For many months now, Israeli start-ups have had trouble continuing their streak of impressive exits of recent years. Despite the air of crisis in the market, quite a few exits are being engineered through mergers and acquisitions, but IPOs are not being mentioned.
It wouldn't be rash to say that this trend will eventually reach the Israeli software industry, fueled by the decentralized solutions developed by the major software firms. Concerned investors will have to be patient. A long-term look at the industry shows that investing in Israel software start-ups is quite worthwhile, even if the difficult market situation is causing delays in realizing the investments.
A study by Carmel Ventures, which focuses on software investments, shows that Israeli software companies holding public issues before the 1999-2000 boom did so at company values reflecting an average multiple of 9 on their revenue. This figure, of course, zoomed durign the ensuing high-tech bubble.
”Most exits by Israeli software companies were achieved through IPOs, although the IPO was frequently followed mergers and acquisitions, as in the case of Precise Software Solutions, New Dimension Software, and Memco,” said Carmel Ventures general partner Rina Shainski pointed out. “Our main conclusion was that investments should be in real companies, with real business.”
What happens when this wisdom conflicts with current reality, in which mergers and acquisitions are virtually the sole exit option? Shainski asserts, “You don’t built a company in order to merge it. Some of what used to be an IPO is now an exit through an acquisition by companies like IBM (NSYE: IBM), VERITAS Software Corporation (Nasdaq: VRTS), and Oracle (Nasdaq: ORCL).
”The IPO market may not recover, but the major companies are still looking for technologies. They’re investing less themselves in technologies, and to some degree, this is even beneficial for the VC market.
”We’re seeing major companies that currently lack money for anything other than their core business, and are keeping a tight rein on their expenses. They’ll eventually want to branch out, but they won’t do it through organic growth; when they know there’s a market, they’ll look elsewhere for what they need. You can see now that when IBM moves into a new field, it uses acquisitions. That’s what happened with Rational Software, which develops software development tools. IBM wanted to make it easy to develop software through its WebSphere middleware system. WebSphere is a fully developed system; IBM is constantly expanding it by adding more and more features.”
This information explain what Carmel Ventures is currently doing. In June 2000, when the fund was closed at $170 million, the size of fund appeared reasonable, if a bit high for a fund focusing on software investments. After all, those were the final days of the boom, when the market value of Nasdaq-listed software companies still seemed unaffected by the law of gravity, and most venture capital fund charters had to include buzz words like “B2B” and “Internet infrastructures”.
Almost three years later, Carmel Ventures is still the Israeli fund with the most capital available for software start-ups. However, in view of the ongoing crisis in the IT sector, which is dependent to a large extent on the software industry, this is no trivial matter.
Carmel Ventures was founded with the idea of spreading the sizeable sum of money raised among at most 16 companies. Given the subsequent events, Carmel Ventures could have been expected to adapt its investment policy to smaller valuations and financing rounds, by spreading its risk among more companies. To this day, however, Carmel Ventures has invested in a total of eight companies, and is sticking to its original policy. Investment funds usually invest their money over 3-4 years; Carmel Ventures is approaching an age at which it would be expected to liquidate its investments.
”We decided in advance not to investment in a large number of companies,” Shainski says. “The idea was to invest an average of about $10 million each in three or companies per partner. We have four partners, plus a partner in Germany, who helps us handle companies in Europe, and with our European deal flow, so it comes to about 16 companies. The idea is to carefully choose the companies, and invest a lot of time in them. At this point, we’re doing pretty well with about half that number.”
”Globes”: What do you do with $170 million in 16 software companies, at today’s valuations?
Shainski: ”An initial investment is usually around $4 million, and there are usually follow-on investments. Some current rounds including other investors amount to $10 million, so two follow-on investments fills out that sum.”
What about spreading the risks? When you invest that much at today’s valuations, aren’t you assuming too big a holding in companies?
”Our usual holding is 20-25%; that justifies the effort we devote to the investment. It’s not an unusual model; there are many US funds that use it a holding of less than 15% is of no interest to them. The accepted range is 15-25%.”
A trans-Atlantic flight
Because it has decided to persist in its original investment policy, Carmel Ventures’ investments sometimes resemble those made during the high-tech boom, especially in the software industry. A year ago, Carmel Ventures led the $5 million seed round for Skybox Security, a rather exceptional sum these days at such an early stage in the life of a software company.
Shainski says Skybox Security’s round actually combined the seed and first financing round in one. If that reminds you of the days when the combining of financing rounds was designed to help software companies shorten their time-to-market (another forgotten new economy mantra), the motive in this case is entirely different.
”When you invest at the seed stage, you’re investing at a point when the product has yet to reach the market,” Shainski explains. “Then comes the stage when the first customers are recruited. This entire phase, which usually requires many resources, is quite difficult now with respect to raising money, but is very important. It’s like a trans-Atlantic flight, with regions that have no place to land.
”Even companies that have money sometimes prefer to obtain addition financing before trying to enter the market, because when you see a company doing its best to penetrate the market, without success, no one will agree to finance it. In my opinion, it’s now easier to raise seed money than to get financing at the next stage. For that reason, you want the seed round to raise enough money to enable the company to get through that barrier. There’s no point in giving it money when it’s in the middle of crossing the ocean. The next point at which financing can be raised is after the company makes its initial sales, at which point you naturally want to continue investing in it.”
Cosmetic changes in the description of its fields for investment are helping Carmel Ventures stick to its investment policy. When the fund was closed, its investment charter included fields like e-commerce infrastructures and solutions, Internet infrastructures, cellular Internet, and large enterprise applications. Its fields have presumably changed, but the fund is still adhering to its software business. How do they do that? Shainski says, “Software isn’t a field. Every field has software now: communications, information security, enterprise software, and applications. Software is more of a business model than a field. It’s completely different from semiconductors and medical equipment.”
Published by Globes [online] - www.globes.co.il - on March 26, 2003