Nasdaq

Profit tax & corporate tax exemptions

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Stimulating Foreign Investors in VC and in SU(especially from the US; and with experience in early stage high tech)

Since Italian VC companies have few links with the US and are not devoted to high tech early stage, then participation of US investors in VC companies is desirable.

For this purpose we propose. Tax exemption to foreign investors in domestic

VC companies. Government investments in domestic VCs on a

dollar per dollar basis together with foreign investors; and an option to the latter to purchase its share at cost (plus interest).