PRINT THIS PAGE Technology-focused private equity investing in Israel07/02/2007. Source: Israel Venture Capital Journal. Yuval Cohen, Fortissimo Capital Fund 
There are sharp differences between private equity investing and venture capital investing. In this Israel Venture Capital Journal article, Yuval Cohen, Managing Partner at Fortissimo Capital Fund, explains the distinctions in several key areas. The Israeli venture capital industry has achieved international recognition and great success. As we all know, the formation of this industry was due to several factors, including (i) programs initiated by the government to provide tax incentives; (ii) commercialisation and adaptation of defense technologies; (iii) the establishment of superior institutions of higher education and (iv) a trained workforce in Israel-based R&D centers at leading technology companies. Today there are many venture capital funds, with billions of dollars available for promising technology start-up companies.
In contrast, the infrastructure for investments in more mature technology companies has not developed at the same pace as the Israeli venture capital industry. On the one hand, many of the entities that had invested in mature technology companies in the past have decided to reduce or otherwise cease their investment activities in this area. This group of investors was comprised primarily of large financial holding companies that had made a strategic decision to focus on more traditional or old economy-type investments. On the other hand, the number of technology companies achieving significant sales has increased. Several of these mature companies were able to raise capital from public markets or through private placements. While many utilized the proceeds to enhance growth, they later may experience a point of inflection where additional growth capital is required.
Fortissimo Capital Fund was established in order to address the need for private equity investments in more mature technology companies. Early stage venture capital investments differ significantly from investments in more mature private equity transactions. Below is a brief comparison of venture capital and private equity with respect to various aspects of an investment.
Risk and Reward
When an early stage venture capitalist meets with a company, he or she will often sit with the founders of the company, and the focus of the evaluation is on the team and the idea. Usually, the idea or concept is not yet mature or proven. The venture capitalist must assess the potential of the concept, the ability to achieve the technological breakthrough and the marketability of the proposed product. The venture capitalist must be willing to take technology, market and execution risk.
In contrast, while VCs work with entrepreneurs, late stage private equity investors interact with a professional executive team including a CEO that is managing dozens or hundreds of employees. The company has a proven product with existing sales and a customer base. There is less technology and market risk since a proven product used by many customers is being sold. The main risk is whether the proposed growth strategy can be successfully implemented. To mitigate the execution risk, the private equity investor will often want to obtain control of the company so that he can supplement management and steer the direction of the company.
The way VCs and late stage private equity investors view returns also differs. The return that can be achieved from one single successful seed stage investment is hard to match in a private equity investment. However, a private equity fund is likely to achieve a greater number of exits (due to its risk level) than a venture capital fund and thereby balance out the overall risk/reward ratio.
Deal Structure
Although venture capitalists and private equity investors both try to protect their investments, the way in which they structure transactions differs. Venture capitalists often acquire preferred shares with certain liquidation preferences and veto rights. There are anti-dilution protections that are included in investment agreements, but VCs must consider the dilution of their current equity holdings if they do not participate in future rounds of financing. In addition, at the venture capital stage, the founder will want to maintain a major holding in the company and continue to navigate the company.
Private equity investors usually do not contemplate additional rounds of financing and therefore focus on structuring a transaction to maximize internal cash generation. Private equity investments are often a great deal more complex than VC transactions. Contrary to a deal with founders, when negotiating with mature companies there are often several parties with whom an agreement or arrangement is required, including existing shareholders, the board of directors, banks, and debt holders. Deep knowledge and understanding of financing mechanisms, restructuring, and re-capitalization alternatives are essential.
If the company is public, in order to obtain shareholder approval a detailed proxy statement must be filed with the exchange and distributed to shareholders, which is both a costly and time-consuming procedure. The investment may be structured as part equity and part debt, including a convertible feature that is a hybrid of both structures. This would provide the investor with a secured interest and preference over other equity holders in the event of a liquidation.
Moreover, since later stage companies have revenues, the convertible note may be repaid even absent profitability or other criteria required in order for the portfolio company to issue a dividend. In some situations, especially if the target company is a public entity, non-recourse bank financing may be available to finance a portion of an investment. There are many creative structures that can be utilized in order to enable the private equity investor to enter at an attractive valuation, while providing management of the company with the proper incentives.
Due Diligence Process
Often, a start-up company seeks to raise venture capital financing before it has achieved any sales, in fact, prior to completing even an "alpha" or "beta" of the product. The venture capitalist needs to evaluate the costs required to get the company to a point where it will achieve a certain milestone, so that it can raise additional capital at an increased valuation. There are no actual financials to review, only projections that have been created based on virtually no historical performance. There are no major contracts to review with partners or customers. The business, legal and financial due diligence required is minimal.
In a private equity investment, however, the company being evaluated has a history that cannot be ignored. Extensive business, legal and financial due diligence must be conducted in order to understand the company's current commitments and potential exposures, as well as to understand the bits and bites of the financial statements. During this exercise, often many inefficiencies are uncovered that later result in the implementation of certain improved processes and procedures. In addition, a comprehensive evaluation must be conducted of the company's sales, customers, pipeline, markets, competition, products and personnel. Specific experience and expertise is required in order to effectively sift through mounds of information and pinpoint the important items to be carefully evaluated and understood.
Operations
A seed stage venture capitalist invests in a company with minimal activity other than R&D operations and focuses on building the infrastructure of the company. The venture capitalist seeks to add value by facilitating introductions to strategic partners. The core concern is not cash or profitability, but rather achieving the technological breakthrough. A venture capitalist has the ability to exit a company by selling a dream, prior to having achieved initial sales or profitability.
A private equity investment is made in a company that is conducting sales and perhaps manufacturing across the globe. Cash conservation and achieving profitability are often key factors in its growth plan. A private equity investor does not consider a future private round of financing, but rather seeks to finance the growth of a company using internal cash generation. Immediate action, such as downsizing, restructuring debt, lay-offs, renegotiating more favorable terms with suppliers and consolidating are ways of preserving cash, while investing in growth areas of the business. Operational experience is required in order to successfully implement both cost-cutting measures and a strategic growth plan.
Impact
As mentioned above, private equity investors usually seek to obtain a controlling interest in a company. The underlying principal is that a company's shareholders should serve as an asset and not a liability to the company. There have been instances where several venture capital funds coinvested in a company, and it was difficult to obtain a consensus among all of their representatives on the board. In order for a private equity investor to be able to impact a portfolio company and ensure that proper decisions are taken and implemented expeditiously, often it seeks to obtain a significant holding (via a majority interest or shareholder agreement) and an ability to influence board decisions.
Conclusion
The technology private equity arena in Israel is currently beginning to sprout and can be expected to continue to expand in the future due to the reasons discussed above. There are distinct processes, skills and expertise that are required for successful late stage investing that may be distinguished from venture capital investing. The evolution of the private equity industry will enable many Israeli companies to obtain late stage funding and to further enhance their growth. A successful private equity industry will not only yield gains to the limited partners in private equity funds and the companies that they support, but by building leading technology companies in Israel, the overall economy and the people of Israel will be major beneficiaries.
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. For more information please visit www.ivc-online.com
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