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.

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