Is venture capital dead? That was question that came to the surface two weeks ago after “The New York Times” featured an article both in print and on its website with the title “A Kink in Venture Capital’s Gold Chain.” The article studied the venture capital industry and questioned whether it had a future. Reading between the lines the answer was no.
The event that prompted the “New York Times” to run this feature was a letter sent to investors by prestigious venture capital firm Sevin Rosen Funds, in which it notified them that it was halting the raising of its tenth fund, and that it would not be raising a new fund. The fund already had commitments amounting to $250 million. In their letter the firm’s managers wrote that they did not believe that venture capital had a future and that they did not want to raise the fund and give investors a low return in a few years time.
When questions such as these are raised in the US, the high-tech and venture capital industries in Israel feel uneasy since these questions apply to the industries here too. There have been no impressive exits here either, (since the beginning of 2006) save for the sale of Passave Inc. to PMC-Sierra Inc. (Nasdaq: PMCS) for $300 million, after $13 million had been invested in it. Acquisitions of companies usually close at around the $100 million mark. IPOs are extremely rare. Seven Israeli companies believe that they will able to make an IPO on Nasdaq before the year-end, and have started the process, but not all of them seem likely to succeed, and even those that do are unlikely to raise astronomical sums or have high valuations.
Local venture capital funds are well aware of this and have been trying to come up with the formula that will keep venture capital alive and kicking. More than anything else, they hope that this is a passing phase. The venture capital industry in the US and its affiliates in Middle East was known as a successful one that would deliver double digit returns for investors. During the bubble years the returns even reached triple digit figures, but since then they have fallen to an average threefold, a return that investors can also get on investment in bonds and at much lower risk.
Eventually there will be balance
Is the venture capital sector about to become history? It depends who you ask. Pitango Venture Capital managing general partner and co-founder Nechemia (Chemi) Peres, Vertex Venture Capital founder, managing partner and Israel Venture Association (IVA) chairman Yoram Oron, BRM Capital managing director Menashe Ezra, whose fund, BRM was one of those who completed a home run this year (a 20 fold yield on Passave, which returned one third of the $150 million fund), all feel that the venture capital sector is not nearing its end, and that this is difficult period, a reaction to the bubble.
Chemi Peres says that at Pitango too, they have been asking themselves the tough question - does the venture capital model work? “My answer is that it does. I do not believe that we can predict what will happen in the long-term future, but I do believe that venture capital is the only answer for innovation and entrepreneurship. I cannot see how new innovative technology companies will manage to function otherwise. There will be a place for venture capital as long as we have innovation and entrepreneurship.”
In theory, this sounds great, but venture capital funds have to return money to investors with fat multiples, and this has not been happening in recent years.
Peres: “True, reaching an exit is difficult. At one time, the main goal for start-ups and investors was an IPO on Nasdaq. This is difficult to achieve today for a number of reasons: the requirement for high profitability and growth rates which young companies have difficulty reaching, and the stringent regulatory requirements of the Sarbanes Oxley rules. All these have made it difficult for companies to make an IPO. I believe that we have reached a situation that is the exact opposite of the bubble period when you could float unstable companies which didn’t make any profit at all. Today we are experiencing unreasonable difficulties and I expect that this will eventually balance out in coming years.”
What about Sevin Rosen’s claim that too much money has flooded into the venture capital business and too many companies were being given financing in every conceivable sector?
“They have a point here. It’s true that too much money has flooded into the venture capital sector but I believe that this too will eventually balance out. The crisis in 2000 brought about a significant drop in the volume of investment. Since then they’ve all returned and there is now a tendency to continue investing while disregarding the exit factors.”
Peres feels that not everything is black. He notes the successes of Skype, which was acquired a year ago for $4 billion by eBay Inc. (Nasdaq: EBAY), and You Tube, which was recently acquired by Google Inc. (Nasdaq: GOOG) for $1.6 billion. Additionally, the Israeli companies Passave and Saifun Semiconductors Ltd. (Nasdaq:SFUN), which floated on Nasdaq a year and a half ago, are also examples of companies that have performed well. “We should not forget Israeli companies that have become significant players, such as M-Systems Flash Disk Pioneers (Nasdaq: FLSH), Amdocs (NYSE: DOX), Mercury Interactive Corp. (Pink Sheets:MERQ.PK), and others; Israeli companies that have become really big. I believe the potential exists.
"It should be understood that venture capital funds operate under an existing model but the process of delivering returns takes time and requires patience. I compare it to marathon runners. We get involved at a stage that requires funds to work efficiently, to finance the companies that can make a leap forward.”
That’s all well and good but what about the future?
“I see companies entering big global such as India, China, Brazil and Russia, all of which have a big market for technology products and have tremendous potential. True, competition is stiff, and perhaps some of the things that were simple once are not that easy any more. So funds will have to provide a response by supporting companies at the more advanced stages and not just the first ones.
“I believe that the current level of exits will pass. In Israel the future is vital, we don’t have a local market so financing entrepreneurial companies is critical. Venture capital has not come to an end; there may some adjustments and changes but it will continue to operate. I see new companies in the fields of water, energy and nanotechnology. Innovation has not disappeared, nor will venture capital.”
IVA Association chairman and Vertex managing partner Yoram Oron takes a similar view to Peres. “Looking it from the macro perspective, it has been proven that investments in venture capital deliver the highest profits over the long-term, compared with those in other fields: a 15-20% yield over 20 years, compared with 10% in stocks and 4-5% in bonds. Venture capital investors consider these alternatives, and the fact is that over the last three years, since the end of the international crisis (which, incidentally, was reflected to a much greater extent in stocks than in venture capital), more and more money has been flooding into venture capital.
Is the future secure?
Oron: “As far as venture capital is concerned, we are in a global market that is expanding continuously, with 5% growth in the West, and 10% in Asia. This means that demand for new technologies and their products is on the rise, and that there is a willingness to pay an extremely high premium on technological innovation. It is true that when it comes to venture capital investment in companies with high working capital or manufacturing companies, the profitability is borderline.”
What about IPOs on stock exchanges?
“It’s true that these investments have yielded a low return due to the small number of IPOs, as a result of the more stringent market regulation, but 9 out of 10 exits in the US last year were through acquisition deals in which the return on investment is very high. The return on these deals is exceptionally high because the buyers are technology companies which prefer, for financial and organizational reasons, to acquire an off-balance sheet R&D activity which will not be seen in the company’s financial statements, and which will not affect the organizational character of a mature, publicly-traded company. These companies are willing to pay five times the R&D costs of start-up companies, and this is very worthwhile for investors.”
Oron and Peres may well be trying to preserve the goose that laid golden eggs for them in the past, believing that it will continue to lay eggs for them in the future. In contrast to Oron and Peres’ funds, which have not had any rich exits recently, Menashe Ezra’s BRM has had a fantastic year. Passave delivered a 20-fold return-on investment for BRM, a success that enabled it to send generous checks to the fund’s investors.
Ezra has reason to believe that the future is promising and that the uproar caused by Sevin Rosen is unrepresentative. “The Sevin Rosen letter to investors is odd,” he says. “After 25 years of activity in the field, they decide that there is no model for venture capital. I would have expected that a serious team like them would have looked into this before they began raising capital and not after they already received commitments totaling $250 million. I am convinced that there is more than meets the eye here.
“As for the letter itself, some of the claims Sevin Rosen made in the letter are correct. It was very difficult to float companies on Nasdaq in 2005 and 2006 too, and mergers were done at multiples of 3. Before the IVA conference back in June, we conducted a study which examined the length of time it took companies to reach an exit from the time they were founded. The study found that the average time to an exit was 5-6 years; that is to say, investors who invest today in new companies, or a fund that commences activity in 2007, can expect exits in 2017. Who knows what will happen by then?
So you’re not concerned?
Ezra: “There’s no doubt that everyone is concerned at the abysmal number of exits today. I think that those who should be more worried than anyone else are the mezzanine funds, which invest in mature companies and expect a fat exit within a year. Twofold of threefold returns are not dramatic and they have a real problem. Israeli funds, however, focus primarily on early-stage investment, and I cannot predict what will happen in the coming years. Economics is cyclical.
"For some reason, investors invest when things are good and get depressed when there’s a crisis. It should be the other way round. We invested in Passave at the lowest point of the depression in 2002. No one wanted to invest, the companies’ values were low, as were the amounts of capital that were raised. It turns out that these were the good years. A professional investor knows that you invest when prices are low, and not when they are rising. To sum up, I’m optimistic.”
Is there any real basis for this optimism?
“It’s true that the industry is undergoing significant change. I think that we will find the right balance over time. Israel has a young industry that is undergoing substantial change. In the US, the industry is older and there are funds that have clearly delivered results, and those whose returns are not all that good. Venture capital investors are professionals and they look at the returns in relation to the alternatives on the public market over time.
"The venture capital market is affected by the public market. It is impossible to make a successful IPO today, and so investors in companies agree to acquisition offers that are not at the levels they might wish for. However, we need to remember that this is a long-term business, and that venture capital takes a long-term perspective, and I have not noticed any dramatic development that should make investors change their positions. This is a tough period, and it has happened before. We should not be influenced by seasonal changes. Either way, I don’t invest in companies that have a valuation which I believe will deliver less than a threefold return on the money.”
Published by Globes [online], Israel business news - www.globes.co.il - on October 23, 2006
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