Thursday, December 18, 2008

Missing the Target

Many of my peers would disagree with me, but I don’t buy the logic behind the recent “zinook” plan that would have the Israeli government aiding venture capital funds directly. Similar to the original “Yozma” program in the early ‘90s, which seeded the Israeli venture capital industry by providing matching investments in funds that raised capital from abroad, the idea this time to provide matching investments for local VCs and investment institutions. Guy Grimland in an article in TheMarker posed tough questions about the economic rationale behind giving money to already well funded VCs given the non-recourse nature of the investment and the current management fee structure of VCs(although VCs would not take any fee or carry interest from the government’s investment).

My issue is much more fundamental, as it is not clear that it is in the interest of Israeli high tech for the government to give capital directly to VCs. This type of intervention distorts the free market, such that while it props up local VCs, it might not actually help Israeli high tech in the short-term or long-term. First of all, VCs won’t be incentivized to invest during the difficult months ahead, which is when start-ups actually need the extra cash. The same can be said of any loan guarantee program that the government is contemplating. Secondly, such a program benefits disproportionately those local funds who recently fundraised or who need to fundraise in the next 12 months. Thirdly, most Israeli funds also invest in non-Israeli companies, meaning the government could technically be helping Israeli VCs to free up investments for non-Israeli companies.

Beyond these obvious points, I have a hard time understanding what problem everyone is focused on, because the notion of helping Israeli high tech is very vague. For instance, the current cash crisis is not one of not having enough capital in the hands of institutional investors, the same way the credit crisis on Wall Street has nothing to do with banks lacking access to cheap capital. Surely VCs don’t lack capital after $2bn was raised over the past 2 years. The issue as I see it is really one of acceptable risk premium. The capital is available, but nobody wants to take the risk with the opportunities they have on the table.

So what is the government’s aim anyway?

Is the government concerned that local VCs will wither away if they don’t raise capital from abroad? Or is this really about helping local VC direct more money to portfolio companies which have been unable to raise new equity based on their current business plan?

Is the government interested in the creation of new start-ups (e.g. as many new ideas as possible). Or is the government interested in job preservation and creation at existing start-ups? Or is the government interested in creating profitable Israeli exits (this is only the legitimate interest of the VCs and their LPs)?

It’s not clear to me what the goal is, because many of these goals are at odds with one another. For instance, some of the best performing investors will actually have only a small impact on employment if done properly. Ironically, some of the worst performing funds will still be great source of indirect employment as they plough more and more money into capital intensive start-ups. It’s not clear.

Directing capital to VCs with the expectation that they will invest in only the best start-ups, and will do so soon if flawed. I would sooner give this capital directly to start-ups in a similar 1:3 matching with new equity raises. This is kind of the idea behind doubling the Chief Scientist's budget. Also, we all know that high tech is not only about VCs, but also about angel investors, corporate investors, incubators and needless to say, foreign investors(66% of Q3 venture investments)! Unless the government is only concerned about Israeli VCs, there are plenty of other ways to encourage funding of Israeli start-ups over the next 18 months.

First off, the real problem facing Israeli high tech and VCs in current time is the strong shekel, which has ruined start-ups’ budgets even before the global recession and capital crisis began. These small companies raise US dollars and take revenues in US dollars, but most expenses are in shekels. So the rising shekel depletes their cash balance and raised their costs at the same time. Hedging works only to a point, and can be costly with the current fluctuations. A gradual devaluing of the shekel would have the strongest impact of all, but it’s a highly political decision. Conversely, if the shekel continues to rise, no government investment in local VCs will be able to reverse this catastrophic effect on Israeli high tech.

If the government wants to encourage high tech investment and therefore, employment, it should do so indirectly, and by creating various investment incentives and technology demand creation. Here are a few ideas:

- Invest heavily in infrastructure projects that use products developed by Israeli companies (think new telecom and wireless services, renewable energy, where Israeli start-ups are trailblazers, but where the Israeli government sorely lags)

- Allow the Chief Scientist Office(CSO) evolve into an organization modeled after the NIH and DARPA, which gives direction to entrepreneurs/start-ups with grants that are backed up by real world needs (this will also give the incubators something real to chew on, and provide a better ROI than the current Chief Scientist Office grants)

- Allow the CSO fund marketing, sales and business development efforts in high tech companies, instead of forcing companies to invest in sometimes development (which can often be very unproductive)

- Provide tax breaks for foreign owned R&D centers that bring important expertise and skill sets to Israel

- Provide capital gains tax breaks for angel investments up to a certain amount (we must recognize that VCs do not and should not have a monopoly on financing start-ups in Israel)

Longer term, there are many more ideas related to the reversing the brain drain(tax holiday for returnees), and investing in education and job retraining (including English language training and Internet usage), but we need short-term solutions that will have an immediate impact in making Israeli companies more attractive to invest in.

Sunday, December 14, 2008

What to Expect for Israeli High Tech

In Israel, one hears about the sub-prime debacle, bank failures, the plummeting stock market, and now the pending collapse of the automotive industry; but aside from a battered local stock market, all of this sounds uniquely American. Some reason that since this is not a tech induced crisis, high tech in Israel should be relatively safe. Not so. I don’t expect any spectacular failures like we have seen in the US, but I do anticipate a drought in financing for start-ups. What makes Israel’s predicament unique is its dependence on high tech exports as an engine of growth(48% of Israel’s industrial exports are high tech) and a dependence on foreign capital to finance that high tech growth. With a high-tech, export driven economy inextricably linked to the US, repercussions from a deep recession are going to be sobering even for those start-ups still flush with cash.

To begin with, the recession will weaken demand for high tech products. According to a McKinsey study, tech spending in the US generally falls 5-7 times farther than GDP during a recession. The reality is that high tech products are a relative luxury compared to many other products and services. The good news is that tech spending is already close to its historical trend line, suggesting that time will not be as bad as during the tech crash of ’01. As for the developing world, tech infrastructure build-outs are likely to continue, but considering their reliance on debt financing, a slowdown is inevitable.

Just as worrying is Israel’s heavy dependence on external capital infusions to sustain its high tech economy, whether it is venture capital, M&A activity or foreign owned R&D center. Half of all venture funding comes from non-Israeli VCs, and most Israeli funds, are themselves dependent on US-based pension funds, endowments and funds of funds. This combined with the reality that much of Israel’s high tech industry consists of unprofitable start-ups is the reason I don’t subscribe to the view of some in our industry who insist on ignoring what is happening around us. Unfortunately, Israeli high tech will suffer, and the more one understands what’s going on, the more prepared one will be.

Unrelated to the current crisis, for the past several years it has become clear that that it takes much more time and revenue momentum for start-ups to reach a liquidity event. For a while, this lengthened time-to-liquidity simply meant larger financing rounds, venture debt and yet more classes of preferred stock. However, now that capital is scarce, the response of investors will be to restrict investments to those companies that exhibit unique capital efficiencies and companies that have a proven revenue model.

Entrepreneurs and CEOs must react to this new reality, and immediate cost cutting is the necessary triage that will reset a company’s operating burn to a more manageable level. Beyond this, many companies need make difficult strategic decisions regarding market focus, development pace, and growth expectations. And for those companies with a proven business model and consistent revenue stream, growth should be curtailed to bring the company faster to a point of breakeven.

I won’t go as far as some of my peers in saying now is the best time to start a company, because that belies a lot of the difficulties any entrepreneur will face. Now is undoubtedly the most difficult time in recent memory to raise capital, unless of course you don’t really need additional capital. For new companies, entrepreneurs need to move back to basics, including bootstrapping, while emphasizing capital efficiency at every step of the way. Fundraising can be an addiction and a curse, so its best to build a business plan that relies on very little on it.

Even with the discouraging macro-economic backdrop, the current crisis does present opportunities for entrepreneurs and their investors. Start-ups use their small size, efficiency, and agility to respond more quickly to macroeconomic changes, and but also to exploit the temporary failings of larger companies. Unlike larger corporates, start-ups don’t have legacy operations, brands, employees, etc. to weigh them down and distract them. Now in fact is the ideal time for “creative destruction” to take hold and for strong entrepreneurs to make their mark for years to come.

Adversity is part of the business whether you are a VC or entrepreneur, and the current environment is time for each one of us rethink the business plan and goals. So while now might be a great time to start a company, it can’t be just any company. Start-ups at all stages should be practicing prudence and pragmatism, while striving to reach a point where their fate is no longer contingent on external capital sources.

Thursday, December 4, 2008

Some Great Articles on the Great Crash

If you haven't read these yet, here are some great in-depth articles and commentaries on the current economic crisis and how we reached this stage. I will add more as I come across them.

The End of Wall Street's Boom by Michael Lewis

The Great Consumer Crash of 2009 by James Quinn

Why Wall Street Always Blows It by Henry Blodget

Infectious Exuberance by Robert Schiller

Debt Man Walking by John B. Judis

When Sales & Marketing Becomes Scientific

Sales and marketing roles in Israeli companies are often handed off to the proverbial American exec who talks baseball with customers, and who conducts business on the fairway. This continental division of labor can work, but since most start-ups succeed or fail on their sales execution, it’s a real handicap for Israeli entrepreneurs. The reluctance to emphasize sales and marketing stems from an over reliance on technology innovation and a cultural divide between Americans and Israelis, the latter of which feel less proficient at the podium or with the pen. Demanding more emphasis on sales and marketing in the early stages from Israeli entrepreneurs is easier said than done, but there is good news at least for aspiring web and software entrepreneurs as the Internet can bridge this gap.

One of the less celebrated transformations in the Web over the last three to four years is emergence of several robust methods for marketing and selling online. In particular, the search-based advertising revenue model of Google has fostered a entire economic system, and spawned essential web business terms such as SEO(search engine optimization) and SEM (search engine marketing). Good SEO work at inception can result in free marketing on Google/Yahoo!, while smart SEM can provide for a consistent way to profitably acquire customers. Beyond the business of search, it is important to understand that Web businesses with a clear value assigned to each customer are generally willing to pay third party affiliates a bounty on each lead they bring to the business. Such lead generation methods based on CPA offer an attractive way to build a business without resorting to longtail advertising.

As a result of the above, online sales and marketing increasingly look like more of a science than an art, making these disciplines more accessible to the programmer situated far away from his customers. This is a godsend for the quintessential Israeli engineer, who might have business sense, but who still doesn’t relish the idea of direct customer interaction. Some Israeli software entrepreneurs have embraced Internet marketing and sales, but not as much as one would expect. Too many Israeli web start-ups are stuck in the old model of competing for eyeballs…a notion that says a great product will generate traffic growth will which in turn bring advertisers. This can work, but is exceedingly difficult to build scale, and often requires larger upfront investment. It also renders affiliates and search engine marketing, ineffective or irrelevant.

With the recession in full swing, I expect to see a move away from ad-based revenue models and more Israeli entrepreneurs launching “smart” web businesses that use SEO, SEM and affiliate marketing techniques. I also expect to see more software companies utilizing the web to market, sell and distribute products online, rather than a traditional sales model of sales reps in the field. Assuming the company has a subscription/service or product sale business, one may even find user acquisition costs declining as advertisers cut back on spending. In short, entrepreneurs who can master the business of the web can rapidly build a profitable business with minimal investment.

It starts with a proper understanding of SEO, which may determine changes to the product spec and definition. SEO should not be an afterthought, once the product is ready, but part of a market survey before starting development. Secondly, it requires a viable revenue model based on more than advertising, such as subscriptions services, online sales or lead generation. And once a lifetime value can be assigned to customers, it requires strong unit economics around online customer acquisition. And if you really care about this last point, you will actually research things like PPC economics around the hundreds of keywords relevant to your product/service.

Have no doubt about it, online marketing and sales talent exists in Israel. Unfortunately, it is cultivated and concentrated in dubious, yet highly profitable market segments such as online gambling, adult content, and forex trading. These individuals understand and appreciate the unit economics of a strong online business model, including SEM, lead generation and affiliate networks. I have already seen individuals with these skill sets entering the mainstream start-up community, but unfortunately, there are not yet enough entrepreneurs savvy enough to grab them or learn from them.

These days, a good business does not start with a patent, but smart utilization of web business techniques at inception stage. We are in a new economic reality, where capital efficiency trumps even product innovation. For those entrepreneurs ready to embrace a different mode of thought, the web offers truly efficient way to reach and acquire customers.