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.

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