Investing in High-tech

Israeli venture capital funds have developed their own characteristics: more patience and nurturing, and occasionally, more participation than their American counterparts.

Israel is a uniquely rich source of hi-tech ideas, start-up companies and global players, for several reasons. The country boasts the highest ratio of scientists and engineers in the world, at about 13.5 per 1000. Newsweek has called Israel Silicon Valley's only rival outside the US; Fortune magazine has lauded its technological innovations. Microsoft, IBM, Intel, US Robotics, and countless others have acquired Israeli companies, technology and brainpower.

Israeli companies comprise the second largest index in the New York stock markets, after Canada. "Israel is technologically excellent in a number of fields: telecommunications, signal processing, imaging, and more. A lot of the best science derives from Israel's state-of-the-art military industries, explains Yossi Sela, executive vice president of Gemini, one of Israel's first major venture capital funds.

Many Israeli hi-tech companies start out as ideas nurtured by "incubators", supported at least in part by the Ministry of Industry and Trade. In 1991 the government set up Israel's first fund, called Yozma, to support start-up endeavors in various forms. Its purpose was to encourage the development of venture capital financing in partnership with private companies. This was the first time the relatively socialist-oriented government tread in the field of outright capitalism, and the venture was a raving success. Since then several domestic VC funds have sprouted, each raising heavy amounts of capital. Gemini, established in 1993, was the first Yozma-backed fund.

However, most of the money in locally managed VC funds comes from abroad. Under local regulations, pension funds - a paramount market player - are prohibited from investing in high-risk venture capital funds. However, more and more local money is becoming involved, as large domestic investment houses are not so restricted. For example, Discount Investment Ltd, a subsidiary of IDB (Israel Discount Bank), is a partner in the Gemini fund; Kardan Investments has a venture capital fund of its own, and more.

In the past, many foreign investors shied away from Israel principally because of their perception of the country as war-torn and because of the Arab boycott on business with Israel. This is largely a thing of the past. Since the onset of the peace process and the rescinding of the secondary and tertiary Arab embargo (and, partially, the primary one too), the world's leading investment banks have opened offices and representations, and investors have been flocking to Israel from the US, Japan, Europe, Korea and more, to investigate, to invest, to create joint ventures and to buy Israeli technology or companies outright.

The irony is that the peace process and regional stability were largely irrelevant to the hi-tech world all along. Israeli companies are typically not mass producers but a source of cutting-edge technology and innovation. "The status of hi-tech investment, and share prices, depend on the global economy, not on momentary regional unrest," Mr. Sela states, pointing out that Intel's billion-dollar plus investment in Israel was wholly unaffected by such as the Gulf war. Also, the well-being of Israeli hi-tech companies is independent of the local market, which is too small to support large endeavors: their market is global, not domestic.

"The golden rule of investing in hi-tech stocks is to be familiar with the technology," warns Mr. Sela. As most investors are better at calculating the bottom line than gaining savvy in the finer details of fuzzy mathematics and advanced hi-tech, the best solution for those hoping to get in at the start of a budding Microsoft is to invest via a venture capital fund, whose function is to locate the best opportunities based on focused research done by appropriate professionals. Also, when investing via a VC fund the investment is spread over several companies, and a few that flop will barely affect the profitability of the entire portfolio.

The Advantageous Brain Drain

The Israeli authorities have typically encouraged foreign investment in domestic hi-tech industry while simultaneously fearing a brain drain from the country due to outright acquisitions of Israeli corporations or technology. Mr. Sela argues that in fact, such acquisitions by foreign companies are actually to Israel's advantage and more deregulation is required.

Israel has an enormous pool of start-up and young companies; estimates vary between 250 new entities a year to thousands. There are more start-ups in Israel than in the whole of Europe. "Europeans take their ideas to large companies; Israelis open a new one," explains a venture capitalist. Sad to relate, many close, even those with remarkable technology. "The biggest problem young Israeli companies typically face is a lack of marketing skills.

One of the best things that can happen to a fledgling Israeli entrepreneur is to be bought out by an international conglomerate, which will take the Israeli company mainstream. Then the next company the Israeli establishes will start out with a solid background in marketing, taught by the parent company that has made it,'" Mr. Sela explains.

No less important: if anything, Mr. Sela notes, acquisition of an Israeli company by a foreign conglomerate will draw brainpower into Israel more than vice versa. "Think about it," Mr. Sela says. "Which has more to offer, the mouse or the elephant? If Siemens buys Ornet or 3COM buys Nicecom, first of all it's flattering to the Israeli company, and second of all, what the elephant has to contribute to the mouse is inevitably greater than the contrary. At the very least, the mouse gains instant access to markets it could previously only dream about, given its limited means."

Why an Israeli venture capital fund?

American venture capital funds, longer in the tooth but more adapted to the American market culture, act from a position of detachment and tend to drop companies that "hit a bump". Israeli venture capital funds have a different approach, one of patience and nurturing and, occasionally, of participation in management. "Israeli VC funds are stubborn," Mr. Sela says. "Sometimes companies may have fantastic technology but a poor marketing background, and their backers become involved in cardinal corporate decision-making. Basically VC investors in Israel have more faith in the companies they select."

Beyond stable backing, Israeli companies offer another relative advantage compared to investment in the West. "The competition for academic manpower in the hi-tech world is fierce," says Mr. Sela. "Israelis tend to stay with their companies for the long term, which means that investors are working with a stable team. This is excellent for the industry as a whole. When an investor puts money into a company, he is also investing in the people, and this is far more worth-while in Israel. For example, the core people who established Nicecom remained after the company was acquired by 3COM." Given the diminutive size of the Israeli market, what does Israeli hi-tech have to offer global giants?

Mainly (if not only) specialized niche products that improve the giants' own products. "A better button, a faster circuit, things the giants don't have the time or inclination to develop themselves but still need for their megaproducts," as one Japanese investor puts it. Israeli technology often forms the core and guts of foreign products: Telrad technology is used in Northern Telecom products, and DSPC developed chips used in Japanese cellular phones, to name but a few examples.

The trick for a private individual to make money in hi-tech is the choice and the timing: to get into the company while its technology is fresh and the company hasn't incurred massive debt in trying to market itself globally. The whole point of investing via a VC fund is to have the fund locate a number of such companies.

"On the basis of its broad knowledge and understanding of the available hi-tech opportunities and of the global market, Gemini is currently invested in 25 companies," Mr. Sela explains. "This is the difference between investing as a VC fund and as an individual who chooses a single company and hopes for the best."

Nothing Ventured Nothing Gained