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Assimilation and self-denigration: a risk to Israel's risk-capital industry31/01/2006. Source: Israel Venture Capital Journal (IVCJ). Roni Hefetz, Founder and General Partner, Walden Israel
 In this IVCJ article, Roni Hefetz, founder and General Partner of Walden Israel, advises Israeli start-ups to exercise caution when seeking funding from US venture firms. He contends that while there are many potential advantages, they sometimes come with a high cost.
In early June 2005, a delegation representing leading US venture capital funds visited Israel. Among the guests were some of the leading Silicon Valley venture funds including Accel, Austin Ventures, ComVentures, LightSpeed, Mayfield, NEA and USVP. These funds – which manage an aggregate of $30 to $40 billion - have been responsible for the creation of such companies as Cisco Systems, Google, eBay and many others that represent the growth engine of the American economy. The delegation also included Grove Street Partners, which represents some of the largest pension funds in North America, and SwissRe, one of the world’s largest financial institutions.
What were they looking for in Israel?
One thing’s for sure – they didn’t travel all the way to Israel for the good weather or the smell of the eucalyptus in the spring. They have plenty of both in California.
They came looking for deals.
I will not discuss in this forum the outworn subject of how "little Israel" manages to create so many attractive technology investment opportunities – so much so that the premier league of American VCs comes all the way here to look for them. It is sufficient to note that there is no similar phenomenon anywhere else in the world.
Rather, it is important to examine the extensive track record of investment in Israeli companies by US VCs in order to draw conclusions and, hopefully, make this cooperation work even better in the future. Have we learned from the past? Have we tried to analyze in-depth case studies of these investments? The success stories? The failures? Are there specific causes for success and failure? What specific conclusions can we draw from such analysis?
Having been part of the Israeli VC industry for more than a decade, I believe the answers to these questions are far from obvious. However, the absence of clear analysis is not enough to prevent managers of Israeli venture funds from setting as a major strategic objective the "convincing of a US fund to invest in their Israeli portfolio company." I often see Israeli CEOs spending precious months traveling the US, only to realize that their efforts are in vain, at which time they revert to local Israeli investors.
Such strategy i.e., attracting a US VC investor, appears at first glance to have a sound rationale, which may be explained by any of the following three (possibly more) conjectures: First, the "Good Housekeeping seal." An investment by a top-tier US VC firm is perceived as "kosher certification" both for the portfolio company and for the Israeli VC that had previously financed it. If the US VC who financed Google agreed to back my company from Migdal Ha’emek – so the argument goes – then clearly we must be doing the right thing.
Secondly, the "added value" argument. Financing by a US VC fund, located in the portfolio company’s main target market, provides the Israeli company with incomparable relationships, invaluable know-how, and intimate acquaintance with market needs and experience. Thirdly, "availability of capital." American VC funds have very deep pockets. They have the means – alone, if necessary – to support the entire financing needs of the company, over a long-term period, until the sought-for exit. . . . The unfortunate bottom line: the aforementioned considerations have produced a troubling phenomenon of assimilation and self-denigration on the part of Israel’s venture funds that often serves neither their own interests, nor those of the companies in which they invest. In spite of the advantages enumerated above, I believe that assimilation and willingness to adopt the American way of venture thinking do not necessarily represent the preferred path. Indeed, if not handled properly, bringing US VC partners into Israeli companies may often produce significant negative consequences, either for the US venture fund involved, or for the Israeli VCs – or both. How is this so?
Shifting management and resources from Israel to the US. US VCs generally want to have the company’s CEO right next door. As Sequoia’s Michael Moritz put it in a speech at a technology conference in Israel, his firm likes to invest in companies that are "within a bike ride from their offices." If that wish is too difficult for the Israeli founder/CEO to accommodate, the result is often a US CEO, preferably one known to the US VC. The logic is clear: Venture capital is a business for risk avoiders, not for risk lovers – and having the company and its management close by is perceived, correctly, as reducing risk. I, too, do not like to invest in companies that are in remote locations. The important point is that venture capital is fundamentally a local business. A highly successful Israeli CEO in Netanya or Carmiel can become a dismal failure once s/he relocates to San Francisco or Boston. In his or her own environment, this manager can flourish, create, inspire and show leadership, but once uprooted, there is a fair chance that productivity will deteriorate quickly. In the words of the poet Tchernichovsky, "A man is nothing but a reflection of his environment and his land." Likewise, a highly successful US CEO may fail when faced with the challenge of leading a group of Israelis located 10,000 miles away and who live and create in a totally different culture. In such circumstances, a US CEO’s performance will very likely deteriorate and his true managerial potential will never be realized, as experience has shown time and time again.
Over-funding: Israeli companies that manage to raise funds from US VCs often raise more money than they would have otherwise raised in Israel. In most cases, they also raise more than the company needs. There are three reasons for this over-funding:
First, most large US VC funds have a minimum investment requirement. A lesser amount will not justify the VC’s attention. Accordingly, if an Israeli start-up has cash needs of $3 million, and the US VC’s minimum requirement is $10 million, the company will have raised $7 million over and above its needs.
Second, when management is moved to the US, expenses rise quickly. It is well known that the operating culture of Israeli companies – for better or worse – is that of lean expenses, improvisation, "cutting corners," creativity and resourcefulness. The operating culture of US start-ups is much more a "by the book" culture. Early in the life of the company, the CEO needs a VP of Sales, a VP of Marketing, and VP Business Development, in addition to the VP of R&D, VP of Finance, etc. I have even seen a sales VP hired, just to learn that the VP sales does not actually sell, but rather s/he manages the sales people – even in a very small, start-up operation. All of this staffing carries a high price tag – cash burn rate is much higher, without a corresponding increase in cash income from revenues.
Third, over-funding increases the company’s "post-money" valuation and therefore could delay an exit. If, for example, an investor expects to make a five times return on his investment, then an exit at a $100 million valuation would satisfy his return expectations if he had financed the company at a $20 million valuation. If, instead, the company raised a much larger round of financing at, say, a $50 million post-money valuation, the exit needed to generate the same five-times return would now jump to $250 million, with all that this implies in terms of timing.
Over-funding, therefore, comes at a price. Moreover, in many cases, I have seen that over-funding leads to a culture of waste and inefficient allocation of resources, in addition to suppressing creativity and resourcefulness – which are, or should be, the cultural building blocks of any start-up company. Paradoxically, when a company receives a lot of cash, the outcome could be killing the development as opposed to seeding it, postponing exit as opposed to accelerating it. . . . Experience shows that the great majority of successful Israeli companies were very careful not to "assimilate" in the sense of outsourcing management and raising excess capital. These companies are run by Israeli CEOs residing in Israel. In addition, the majority of great success stories to emerge from Israel are companies that have raised relatively small amounts of capital. Such is the case of Check Point, which raised only $500,000 before its IPO and whose CEO, Gil Schwed, lives in Israel. Additional examples are M-Systems, led by Dov Moran; Syneron – and previously ESC Medical – led by Shimon Eckhouse; Galileo (Avigdor Willenz); the RAD group of technology companies (Zohar and Yehuda Zisapel). The list goes on and on. Conversely, it is far more difficult to identify highly successful Israeli companies whose management teams relocated to the US or ones that have successfully hired an American CEO and became extremely successful.
All of the above leads me to two key conclusions: First, as to location of the CEO. If the company’s board of directors and the CEO himself have reached a well-substantiated conclusion that the CEO must reside in the US, after having considered all the challenges associated with such a move, then that probably is the correct decision to make at that time. However, such a decision would be wrong if it were the result of a demand by a US fund that makes it a condition of its investment, without fully understanding the company’s circumstances. Such a requirement might well serve to lessen a US investor’s feeling of insecurity when contemplating an investment in a remote area. It will not, however, serve the best interests of the company.
Second, as to amount of capital raised: A company needs to raise as much capital as is required to achieve the next significant milestone in its corporate development – for example, completion of a prototype or realization of initial revenues – plus some reserves.
Having discussed the pitfalls of over-funding, a company must reject funding where the amount is a derivative of other considerations, such as the size of the fund making the investment, or the fund’s minimum threshold. The intent of this article is not to express criticism of any particular investment model, Israeli or US. My intention, rather, is to highlight some of the cultural differences, as well as the huge differences in the nature and size of the US and Israeli economies and their respective venture funds, all of which point to the need for awareness and sensitivity when making cross-border investments. The avoidance of detailed analysis, on a case-by-case basis, will reduce the chances of success for Israeli companies in the US market.
We have to remember that the US venture capital industry has achieved remarkable success, during periods of economic growth as well as slowdown, and over long periods lasting several decades. We Israelis who are active in the venture industry have a lot to learn. However, learning is not the same as assimilation. Learning is not self-denigration, nor is it imitation. I am firmly convinced that our venture capital industry can derive tremendous benefits from building close ties with US venture funds that can contribute significant added value to Israeli companies. If we can integrate the unique Israeli know-how, experience and culture with the strong fundamentals offered by US venture funds – we could, and should, stand to gain a great deal more.
This article 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. This article originally appeared in the Hebrew language Ha’aretz daily newspaper in Israel. The translation appeared in IVCJ by courtesy of Ha’aretz. For more information please visit www.ivc-online.com
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