VCs love doing business in Israel, but most of their money goes to Europe.
Source: Red Herring October 17, 2005 Issue
When venture capitalist Kaj Erik Relander traveled to Tel Aviv three years ago to conduct due diligence on a potential investment, he got a surprise when he arrived at his hotel. The CEO of the computer security company, who was completing his annual military service obligation in the West Bank, was waiting in the lobby in full military uniform with an Uzi slung over his shoulder.
After discussing the business plan, Mr. Relander, a partner in Accel Venture’s London office, casually asked the entrepreneur what he did that day. “‘We broke up five bomb factories and killed three, four terrorists,’” recalls Mr. Relander. “I thought to myself: Whatever he meets in the corporate world can’t possibly be more daunting.”
Impressed by the true grit and entrepreneurial spirit of Israeli tech executives and the country’s technological innovations and business-friendly environment, Accel and other U.S. VC firms are flocking to Israel, sometimes to the detriment of Europe.
So where is the gap?
Accel’s Europe, Middle East, and Africa (EMEA) fund, for example, does 40 percent of its deals in Israel and 40 percent in the United Kingdom, which leaves only 20 percent for the entire European Continent. The four-year-old EMEA fund’s track record speaks for itself: two exits so far in Israel and none in Europe, says Mr. Relander, a native of Finland and former CEO of Finnish telecom Sonera.
“The question is, where is Europe going?” he asks.
“It really boils down to the fundamental political environment, whether it decides that having a thriving entrepreneurial sector is good for society, and how much government and the state has to be involved in governing it.”
The malaise about entrepreneurship in Europe is the opposite of investor attitudes toward Israel, which has worked hard to overcome the reticence of foreign investors to do business where terrorism and political violence are a part of the landscape. In fact, Israel gets such good press for its investment climate that many U.S. and European venture capitalists believe that deal flow and exits are better in Israel than in Europe outside the U.K.
But the numbers don’t support this perception. The amount of equity invested in information technology companies in Europe was 3.5 times that invested in Israel; the number of IT investment transactions in Europe was 5.3 times the number in Israel between the first quarter of 1999 and the second quarter of this year, according to VentureSource data analyzed by London’s TLcom Capital Partners.
Of course, Israel has a population of just 6.2 million, compared to the European Union’s 470 million. For its size, there’s no doubt that Israel outperforms any country in Europe as a center of entrepreneurial innovation. This year, one-fifth of the private companies on Red Herring’s Europe 100 list were Israeli, versus 33 from the U.K. and 10 from France.
While Israel is clearly a vibrant market, Europe surprisingly fares better when it comes to IPOs and acquisitions, according to TLcom’s analysis of a VentureSource database of exit transactions between January 2003 and June 2005. Of a total of 39 information and communications technology venture-backed IPOs between 2003 and the first quarter of 2005, 34 were European and only five Israeli, according to the TLcom analysis.
The same study ranks the top 18 European and Israel trade sales (mergers or acquisitions) by value from January 2003 to the first quarter of this year. Only four of the 18 are Israeli, and only two of those four—System Management Arts, a network and systems management tools company that storage leader EMC bought in February for $260 million, and P-Cube, a connectivity and communications tools company sold to Cisco in October 2004 for $200 million—make the top 10.
When acquisitions from January 2003 to the first quarter of 2005 are measured by return multiples, only two of the top 25 are Israeli, and neither is in the top 10. “If you invest in Europe, you are more likely to get a return and a better return on the capital,” says Colin Watts, a partner at TLcom.
A Better Sales Pitch
So why does Israel get all the buzz? When it comes to marketing itself as a hot tech market and an attractive place to invest, Israel wins hands down. Venture capitalist Johan Pontin, a native of Sweden now living in Boston, has invested in both European and Israeli companies. He recalls how he and a group of U.S. venture capitalists were recently invited to Israel by the government; they were given the red-carpet treatment and access to the country’s top politicians.
“We were told we would be given a special tax break if we invested, and it was made clear that the government was adjusting its fiscal policy to be friendly to venture capital,” says Mr. Pontin, a founding partner in Pod Holding, a private-equity firm based in Boston and Stockholm that invests in information and communications technology companies. “As an investor I find that highly attractive. Compare that to countries like France and Germany. What are they doing? Nothing.”
France actually is trying to make itself a more attractive place for tech startups. It has, for example, adopted legislation that permits independent small- and medium-sized businesses younger than eight years old that allocate at least 15 percent of their budgets to R&D to be fully exempt from corporate taxes, achieve full and uncapped capital gains, give a tax exemption to investors, and receive relief for national insurance contributions for all researchers and R&D managers.
But impressions count. France lacks the reputation and the buzz of Israel, and it has the additional burden of trying to undo a reputation for high social charges, inflexible labor laws, and horrendous bureaucracy. It is no accident, say observers, that most of France’s successful tech entrepreneurs have fled the country.
From the start, Israel created the right environment for venture capital, says Chemi Peres, co-founder and managing general partner at Pitango Ventures and a pioneer of the Israeli venture industry.
Some 133 foreign VC firms invested in more than one Israeli tech company in Israel between 2000 and 2005, including well-known Silicon Valley firms such as Sequoia, Lightspeed, and Greylock, according to the Israel Venture Capital & Private Equity Journal. Tech investments now total about $1.5 billion a year vs. $8.9 billion in Europe. Israeli VC funds provide about 50 percent of investment money and focus mainly on early stage; the rest comes from foreign VCs who focus on B-round or later-stage companies.
VCs also see Israel’s strengths in communications, security, and medical devices. Europe, meanwhile, has no clear leadership role in any particular tech space, with the exception of wireless. Nokia is the No. 1 handset maker; Symbian makes the No. 1 operating system, and Europe is home to three of the world’s largest and most successful mobile operators, Vodafone, T-Mobile, and Orange.
Europe has also pioneered disruptive “free” technologies such as open-source software and VoIP, but many of the founders and the technologies have ended up in the United States. Linus Torvalds, the Finnish founder of Linux, now lives and works in the U.S., Germany’s SuSE was swallowed by Novell, and Luxembourg-based Skype was acquired by eBay in September for $2.6 billion.
Technology continues to be a sideline rather than a major focus in countries like France and Germany, say critics. In contrast, Israel has “had a very unique focus on innovation since the inception of the country, mainly on the military side, to compensate for the lack of other resources,” says Mr. Peres. “From day one, we bet on technology.”
Military Subsidies
The Israeli government has indirectly subsidized the tech sector by pouring tens of billions of dollars into defense R&D, and then allowing entrepreneurs to adapt for commercial use—free of charge—intellectual property developed by the military, says Yoram Oron, general partner at Vertex Venture Capital and the current president of the Israeli Venture Capital Association (IVCA).
This has led to the creation of successful Israeli ventures such as Checkpoint, an Internet security company, and Gilat Satellite Networks, which specializes in satellite-based communications networks. The third phase, which is happening now, is the free flow of intellectual property from the military to the private sector, says Ran Shahor, a general partner at Star Venture Capital Management, which invests in companies in Israel, the U.S., and Europe.
A large number of Israel’s tech entrepreneurs come from army units that focus on high-tech R&D, says Mr. Shahor, the former Military Secretary of the Ministry of Defense who spent 26 years in the Israeli military.
The founders of four of the 12 Israeli tech investments Star Ventures has made in the last two years came out of the same army R&D unit, says Mr. Shahor. “When young talent comes out of this unit they are trained to manage projects in short development cycles, with deep end-user involvement, and on a large scale—making them perfect founders for the high-tech industry,” he says.
Another key ingredient to success, he says, is connected to the national attitude—a certain cockiness that he describes as a lack of respect for authority and overt self-confidence. “If you show a good device to a German engineer he will say he is very impressed. Show the same device to an Israeli and his immediate reaction will be, ‘I can do it better,’ regardless of whether he really is a better engineer,” says Mr. Shahor.
But it’s not just the quality of entrepreneurs that sets apart the Israeli markets from those in Europe, say local and foreign venture capitalists. It’s also the quantity.
The June issue of the Israeli Venture Capital & Private Equity Journal lists 263 tech and life sciences companies founded by serial entrepreneurs. True, Europe has produced a few high-profile mavericks like Niklas Zennstrom, co-founder of KaZaa and Skype, but even the most stalwart defenders of the European tech market agree that Israel has far more serial entrepreneurs than all of Europe. “Risk taking is in the Israeli culture,” says Gil Forer, the London-based global director of Ernst & Young’s Venture Capital Advisory Group.
The reality of everyday life in Israel, which includes terrorist attacks and a variety of hardships, means that people live in an almost perpetual state of crisis, a perfect breeding ground for entrepreneurs, say observers.
And Europe has successful large technology companies such as Alcatel and Siemens that provide secure jobs for talented technologists, an alternative that Israelis don’t have.
Fear of Failure… and Success
And, says Israeli tech entrepreneur and investor Yossi Vardi, “In Israel, failing in an honest way is not a disgrace—if you fail it means that you have gained in experience.” In Israel, people are more willing to take risks than in Europe.
“In Germany, if you fail you are shamed; in England, it is an embarrassment. But in the U.S. and Israel, it is a badge of honor,” says Mr. Vardi. In the 1960s, he founded Advanced Technologies, which was at the time Israel’s largest software company. He went on to become the founding investor and chairman of Mirabilis, the creator of the popular Internet communications program ICQ, which was purchased by AOL in 1998 for a reported $400 million. In Israel, financial success such as Mr. Vardi’s is celebrated. The problem with Europe, says Accel’s Mr. Relander, is that neither success nor failure is accepted.
Another important element in Israel’s favor is that the tech sector there, like Silicon Valley, is a close-knit community. “You are either a friend or an enemy of everybody,” says Mr. Vardi.
The combination of a compact local community and close ties to the U.S. market and U.S. investors means that there is a lower chance that two companies in the same region will try to reinvent the wheel at the same time, says Sven Lingjaerde, a Geneva-based founding partner of Vision Capital and a founder of the European Tech Tour, a nonprofit association that has linked foreign venture capitalists with entrepreneurs in Europe and in Israel.
The same is not true in Europe’s fragmented market. In Europe, “there are 2,300 tech companies, and when you sprinkle them around the map of Europe you end up with lots of companies reinventing the wheel everywhere,” says Mr. Lingjaerde.
Large European countries have somewhat of an advantage with a large local market, but that can also translate into a disadvantage. Entrepreneurs in these countries often don’t think globally from day one; Israelis do because they have no choice.
Europe has the edge over Israel in one area: biopharma. While Israel is strong in medical devices, biotech has remained under-funded, says Batsheva Elran, a partner in Medica Venture Partners, one of the largest and oldest healthcare funds in Israel. But the drought could be ending. In 2004, four drugs that stemmed from Israeli innovation—including multiple sclerosis treatments Rebif and Copaxone, Alzheimer’s treatment Exelon, and chemotherapy drug Doxil—led to over $3 billion in sales for the companies that developed the medications.
Capital Market Reforms
While Israeli startups have suffered from a lack of exits, Israeli companies actually fared better as a whole then their counterparts in Europe and the U.S. Based on TLcom’s analysis of IPO and M&A data from 2003 to the second quarter of 2005, the median exit in Israel was $34.8 million, compared to $29.5 million in Europe and $34 million in the U.S.
The data shows that Europe and Israel produce a disproportionately high number of good exits relative to the capital invested. But the market perception is distorted by the number of companies that originate in Europe and Israel, but are registered in the U.S. in an effort to improve their access to the U.S. exit markets, says TLcom’s Mr. Watts.
Both Israel and Europe share the same problem: The Nasdaq bar has been raised and Sarbanes-Oxley disclosure requirements make it much more expensive to go public in the U.S. So far, domestic exchanges have not successfully attracted young tech companies. However, Israel and some European countries are taking steps to change that.
The IVCA is working with the Tel Aviv stock exchange to develop a market for young companies to go public there, says Pitango Venture’s Mr. Peres. Rules about the distribution of shares, the amount of money to be raised, and the dilution during an IPO need to be adjusted for young tech companies, he adds.
Mr. Peres also believes that tax advantages need to be introduced to mirror those offered to technology innovation IPOs on London’s AIM exchange for small companies. AIM is proving very attractive for Israeli tech companies; last year, 14 of AIM’s 180 IPOs were Israeli companies, says Mr. Peres.
For its part, France is set to decide within the next three months whether it will offer significant tax incentives to investors in young companies that list on the French stock exchange, says Philippe Pouletty, a French serial entrepreneur and co-founder of Truffle Ventures in Paris. Without a major move to improve stock market conditions in Europe, he and others are predicting that more companies will move out of Europe.
Curing What Ails Europe
Fixing its capital markets won’t be enough, though. Europe would do well to take a leaf from Israel’s page and start becoming more business-friendly if it wants to capitalize on its innovations, say observers. “We are in a situation where a Labor prime minister in the U.K. is explaining what a market economy is to central European governments, which is a bit strange,” says Accel’s Mr. Relander.
But despite obstacles, which include tax issues, lack of a Nasdaq-like exchange, conservative take-up of information technology by businesses, and a culture that does not encourage entrepreneurship, Europe is doing better than most people give it credit for, argues Jean-Bernard Schmidt, head of Paris-based Sofinnova Partners and a former head of the European Venture Capital Association.
All it needs is a few more visible successes, such as Skype’s sale to eBay, he says.
The Skype sale follows Yahoo’s $575-million purchase of French price-comparison web site Kelkoo in March 2004. Both European companies got U.S.-sized valuations and Mr. Schmidt says he sees more deals like this in the future.
Another good sign: U.S. venture firms that never invested in Europe—such as Draper Fisher Jurvetson, Bessemer Venture Partners, and Highland Capital—are now doing deals directly in Europe. “There are two reasons why they are coming now,” says Mr. Schmidt. “They are finding that there are good deals in Europe, and they are finding in Europe better deals than they find in the U.S.”
There is evidence to support his theory. Europe and Israel have seen more IPOS with 10-times returns than has the U.S. over the last 30 months, according the VentureSource data analyzed by TLcom.
So why is it, then, that European VCs still point to the historical scarcity of high-value exits for venture-backed companies in Europe as a main cause for the disappointing performance when compared to the U.S.?
Limited partners need to get with the times, argue TLcom’s Mr. Watts and Sofinnova’s Mr. Schmidt. “The future is not just an extrapolation of the past,” says Mr. Schmidt.
The situation in Europe is improving drastically, agrees Gerry Montanus, a senior partner for 21 years in the London office of Atlas Venture, a $2.2-billion fund with offices in the U.S. and Europe.
“We now have the luxury of serial entrepreneurs, a vastly matured venture capital community, and we are starting to have big success stories,” he says, pointing to the Netherlands’ TomTom, which makes navigation systems for cars. The company had a market cap of $1.9 billion when it went public with no venture backing last June.
In the past, European startups suffered from under-funding and VCs with a too-local point of view. No more, says Mr. Montanus. More international VCs are entering the market, and whether it’s Accel, Benchmark, or Sofinnova, they all have the same ambition: build an international company. And if that requires moving a company’s headquarters to the U.S., then so be it.
In Europe, you may need to mine a little harder to get to the gold, but it’s there, says Mr. Watts. He points to Red Herring 100 company Media Lario, an Italian space and defense firm that makes mirrors for X-ray telescopes. TLcom recognized that the technology could help chip manufacturers move to the next generation of lithography, an application Media Lario had never envisioned. Intel agreed to co-invest, as did Draper Fisher Jurvetson. Switzerland’s Vision Capital came in as a secondary investor. A high-profile U.S. executive was brought in to run the company, and business is now flourishing.
“VCs here have to really roll up their sleeves,” says Mr. Watts. Not all of them do, however. Skype’s CEO has complained to the Swedish press that because he could not raise money in his home market, foreign VCs benefited most from his exit.
Waking the Sleeping Beauty
Some observers say there is reason for optimism. TLcom’s analysis shows a marked decline in the proportion of venture-backed liquidations from the first quarter of 2003 to the second quarter of 2005, particularly in Europe—an indication that venture portfolios have been cleaned up, says TLcom’s Mr. Watts.
Looking forward, he says investors agree that a significant number of high-quality European companies have made it through a very tough period and are now enjoying rapid and significant revenue growth. This includes communications companies such as Switzerland’s Esmertec, which announced its intention to go public September 16, as well as semiconductor companies like Icera (a Red Herring 100 company), which was founded by serial entrepreneur Stan Boland.
Sofinnova’s Mr. Schmidt sees a whole crop of biotech companies coming of age. And expect to see some disruptive technology emanating from Europe in spaces such as nanotech and clean energy, says Vision Capital’s Mr. Lingjaerde.
If Europe can emulate Israel and get the “food chain” right—including the business environment and the VCs, “then you can give the kiss to the sleeping beauty and get results,” says Mr. Lingjaerde.
With Israel in full battle gear and gunning for capital, Europe’s sleeping beauties had better wake up soon.
