The US VC industry emerged during the 40s and passed through a number of evolutionary phases in which it gradually learned the VC business e.g. how to screen companies, how to sell companies or to undertake an IPO; how to contribute Value to the company, how to build large companies, how to forge strategic partnerships and how to become global. According to Chemi Peres of Polaris, the Israeli VC industry underwent a similar process but within a much more compressed time frame-one rather than four decades38
We can distinguish between three distinct phases in the evolution of Israel’s VC industry: Phase 1 (1993-96) during which the direct impact of the Yozma took place and during which we can talk of VC industry emergence; Phase 2 (1996-99);
and Phase 3 (1999-2000) where Israeli VC funds are establishing offices abroad and investing more and more in non-Israeli hi tech companies.
3.1 Phase 1(1993-96)
Yozma Funds were sponsored jointly by domestic and by foreign financial institutions. VC fund size was small—about 20 $million; did not have experience and invested largely on the basis of intuition with relatively little knowledge about specific segments/areas of industry; and they invariably co-invested with other funds (in order to spread risks). The foreign organizations helped manage the funds and promoted a learning process. Israeli VCs learned how to undertake VC transactions, how to undertake ‘due diligence’, knowledge of the market, etc. Funds without foreign partners learned from those with foreign partners through co-investment (“Collective Learning”). During this process, Start Up companies themselves also learned how to work with VCs and what VCs could offer them in addition to finance.The objectives of funds in the first phase were to exit through M&A i.e.
through sale of the Israeli Start Up to a (usually foreign) large company. Large numbers of such transactions took place at low values (between 10-70 $ million). This is the easiest way of “exiting” and therefore the standard one adopted during this period.
3.2 Phase 2(1996-99)
During the second phase a larger number of corporate Strategic Partners began to participate in the funds, as well as institutional investors such as Pension Funds.
Most of the effort was devoted to develop links with Investment Banks (and with the most important Analysts in US investment banks) since the objective was to ‘exit’
through IPO rather than through M&A. During this period, VC funds were larger (around 100 $million) with a large component of important international organizations. VC fund managers became more experienced and they better
marketing capabilities since, for floating, a company needs a selling product (although it need not be profitable). In contrast, most M&A are based on the technology and technological excellence of SU and of its staff.
38 Interview Sept 2000.
understood the business. They succeeded in generating ‘value added’ over and beyond the equity they purchased; and they realized that it was not enough to identify good companies. They also spent more time with each individual portfolio company. They discovered that there could be problems with Start Up managers so they devoted more time to build up the Management Team of portfolio companies. Finally, they realized that selling a company is not the wisest move that the challenge is to help companies grow. This means that they increasingly had to relate to the market. During this period we also see a process of generating links with US Venture Capital companies. This would enable utilization of those companies’ strategic links with clients and other organizations. At this stage we see the beginnings of investments not only in Israeli Start-Ups but also in Israeli-related companies e.g. US companies founded by Israelis.
3.3 Phase 3(1999-2000)
In this phase VC funds were larger—over 200 $million; more partners in particular US partners; establishing offices abroad (today all leading VCs have offices in the US, in Europe or in both). There is an increased emphasis in linking directly with Strategic Partners like Nortel, Cisco, AOL, Yahoo, etc.; and continued and enhanced efforts at understanding the market. Correspondingly, there are less links with Investment Banks (also by then Investment Banks by themselves would offer their underwriting services to good Israeli Companies). This reflects the fact the Israeli companies by then already acquired an international reputation. In those circumstances any inquiry of an Israeli VC concerning IPO of one of its portfolio companies would lead the Investment Bank to check the company. In this phase, competition is Global Competition, and good Israeli companies know how to ‘reach’
or ‘access’ US VCs alone; and the latter also directly search for good companies in Israel. US VCs have an advantage that they know better than Israeli VCs how to search for good managers in the US. They also have better links with Strategic Partners; and better knowledge of the market. Israeli VCs try to link directly to Strategic Partners (and not through US VC) who frequently are also investors in their funds. We can say that the objective here is not only to exit (including the option of doing so through an IPO as in the previous phase) but also of building large, indigenous companies. This means carefully nurturing and building companies from the SU phase up to even after the IPO. In this last phase, the leading Israeli VC companies are not so different than US VCs. They also start investing in Israel-related companies (e.g. in the US) and not only in Israeli companies.
Comment
The above description suggests that a significant evolutionary/systemic process underpinned the remarkable quantitative growth of Israel’s VC industry and high tech cluster of the 90s. Considerable learning took place, including ‘collective learning’ and ‘learning from others’. Beyond increased proficiency in their contracting with SU and investors designed to avoid conflicts of interest and agency problems (not surveyed here), VC s increasingly learned how to provide value added to portfolio companies and how to ‘exit’. VC efficiency also benefited from the appearance of ancillary service & input suppliers (to themselves and to the high tech industry as a whole); from economies of scale & specialization; and from increased networking (including with outside agents).
These qualitative changes are basic for our understanding of the successful VC-SU co-evolutionary process, which are central for our understanding of the new high tech cluster of the 90s.39
SUMMARY & CONCLUSIONS: CO-EVOLUTION AND CLUSTER DYINAMICS This paper analyses Background Conditions, Policies and the processes leading to Emergence of Israel's Venture Capital Industry in the 90s. The approach adopted is explicitly a Systems/ Evolutionary Perspective focusing on integrating the 'classical way' of approaching Venture Capital with the broader High Tech Cluster; and on the links between VC and SU. This forces us to identify phases in the VC industry, to discuss 'collective learning' and cumulative effects, etc.We end up identifying and to some extent characterizing Israel's 'model' of Venture Capital emergence and development; and some aspects of the 'Silicon Valley' model of high tech which developed there in the 90s.
Background Conditions and Horizontal R&D incentives
Israel's Venture Capital industry and high tech cluster of the 90s is an outgrowth of high tech as it developed during the seventies and eighties and which involved a significant Military-oriented component including a high share of Defense R&D in aggregate National R&D. Civilian high tech industry grew in parallel to the Military oriented component, although initially at a slower rate. Both components of high tech reinforced each other till the mid eighties (when severe resource constraints dampened further development of the military component, a fact which led to a successful shift of resources to 'civilian' high tech). During this period a large technological infrastructure was established; and a significant process of Learning in connection with Civilian R&D
& Innovation took place. It was a period were Civilian oriented R&D/Innovation activities and R&D/Innovation Capabilities penetrated and were diffused throughout the Business Sector. Hundreds of companies, large and small, were performing R&D on a routine basis towards the end of the 80s. They had learned how to search for good R&D projects, search for market information, link Marketing & Production to R&D, shift from 'simple' to 'complex' R&D projects as well as learning how to manage the innovation process as a whole. All of this led to an R&D- performing segment of the Business sector; and also to a clearly identifiable Civilian oriented, and 'Electronics'-oriented, High Tech industry. This practical 'collective' knowledge about R&D and innovation within the Business Sector was the basis upon which the future Venture Capital industry grew. Also many VC Company founders' (and also an important share of SU of the 90s) were individuals who had prior experience with the Electronics Industry of the 80s.
Underlying the high tech success of the 80s was a very successful R&D support scheme, the 'backbone' Industrial R&D fund, whose implementation began in 1969/70 through a specialized Government Agency set at the Ministry of Industry and Trade: The Office of the Chief Scientist (OCS). Creation of this bureau was probably one of the most momentous events in Israel's Innovation & Technology Policy. Though its successful implementation of such an R&D support scheme --an Horizontal Program oriented to the business sector as a whole; and involving 'Neutral' incentives-- the OCS made a substantial contribution to the Electronics Industry of the 80s and to the new
39 This paper has only scratched the surface of these matters. The accompanying paper (Part 2) deepens the analysis by focusing on individual companies and funds: ascertaining private performance and social impact on the one hand; and characterizing founders & managers, capabilities & strategies on the other.
high tech cluster of the 90s. Implementation of the backbone R&D support scheme succeeded not only in providing incentives to R&D but also in generating the Collective Learning Processes underpinning the above-mentioned broad set of R&D/Innovation Capabilities. Moreover, the successes and weaknesses of what was almost a single program of Government support, and the changing environment-- particularly as regards to Globalization of Capital Markets and the emerging possibility of launching IPOs of young SU companies at NASDAQ-- led during the early 90s to the string of new Government Programs associated with the emergence of Venture Capital.
Targeted Cluster-Creating Policies
Despite the above successes and the increased numbers of SU created during the late 80s and early 90s, serious problems concerning their survival and growth emerged. The rate of failure of SU companies did not increase during this period.; and it gradually began to dawn to policy makers (particularly to the Chief Scientist at the time) that the 20 year old R&D support scheme while necessary was not any more a sufficient condition for further development of High Tech. The real problem was successful transition to the post SU phase of new company growth; and the crux of the problem was identified as non-existence (with some exception) of a special financial institution developed in the US during the preceding two decades--Venture Capital. Venture Capital not only provided resources through the purchase of equity of SU companies; it also provided important value adding functions & activities such as management, head hunting, R&D & Strategy focus, links with clients and Strategic Investors, and last but not least a channel for linking both to public (i.e. stock market) and private (M&A deals, particularly with MNE) capital markets. While Capital Markets were becoming global not every country could exploit the new opportunities; and at that time the creation of a domestic Venture Capital industry was an essential pre-condition which Israel (in anticipation of other peripheral economies with a technology & skills orientation) readily generated.
Given the above-mentioned favorable background and new challenges, the mechanism for triggering a domestic Venture Capital industry was a Targeted VC support program entitled 'The Yozma Program' where a 100 M $ Government VC company was set up early in 1993. Of these funds 80 M$ were invested in 10 private funds of approximately 20 M $ each (where Government held 40 % that is 8 M$) with the remaining 20 M$ being invested directly by a Government Fund ('Yozma'). The program incentives were directed to a particular sector--Venture Capital--rather than to the Business Sector as a whole. A condition for being part of the program was the involvement of a reputable foreign Financial Institution together with a reputable local Financial Institution. The incentive, beyond Government’s risk sharing with private investors, derived from the possibility of purchasing the Government share approximately at cost (strong incentives to the upside i.e. whenever VC ‘exits’
generate substantial profits—which in most cases they did). Yozma directly generated 250 M $ which were invested in the following 1-3 years in over 200 portfolio companies. The high and rapid returns obtained by these funds (the result of some very successful 'exits' both IPO and M&A) stimulated a Schumpeterian 'swarming' process were both follow up funds to existing VC companies and completely new VC companies entered the market. These, the earning of the first round of new companies, and the enhanced reputation of Israel's new high tech cluster increased considerably the rate of SU creation, and the numbers of successful 'exits'. Thus a self sustained growth process, of cumulative nature, set in. This would correspond to the 'Reproduction' phase of Evolutionary Processes. It is important to point out that the policy process leading to
Yozma began in the early 90s; that several alternatives were probed including another Targeted Government Program (Inbal) with only very limited success (Variation); and that a lot of search and even policy relevant research took place before 'Selection' of the Yozma policy configuration took place.
A VC-SU Co-Evolutionary Dynamic Process
The data reported above and other evidence shows an interesting dynamic sequence involving VC- SU co-evolution. It involves three ‘phases’ and looks as follows:
Significance Pre-emergence activity(prior to 1992): existing or new SU – we estimate that between 80 and 143 were founded in 1991-2 only; preliminary successes with IPO s in Nasdaq -about 12; some Limited Partnership typeVC activity (Athena/Veritas & Star) & VC-related activity by other institutions and key individuals (Adi Shalev, Jay Morrison & others)—all of this generated conditions for the implementation of Yozma
Policy-Induced Creation of Critical Mass: Yozma generated a discontinuous jump in VC and VC & SU–related activity during 1993-6: large increases in VC capital raised, and about 250 new VC-backed companies compared to about 30 VC-backed SU during 1991-2;
Cumulativeness & Steady Growth: the above led tto sharp increases in exits particularly IPOs in Nasdaq during the First Phase of the VC industry: in 1996 these amounted to 24 against 12 per year between 1993-95; and these in turn generated a self-sustained process of steady growth characterized by: significant increases in the number of start ups (greater incentives to entrepreneurs to found SU companies);
increases in the number of SU which grew beyond the SU phase; further entry into the VC industry; and sharp increases in public offerings and M&As.40
Structure of Exits: The relative importance of IPO s and M&A s seemed to have changed through time, with IPOs playing the major role in the initial, pre-emergence phase; and with M&A s relative role increasing thereafter when both types of exit contributed to cumulativeness & steady growth. In absolute terms M&A s seemed to have paralleled IPOs in numbers and presumably in importance towards the end of the decade that is after emergence of VC industry and once the high tech cluster acquired an international reputation.
It is important to note that several pre-Yozma agents, like Star, were already making profits in the new activities characterizing the new model of high tech: SU investments, IPOs, M&A etc. So were Giza and Mofet, and to a lower extent Athena/Veritas41 There must have been a large number of very good SU companies around- created by returning Israelis, spun-off from MNE s and from the Defense Industries, etc. These represented very rich pickings for the small numbers of Schumpeterian investors and VCs active at the time. Other VC s and VC-type investments were less profitable or unprofitable since up-front learning costs were incurred42. But meager profits and losses did not deter others to enter since there were
40 Thus the cluster was offering SU better and better growth and entry possibilities. A related study of the Data Security industry suggests that undertaking an IPO is a necessary but not sufficient condition for a SU to grow and become an indigenous company undertaking downstream production and marketing.
41 Not included in our sample, but for a long time wrongly considered the only VC company prior to Yozma(it rather was the most senior of all the pre-Yozma companies since it was founded in 1985).
42 For example the Limited Partnership mode of VC organization was certainly not yet established in the years preceding Yozma and VC/cluster emergence. The pre-Yozma "Inbal Program' helped, in a negative way to promote the L.P. form of VC organization, by showing the limitations of publicly traded Funds (e.g. constraints on
strong expectations of profit. The fact was that in this immediate pre-emergence period few of the IPOs were VC-backed (given the generalized absence of VC companies) confirms that ‘the market’ was already ‘pointing the way’ to activities typical of VC & SU-- even ‘early stage’ investments which subsequently characterized Israel’s VC industry In evolutionary language, there were clear processes of variation in these years, including new variants of activities/organization/strategies, which subsequently were shown to be profitable.
This conclusion is consistent with a very rapid growth of VC and high tech after Yozma. Yozma funds were extremely profitable- the Success Ratios were extremely high and all except two of the 10 Yozma funds exercised their right to buy back the 40% Government shares. High private profitability must have led, through entry/imitation and expansion of existing companies, to the early onset of Cumulativeness/Take Off in the VC industry as a whole.
The whole process took about six years: during the first three years favorable
‘immediate pre-Yozma/ pre-emergence conditions’ were created; and during the next three years the VC industry & hi-tech cluster emerged. The main point of the narrative is not only that the period was short but that there were profitable investments, companies, and even VCs prior to emergence.
The Profile of hi tech Cluster Emergence & Development
We now can identify Israel's Profile of Emergence of the VC & SU-intensive model of high tech (‘Silicon Valley Model’) in terms of (8) characteristics
1. Favorable Background Conditions in terms both of a pre-existing Electronics Industry whose ‘reconfiguration’ led to the new model of the 90s; and in terms of pre-existing policies and policy institutions, which contributed to such a process. These were preconditions to any attempt to create the VC industry.
2. A pre-emergence, market led experimental period (“variation”) which oriented and set the stage for VC Targeted Policies to generate ‘critical mass’(“selection”). This in turn led to subsequent cumulativeness and steady growth of both VC and high tech
3. Strong VC-SU co-evolution, starting in the pre-emergence period, which explains the speed of the process;
4. A VC-led high tech cluster ‘Emergence’ process
5. An emphasis on ‘early SU phase’ VC investments(see Part 2)
6. Strengthening of links with Global Capital Markets, with a critical role initially being
6. Strengthening of links with Global Capital Markets, with a critical role initially being