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From Jaffa to Java20/12/2005. Source: Israel Venture Capital Journal. Yaron Polak, Genesis Partners
 Israel's software developers are on the global map, but with changes in the industry, will they continue to have appeal to VC investors? Yaron Polak, Partner in Genesis Partners, provides his insights in this Israel Venture Capital Journal article.
In 1992, Israel's software exports were roughly equivalent to its orange exports. Since then, software exports have increased by more than 2000 percent, and orange exports fell by more than half. Today, the software sector accounts for over one-quarter of all Israeli technology exports. In terms of venture capital, the software sector has attracted almost one-third of all investments in Israel in the past two years.
Recently, questions have arisen as to whether this trend would be maintained. In the last four years we have witnessed a massive consolidation in the global software industry with mammoth transactions, such as Oracle acquiring PeopleSoft. This, combined with the fact that relatively few VC-backed software companies have gone public in the last few years or have managed to break the $100 million revenue barrier on their own, has recently caused some US venture capital firms to question the sector's ability to generate VC type of returns.
The challenges are real, but we are convinced that investments in Israeli software start-ups will continue to be attractive for the VC community. First, Israel is home to a huge amount of software and domain expertise. Second, Israeli software companies have a tradition of capital efficiency, which can boost VC returns.
Finally, Israeli entrepreneurs have repeatedly proven their creativity and their ability to build global companies from the ground up. As a result, Israel has consistently demonstrated strength in the software arena, and it is more likely than not that other Israeli software leaders will emerge to follow in the footsteps of other local software giants such as Amdocs, Comverse, Check Point, and Mercury. These four companies are among the top 25 software companies in the world by market capitalization. In the last decade Israel has demonstrated its ability to produce global software giants.
Check Point's success is perhaps the best known, but it is not the only success story. Amdocs and Comverse, both publicly traded in the US, have over $1 billion in revenue each. Since 1998, there have been more than 10 acquisitions of Israeli software houses valued at well over $100 million including BMC's $675 million purchase of New Dimension and Veritas' $609 million purchase of Precise Software Solutions. As further testament to Israel's software leadership, R&D centres have been established here by global giants including SAP, BMC, Computer Associates, Microsoft, EMC, AOL and Convergys.
What accounts for Israel's strength in software development? Not unlike other segments of Israeli's technology sector, Israeli software has its roots partially in the military, which had a need for both security software and for systems for monitoring and cataloguing vast quantities of data. Israel's expertise in firewalls and call centre software springs from these military applications. Other areas of software strength developed as civilian sectors from day one, such as telecom services and customer care and billing (CC&B). Today, there is a critical mass of software engineering talent in each of these areas and, indeed, many others.
Israel's geographic and geopolitical situation - far from major markets and customers - has contributed to the development of a strong local culture of software engineering. By necessity, Israeli software developers must take into account the many languages, currencies, and compliance environments of customers around the world. Israeli-built software is, from day one, written with the global marketplace in mind. In an increasingly small world, this has proven to be a significant advantage as Israeli software companies seek customers in multiple regions. It is not uncommon for an Israeli software start-up to seek VC funding after it has already multiple commercial implementations in different countries and different languages. The ability of the Israeli entrepreneur to develop software for the global marketplace is unmatched.
In addition, Israeli software developers helped pioneer the use of new technologies, such as rules-based architecture and state machines. They have also consistently been early adopters of modern software architectures such as .NET and J2EE. As a result, software developed in Israel has a well-deserved reputation for interoperability, flexibility and elegant architecture. This contributes to more efficient R&D, scalable software, faster implementations and happier customers.
Leading Israeli software companies have leveraged these advantages, coupled with smart business strategy, to catapult themselves to positions of global leadership. For example, both Nice and Verint offer intelligent multimedia recording solutions based on technology originally developed in the military. While Verint is a leader in surveillance applications in the intelligence community, Nice leveraged its technological strength to take a leadership position in the civilian call centre market.
Israeli software companies that achieve significant success tend to spawn several other smaller companies in their wake. Amdocs, for example, was founded in the 1970s with a focus on Yellow Pages automation. It has grown into a world leader in customer care and billing. The company went public in 1998 and currently trades at a market capitalization of about $5.5 billion. Amdocs paved the way for other successes in the CC&B domain, such as Wiztec (acquired by Amdocs rival Convergys), Mind CTI, FTS, and Maxbill.
Similarly, Check Point's success in the security space is well known. The company was the first to develop firewall technology and is now a leader in the virtual private network (VPN) area. But Check Point is not the only security leader that Israel has produced. Memco (acquired by Platinum, which was in turn acquired by Computer Associates) is another example of Israeli creativity in the security software domain.
Like Amdocs, many Israeli software companies achieve growth by winning in one niche and finding ways to leverage that success into new, related areas. Comverse, which began by offering voicemail solutions for cellular operators, has developed into a leader in several other areas including messaging and data solutions.
Mercury Interactive started out in the load testing and simulation market, but has since diversified into broader infrastructure and application management. Today, Mercury is one of the global players in IT governance. Mercury recently acquired another Israeli company, Appilog, to add to its offering in the application management space. Vertical enterprise applications have also been a fertile ground for Israeli start-ups such as Retalix (in retail enterprise management) and Fundtech and FIS (in financial services).
Important questions and challenges do exist. First, software companies have demonstrated a difficulty in breaking the $100 million barrier in revenues. Second, acquisition valuations of software companies have been depressed recently at around 2X-3X revenues. Third, the ability of global software giants to rapidly replicate and roll-out new services may threaten the ability of new entrants to gain and hold market share. Fourth, enterprise software offerings must meet very high standards of performance and support - and the bar is constantly being raised.
Despite these challenges, there is every reason to believe that Israeli software start-ups represent a very attractive VC investment opportunity. Software investments offer VCs advantages compared with other sectors. Most significantly, software development, if done properly, can be highly capital efficient. It is not unrealistic for a software company to reach profitability at $25 million-$30 million in sales with less than $15 million in financing. The investment required for hardware or semiconductor development is often twice as great, if not higher. Secondly, while software suffers from lower barriers to entry in R&D, it benefits from comparatively high barriers to entry in customer loyalty. Winning a large enter-prise account can be a challenge, but corporations that have come to depend on mission-critical software are unlikely to switch vendors midstream. This can help provide a start-up with recurring revenues and up-sell opportunities that may boost valuations.
Furthermore, buyers of software have come to realize the business value that the right application, or vertical software, can generate for their business. There are still many sectors that can benefit from vertical applications with specific business knowledge that help enterprises gain an advantage over their competition.
With so many success stories and promising start-ups, it is not surprising that software is still an area of high attraction for the Israeli VC community. Ultimately, the success of the software sector in Israel will depend on the strength of its software developers and entrepreneurs and their continued ability to achieve higher capital efficiency than in other countries. In that regard, there is no doubt that Israel's future in software is bright.
The country is home to development teams with exceptional domain expertise in a wide range of areas and hundreds of aggressive entrepreneurs and seasoned managers who have succeeded in the past and are now looking for their next big opportunity. There is every reason to believe that the innovation, creativity and technical expertise that propelled Israeli software start-ups in the past are as strong as ever and that the next Check Point or Mercury is just around the corner.
Yaron Polak, Partner, Genesis Partners.
This article first appeared in the Israel Venture Capital & Private Equity Journal (IVCJ). IVC Research Center publishes the Israel Venture Capital & Private Equity Journal, a quarterly review of trends and developments in the Israeli-related venture capital industry. IVCJ, distributed worldwide, is dedicated to provide wide-range coverage of Israel's venture capital industry. For more information please visit www.ivc-online.com
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