Monday, March 30, 2009

Marching to a Slightly Different Beat

A recent TechCrunch post by Sarah Lacy raises some interesting questions about Israeli high tech, in particular why is Israel seems to be limited to small exits and why have venture capital returns been poor relative to the top US funds. One can’t compare venture markets at a given moment in time without taking into consideration the fact that Israel is primarily a market for technology start-ups. By technology companies, I refer to those start-ups founded by engineers, and whose personnel consist almost entirely of engineers until a product is finally ready to enter the market. These are companies which requires 2-3 rounds of financing to complete R&D, and which differentiate themselves from the competition based on a technological edge. Whether in the US or Israel, technology companies have a longer gestation period and require more capital to reach revenue stage, hence making them more sensitive to market cycles. Those who invest in the early stages of technology companies, including most of the Israeli venture community, will therefore have longer gestation periods of their own until meaningful returns (or losses) can be demonstrated. However, Israel has some additional attributes that exacerbate this overrepresentation of technology companies in the start-up market.

Entrepreneurial Engineering Culture: Unlike the US, there are only few billion-dollar tech entrepreneurs to look up to (and maybe only one associated with a founder’s name), but literally hundreds of entrepreneurs who sold the equivalent of a prototype technology for tens of millions of dollars. These entrepreneurs are successful, but did not build successful or scalable businesses, and may or may not have made their investors money along the way. On the whole, Israel is not yet a market for building highly profitable and scalable companies, but still a technology heavy market that serves as an outsourced R&D lab for the world’s largest corporations. This situation is a product of Israel's engineering oriented entrepreneurial culture, where there is a desire to be recognized foremost for their technology brilliance. As a result, many Israeli entrepreneurs are centered on developing a clever technology, and not necessarily on developing a clever business backed up by strong technology. They want to be hailed a genius, and to be rewarded handsomely by being acquired by a large American corporation, or simply selling the patents. This is far more prestigious in a market overrun with engineers, and let’s face it…its easier and more gratifying to explain to mom how someone paid you millions for your cerebral prowess, than talking about EBITDA margins and growth. My cynicism aside, not all entrepreneurs are really focused on building a profitable business, and this has to change.

Spoiled by Tech M&A: The myriad technology acquisitions of Israeli companies with little or no revenues (not to speak of profits) has created a vicious (or virtuous) cycle that engenders yet more technology oriented companies, entrepreneurs and technology exits. I can write all I want about the need to focus on building and financing real businesses and leaving technology to the labs, but then bankers and corporate M&A teams come an pay outrageous sums for early stage technology companies! Looking at acquisitions over the past four years, one will find that in 90% of these deals, valuations were not calculated based on revenue multiples (let alone EBIDTA multiples). Entrepreneurs and their VCs are spoiled by these acquisitions because, devoid of financial metrics, building and navigating such companies is incredible difficult. In this market, its downright impossible. Moreover, these types of pre-revenue tech exits create a false hope for hobbling start-ups, their entrepreneurs and investors.

Billion-Dollar Companies: Many Israeli VCs are culpable in focusing entrepreneurs to focus on technology, rather than on a smart business strategy and early revenues. A lot of the problem stems from what I see as a quixotic quest to build a “billion dollar company.” This pressure in turn comes from limited partners of VCs, who see billion dollar exits as the only way to ensure strong venture returns managing hundreds of millions of dollars. They may be right, but how can investors possibly recognize such opportunities as seed or Series A investor? The result of insisting on billion dollar opportunities, is throwing lots of money at very risky, early stage bets. If companies raised less capital, and were more efficient and productive with that capital, we could focus on hundred-million dollar companies and give everyone fantastic returns.

Selling Too Late: I have often cringed at the notion that Israeli entrepreneurs and their VCs sell “too early”, although I assume there are a few corner cases like this. I have never seen data to back-up this assertion, but presumably the argument is that if everyone has a bit more patience, exit valuations would rise and we would have more Checkpoints, ICQs and Comverses. Those who put forth this argument probably have a certain start-up in mind, but few ever mention a company’s name or can point to the absurdly low valuation multiple at the time of sale. Because the vast majority of exits are pre-revenue companies sold at decent prices, the idea of waiting for the company to be valued based on revenue and EBITDA multiples is pretty bold. And if the argument is that the valuation multiple was too low at the time of sale, we should remember that such hindsight is only relative to current market conditions and valuation multiples. I mean are any company’s valuation multiples really better in today’s brutal market? I am sure there are also a handful of companies that might have had a good shot at maintaining their independence and growing into large public companies, but these are certainly the exception. I argue the contrary, as I come across too many tear jerking stories of companies who recently closed their doors or who were forced to sell in a firesale, several years after refusing to be sold at ostensibly very attractive valuations. I hesitate to name names, because of the confidential nature of this business, but they are legion and everyone knows at least one. The reality is that most sectors go through a certain hype cycle, and those fortunate enough to be ahead of the curve and to recognize it, can capitalize and find riches. If we Israelis are guilty of anything, it’s sometimes believing our own hype and failing to capitalize on it in time when an exit opportunity appears.

No Israeli Growth Capital: The final unique attribute about the Israeli venture market is the absence of growth capital, which is really a prerequisite to building large and lasting companies. However, the reason there aren’t any late stage VCs is not because they have yet to discover Israel, but rather because there are so few late stage Israeli start-ups and few that meet the investment criteria of growth capital investors. Many exciting companies are acquired ahead of building a business, but there are other factors at play. I often get the sense that because some entrepreneurs can almost taste the exit proceeds, many of them approach late stage financing as if they were really negotiating the sale of the company. By this I mean, their goal of price optimization eclipses their goal building a business plan that can justify late stage financing and high valuations.

As similar as they are to one another, the US and Israel venture markets are still apples and oranges. These 5 attributes of Israeli venture capital reinforce one another and provide some explanation for why venture returns might not reflect those in the US. It also explains why it is so difficult to build large Israeli companies; namely, because we are so good at selling technology companies. This is a far better situation than almost any other geography worldwide, so we shouldn't be ashamed, or abandon it. However, I do believe that entrepreneurs and VCs should focus one another on gradually getting out of this cycle of technology sales, as it is the natural evolution of Israeli high tech.