Unlike most of his venture capital industry colleagues, Promod Haque general partner in Norwest Venture Partners (NVP), one of the largest and most venerable venture capital firms in the US, has done very well over the past two years. He continued to produce exits during this period, which catapulted him in February to second place on “Forbes” magazine’s prestigious Midas List of venture capital moguls.
Haque arrived in Israel on his first visit last week. In contrast to other major US funds, NVP had only a single Israel company in its portfolio until recently Accord Networks, sold to Polycom in a $340 million share swap in 2000. Haque himself recently became involved in an Israeli venture after a portfolio company of his, a voice over Internet protocol (VoIP) company called NexVerse Networks, merged with ECI Telecom’s(Nasdaq:ECIL) former NGTS digital circuit multiplication equipment division to form Veraz Networks, with Haque as chairman.
Haque says this deal has opened the way to a change in NVP’s policy on investments in Israel, reflecting a new trend in the US venture capital industry one which local start-ups can certainly regard as a positive sign. “Although Silicon Valley salaries have fallen, they are still higher than in the 1990s,” Haque explains. “Salary costs can be reduced by transferring business out of the US, mostly to India, but also to Israel. Your salaries are about half those in Silicon Valley; in India, they are a quarter. Today, we won’t fund a company in Silicon Valley unless it shows us that it can do a large part of its R&D outside the US. Otherwise, we won’t touch it. That also answers the question why we did practically no deals involving Israel in the past we simply didn’t have to. The cost of capital was low, we could raise all the money these companies needed to employ engineers in Silicon Valley, and the exits were so high that it made no difference in any case we still made money. That’s no longer true. Today, you have to tell the entrepreneurs at the outset to form a cost structure that will enable them to reach the break-even point with less capital. Otherwise, neither they nor I will make money.”
”Globes”: Will Israel now become a source of dealflow for you?
Haque: ”Definitely, although we don’t plan to keep a team here. Accel general partner Bruce Golden told me that he had done 13 deals in his European fund, seven of which were in Israel. I think the reason is that the work ethic in countries like India and Israel is very different than the attitude in Europe.
”Europeans are lazy. They’re not entrepreneurs; they’re bureaucrats. Israeli culture is different. The work ethic here is very similar to that in Silicon Valley. You can’t say that about Britain or France, although there are exceptions. I believe that is the reason why Accel Partners is doing more deals here than in Britain. Their office is in London, and I don’t think they’ve done a single deal there.”
Schizophrenic start-up
Haque’s new geographic criterion is being applied in Veraz, whose main offices are in the US, with a development center in Israel. This structure looks like a deliberate choice by NVP, but what led the fund to set up Veraz, and to give priority to business outside the US, was a quite accidental meeting.
The story of Veraz begins with the severe crisis at ECI, which led to a renewed focus on its core business. In 2002, ECI merged its Enavis Networks subsidiary into its LightScape Optical Networks division, and completed the sale of InnoWave to Alvarion (Nasdaq: ALVR) for $9.7 million in February 2003. ECI also spun off its next generation telephony solutions (NGTS) division by founding Veraz. NGTS was the division that produced ECI’s first international commercial success. In the early 1980s, it began manufacturing a digital circuit multiplication equipment (DCME) product for compressing telephone lines, based on technology for broadcasting multiple telephone channels on a single line. In recent years, with the increase in the deployment and capacity of optical fibers, the need for these products has fallen substantially. ECI therefore decided to develop other products in its NGTS division, using VoIP switches. Despite the great hopes pinned on it, however, the penetration rate of VoIP technology has been slow. In keeping with ECI’s decision to abandon business that is not immediately profitable, ECI has also gotten out of this field.
Credit for the founding of Veraz actually belongs to two people. One is Barak Hachamov, former Clal Electronics Industries VP business development, and a compulsive entrepreneur, who was involved in the founding of Siliquent, Corrigent Systems, Axonlink, and Atrica, and who currently sits on the Veraz board of directors. The other is Veraz CEO Tal Simchony, former CEO of ECI’s NGTS division. Last year, the two men began considering various ideas for applying the plan, and realized the potential of combining the NGTS product line with a company like NexVerse.
Haque reveals that NexVerse had its own problems at that time: “In 1998, when the company was founded, we planned to develop switching software that would become the operating system for telephone companies, and would not depend on the hardware used for it. After spending $70-80 million on the software development, the telecommunications industry encountered a crisis, and telecommunications operators stopped spending money.”
Haque says that at this point, the company realized that it had to alter the basic business model on which it was founded. While the company had formerly focused on developing software, believing that communications providers would prefer to buy the software and hardware separately in order to save costs, it now began to assemble a solution including both hardware and software.
The market began looking at comprehensive solutions,” Haque explains. “The customers were no longer interested in buying pieces and doing their own assembly, so we started cooperating with hardware suppliers. We looked at Cisco Systems (Nasdaq: CSCO), which is actually our competitor; Lucent Technologies (NYSE: LU), and Nortel Networks (NYSE: NT). We then switched to smaller companies. Among others, we considered cooperation with Israeli company AudioCodes (Nasdaq: AUDC), and eventually settled on ECI’s NGTS.”
Hachamov and Simchony’s business model, which they presented to Haque, was confined to the combination of NGTS’s hardware with NexVerse’s software. Veraz also obtained the DCME products, which NGTS continued to manufacture. The company thereby acquired another source of revenue, before its VoIP business matured, and, equally important, access to customers.
”What will happen in the long-term is that the VoIP business will outstrip the DCME business,” Haque predicts. “It’s the other way around now, but that’s the beauty of the model you take a source of revenue, which right now is mature and stable, but will start slipping at some point, and meanwhile, the VoIP products will start catching on.”
You have two product lines, for which you need twice the sales staff. Isn’t that slightly schizophrenic for a start-up?
”You’re right, but we have invested very little in DCME marketing. In the telecommunications market, when your customers’ business is growing, they go on buying the same product, because most of their business in that field is from repeat sales to existing customers. That’s cheaper than recruiting new customers. Our investment in product development was also very low. Most of the R&D effort is focused on the IP products.”
”The funds’ will have to forget about irrational exits”
Veraz raised $30 million when it was founded: $10 million from ECI, which became its main shareholder; $14.5 million from the NexVerse shareholders and US funds Battery Ventures, Levensohn Venture Partners, and Kleiner Perkins Caufield & Byers; and $5.5 million from US fund Argonaut Partners. Haque claims that in contrast with the usual late 1990s financing procedure for telecommunications companies, this financing round is designed to be company’s last external financing.
”During the Internet boom, the cost of capital fell,” he explains. “Once upon a time, I could have raised $80 million, as NexVerse did, and it would have considered a routine affair. You can’t do that today, because people wouldn’t make their money back. The venture capital industry’s entire business model has changed.
”The funds’ will have to forget about the irrational exits of 1995-1999,” Haque says. As an example, he mentions optical communications company Cerent, acquired by Cisco in a share swap that reflected a $7.3 billion company value at the time. “The $11 million invested in Cerent became $1.5 billion,” he says. This deal, incidentally, served as a catalyst for the Lucent-Chromatis deal, and greatly affected the high ($4.7 billion) price tag for the Israeli company.
Haque says that exits have now returned to saner values. “We invested $12 million in Winphoria Networks in 2003, and took home $27 million, after the company was sold for $179 million. We invested $13 million in Resonext Communications, and we took home only $25 million. We still made money, but exit values have contracted.
”It’s very similar to what we saw at the beginning of the 1990s, when exits were $150 million each. That meant that you couldn’t give a company $80 million in financing, because no one would make money. Companies had to make more effective use of the money they raised. A company developing enterprise software currently needs no more than $20 million to achieve the operational break-even point. A hardware company that makes semiconductors or telecommunications equipment has to reach the break-even point on $35 million.”
”Too much money entered the industry in the past five years”
NVP has invested a total of $1.8 billion in 350 companies to date. Haque is personally responsible for over 50 of those investments, with a rare success rate of 17 IPOs and 18 acquisitions, winning him second place on “Forbes” magazine’s 2003 Midas List, up from 15th place in 2002, and 24th in 2001. According to the list, which rates venture capital executives according to the value of the exits of the companies in which they invested, Haque “likes communications and enterprise software.”
”My attitude is that if there are three companies in a given space, I don’t want to invest in them,” Haque says in explaining his investment philosophy. For example, we invested in Cerent when it was the first private company in the optical networks sector, before there even was such a category. Four or five companies later sprang up there, and made money.
”The problem is that two much money entered the industry over the past five years, and too many portfolio companies were founded. 18 months ago, the Robertson Stephens investment bank (which has since closed) counted the optimal telecommunications companies at 170. In my opinion, that’s 165 more than are needed, and they have been closing down, one after another. It’s indicative that 10,000 companies were founded in Silicon Valley alone in 1998-2001. The last statistics I saw were that only 5,000 of them were left, and I think the consensus is that the number should go down to 1,000, because there’s not enough demand for all those companies and the products and services they supply.”
Companies that have already fulfilled Haque’s rigorous innovation criteria encounter a serious problem, which is typical of today’s small companies. “The customers’ buying habits have changed,” he says. “Alongside those clients that were always skeptical and conservative, during the boom there were also many customers eager to adopt new technologies. That was the sweet spot for start-ups. They were the usual target for all the small companies with new products, because it’s very hard for a small company to sell to a “Fortune 500” customer.
”The problem is that, due to the crisis, companies that were once enthusiastic about technologies have been cutting back. The first ones to go were the young, visionary ones. Most companies today are pragmatic and cautious, and senior managers make most of the decisions. The first thing they do is say that they don’t want to buy from a start-up, because they don’t value technology. They don’t want to buy a vision; they want to buy a return on their investment, and reliability.”
How is Veraz handling this problem?
”By using its model of merging its new product line with its old one, which has acquired a reputation for reliability over many years. Today, when we go to AT&T (NYSE: T), they don’t have the same enthusiasm for technology that they once had. The CTO is the one who decides, and he asks, ‘Who is Veraz?’ We tell him we merged with that group from ECI, and he can talk with his engineers, who tell him that his laboratories are full of our equipment. Then he goes to check, and when he comes back, he says, ‘You know what? We’ve got 50 boxes that have been working here for 10 years already. These people are good; close the deal.’ That’s how we solve the problem.”
Published by Globes [online] -l www.globes.co.il - on September 25, 2003