Israel Tech Sector Facing Funding Crisis

Venture capital flow into Israel’s celebrated high-tech sector has hit a
downward spiral, raising fears the ongoing political tension could dampen
interest in the industry but many investors blame the dwindling numbers on
the state of the economy in general.

In and around Israel, the political conflict is matter-of-factly described
as ‘The Situation’ and many feel the continued unrest will squeeze the life
from the technology industry there but, if VC backers have their way, money
will continue to flow into companies with large-scale research and
development facilities there.

“Israel has its own VC industry. There are still billions of dollars in
available cash to invest in Israel and we aren’t going to be affected by the
(political) situation. If you look at the latest VC numbers, you’ll find
Israeli companies being funded everyday, whether at seed level or later
stage,” said Ogen Perry, a partner at Vertex Management Israel, which
manages three venture funds with a total capitalization of $250 million.

By nature, Perry said Israeli start-ups were export-oriented, which helps to
avoid the economic perils of political conflicts. “The first thing we worry
about is the state of the market. For the average Israeli hi-tech company,
the markets are elsewhere, usually in the U.S. or Europe,” he said.

Sliding Investments
Even as Perry remains bullish on Israel, historically a hotbed for tech
start-ups (mostly in the data security space), the latest statistics show a
southward slide in investments. The Israel Venture Capital Research Center,
which tracks money flowing into the country, reports that 80 start-ups
raised $376 million in the first quarter this year, a 19 percent drop-off
from the previous quarter and a whopping 41 percent less than the same
year-ago quarter.

“The first quarter of 2002 was characterized by a decline both in capital
raised by Israeli high-tech companies and in total investments made by
Israeli VCs,” the Center said, adding that 98 Israeli venture capital funds
invested $138 million in high-tech companies, an 18 percent decline from Q4
2001.

While those numbers compare favorably with the depressed state of venture
capital infusion into U.S.-based companies, one Israel tech expert isn’t
masking his pessimism. Yigal Erlich, chairman of the Israel Venture
Association, doesn’t expect local funds to raise even $200 million this year,
quite a dip for an industry that raked in a record $3.7 billion just two
years ago. While fund raising and investments declined in 2001 because of
the death of the dot-com industry and the slowing U.S. economy, Erlich is
predicting the political ‘situation’ will make things even worse this year.

“In 2001, there was an uprising, but somehow foreign investors got used to
it…In 2002, it intensified nearly to the level of war, and that certainly
makes people less willing to come to Israel and to invest. Even veteran
investors don’t come if they don’t have to,” Erlich declared.

Continue with An Optimistic Front on page 2…

An Optimistic Front
Unlike Erlich, Perry and other VCs with big money wagered on Israeli tech
companies maintain an optimistic front. Indeed, in the last month alone,
big-name investors like Intel Capital Ventures and Benchmark Capital have
plunked down money to back Israeli start-ups.

Eyal Kaplan, general partner of Walden
Israel
, which manages close to $200 million in early stage investments
in Israel, believes the market is still ripe for the taking. “I would argue
that the venture climate in Israel is more in sync with the state of the
U.S. economy, rather than the (political) conflict. I think it’s fair to
say first time investors would be cautious right now but existing investors
aren’t necessarily shying away from Israeli companies,” Kaplan said in an
interview with internetnews.com. “In the past couple of months,
we’ve seen a large number of high-profile deals where investors are showing
faith in good, solid companies in Israel,” he added.

Daniel Goldman, a principal of Goldman Investments also
believes the conflict does not have a direct bearing on the operating
technology companies or the VCs who back them.

“I feel that Israel’s branding within the world of technology is such that
despite the current tensions in the world’s markets, to which 90 percent of
Israel’s high-tech economy is directed, are attracted to genuine emerging
technologies sourced inside Israel,” Goldman said.

“They are, of course, affected in the same way as the technology driven
companies around the world under the cloud of continuing economic
uncertainty,” said Goldman, whose firm provides investment management and
investment banking services to a range of Israeli and U.S. technology
companies, mainly in the communication and software fields.

Tweaking Operations
Kenneth Bob, CEO of web authentication software firm Safe3W, said the conflict has not in any
way affected business at the company’s R&D facilities in Israel. “Our
development team hasn’t had work interrupted due to the events there.
Israelis have become used to the situation and we’ve managed to work around
the events,” he said.

Safe3W, which has corporate headquarters in New York, has tweaked everyday
operations a bit to deal with the ramifications of the conflict, Bob said.
“One thing that has changed, for instance, is the fact that our distribution
partners around the world prefer not to travel to Israel for training.
So, we have to conduct training at the home country of the distribution
partner,” he said.

Outside of that, Bob said it’s “business as usual” for Safe3W, even on the
ground in Israel. “Certainly, there is concern but, when I visited our
development team recently, the situation wasn’t the first thing they wanted
to talk about. They wanted to discuss the development and sales issues.
Israelis have learned to take it in stride.”

Bob’s sentiments were echoed by Vertex Management’s Perry, who does not plan
a slowdown in spending on Israeli-based tech companies. Vertex has about 25
companies in a portfolio of diverse investments, ranging from
communications and information networking to software and life sciences
plays.

“We have quite a lot of dry powder in Vertex II. We have about $160 million
in that fund and most is available for investments. We’re not slowing down
at all,” Perry said. “My charter is to invest in Israeli companies. That
would be true for any Israeli VC that you talk to. My planning is
completely unaffected by the political situation. I think it’s the same for
a VC in the United States. They are looking at the merits of companies and
not at country of origin or the political situation.”

Continue with Economics not Politics on page 3…

Economics not Politics
For a VC going out and raising a new fund from international backers, Perry
said the political conflict could be a major impediment. “Anyone trying to
raise a fund right now, because of the
economy and the political situation, would find it very tough. But, with a
bounceback in the economy, I think that will improve,” he said. “It all
depends on the track record of the fund managers, of course.”

Walden’s Kaplan agreed. “By and large, it’s very difficult to raise money
for venture funds, especially from overseas. Most people attribute it to
political situation but, if you look at the U.S., very few venture funds have
raised new money. I don’t believe there has been one (U.S. VC) that closed a
new fund in 2002. Some investors are reluctant to make new commitments to
Israeli funds but, if you look at the U.S. situation, there isn’t much
difference and that tells me it is more based on the state of the economy.”

Contingency Plans
He said investors were keeping close tabs on portfolio companies during the
crisis to ensure there are contingency plans to deal with war-related
emergencies. “Everyone is making contingency plans. Clients are asking about
support mechanisms, which is normal in this climate. But, (our companies)
haven’t experienced any loss of business as a result of the conflict.

“Companies are making sure there are backups for codes, manuals, customer
lists. A lot of boards are asking management to make sure
there is an ability to establish an interim R&D operation in Israel, just in
case it is difficult to travel outside of the country. They are setting up
things like emergency core customer service,” Kaplan explained.

“Worst case scenario, there will be panic and no flights. Mostly, companies
are looking for short term back up plans for customer support,” he said,
noting that companies have equipped their sales forces with detailed Q&A
pages to respond promptly when nervous clients need urgent answers.

He said the history of political strife in Israel has hardened the resolve
of its people and this extends to software engineers in the high-tech
sector. “I think a lot of Israelis are used to crisis situations. They
want to prove they can function much better under that kind of pressure.
That actually helped the country survive in the past 50 years or so.”

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