venture capital’s contribution to the israeli economy, by yacov sheinin and chen herzog

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SummarySummary

Venture CapitalVenture Capital’ ’ ss

Contribution to theContribution to the

Israeli Economy Israeli Economy

June 15, 2005 June 15, 2005 June 15, 2005



222 DraftDraftDraft --- translated from Hebrewtranslated from Hebrewtranslated from Hebrew

IntroductionIntroduction

We are pleased to present to the annual IVA conference this analysis

prepared for the IVA by Economic Models headed by Dr Yacov Sheinin.

Our aim is to lay the foundation for understanding the role of VC in Israel.

This report analyses for the first time the contribution of VC investors to

the Israeli economy in the past decade and highlights their functions and

unique contribution in the present and future.

We hope that this report will contribute greatly to the current dialog

regarding government action including establishing policy and strategic

action for the long term, encompassing areas such as education, R&D and

development of capital markets.

Yoram Oron – Chairman, Israel Venture Association

Co-founder Vertex VC



Table of ContentsTable of Contents

Introduction………………………………………..4

Summary and Conclusions………………………5

Growth Potential of the Economy………...…..27

Presented by Dr. Yacov Sheinin and Chen Herzog




IntroductionIntroduction

This study, prepared for the IVA, evaluates the contribution of VentureCapital investments to the growth of Israel’s economy.

While VCs have been active in Israel for over 10 years, there is no complete

study of the VCs contribution to the Israeli economy, which is therefore

unclear.

This analysis discusses only the contribution to Israel’s economy and does

not discuss the opportunity for investors, VC funds or fund managers.

We evaluate the contribution to the economy in terms of GDP growth and

an increase in employment. We place a large emphasis on the long term

drivers of these factors.

This study relies upon data collected and formulated by Economic ModelsEconomic Models

over many years.

The data on VC capital raising and investment was obtained from the IVC

Research Center and has not been confirmed by us.



1. Summary and Conclusions1. Summary and Conclusions




VC Capital Raising andVC Capital Raising and

Investment in IsraelInvestment in Israel

15,64015,640

1,000

2,300

12,34012,340

6,590

5,760

Available resources for investment of Israeli VC funds

Total VC investments in IsraelTotal VC investments in Israel

Investment of foreign VC in Israel

Total capital raised by Israeli VCsTotal capital raised by Israeli VCs

and investments in Israel by foreign VCsand investments in Israel by foreign VCs

Investment of Israeli VC funds abroad and other

Investment and management costs of Israeli VC funds, in Israel

Source: IVC Research Center, Economic Models

1995-2004, Mil. $




The Direct Contribution of VCThe Direct Contribution of VCVarious VC investors (Israeli and foreign), have invested over 12 $B in Israel

in the past decade, mostly derived from foreign sources. This amount, in

proportion to GDP, represents the highest rate in the world.

Most funding (about 70%) has been channeled to paying wages to Israeli

workers. As the economy has a high level of unemployment, it makes a

direct contribution to GDP (unlike investments in imported machinery andequipment).

Fund raising and VC investments continue in 2005. We expect 1.5 $B of

investments and about 1 $B to be raised by Israeli managed VC funds thisyear.

We can therefore conclude that currently, VC investments have a direct

contribution of over 1% to Israel’s GDP.




VC Contribution to IsraeliVC Contribution to Israeli

Relative Advantage EscalationRelative Advantage EscalationThe rare combination in Israel of a high level of technological ability in

electronics and software companies, together with enormous research

capabilities, globally-embracing export ties, and a rare ability of fund

raising, allows the unparalleled growth in the electronics and software

sectors.

This advantage of the Israeli economy can last as long as the Israeli

education system safeguards these skills. VC investments play an

important role in this advantage.

The amount of VC invested in Israel as a portion of GDP is the highest

in the world and the output of “Information and Communication

Technology” (ICT) as a portion of GDP is also the highest in the world.




VC Investment in ICTVC Investment in ICT

Relative to GDPRelative to GDP

Source: OECD 1999-2002, IVC Research Center 2002, CBS (Isr.)

0.0%

0.1%

0.2%0.3%

0.4%

0.5%

0.6%

0.7%

0.8%

I s r a e l

U S

A

C a n a d

a

K o r e

a

S w e d e

n

U

K

N e t h e r l a n d

s

I r e l a n

d

F r a n c

e

F i n l a n

d

B e l g i u m E U

N o r w a

y

N e w

D e n m a r

k

G e r m a n

y

A u s t r a l i a

I t a l y

S w i t z e r l a n

d

G r e e c

e

S p a i n

P o r t u g

a l

A u s t r

i a

J a p a

n




R2

= 0.57

4

5

6

7

8

9

10

11

12

13

14

0.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9

Israel

FinlandKorea

UK USA

Sweden

France

Netherlands

Japan

Canada

Ireland

The Correlation between VC and ICTThe Correlation between VC and ICT

*Finland was removed from the sample (Nokia biased).Source: USA Census, OECD 1999-2002, IVC Research Center 2002, CBS (Isr.)

% VC investment in ICT as a proportion of GDP

I C T s h a r e

o f G D P ( % )




The Contribution to Human CapitalThe Contribution to Human CapitalWage payments to Israeli workers for R&D lead to an accumulation

of experience and expertise and creates an intangible but important

asset for the Israeli economy, even in cases of start-up closure dueto unfeasible business models.

We should view VC investment in failed enterprises as a

contribution to the overall development of Israeli technology. Afailed business is not necessarily a failure from a national economic

point of view.

We find the cumulative experience (of failures and successes) as partof the total Israeli relative advantage in the advanced technology

sectors.




The Contribution to theThe Contribution to the

StartStart--up Sector up Sector 90% of VC investments are in early stage start-ups; VC investment is the

dominant source of capital for these companies.

We believe that without VC funding, the Israeli start-up sector would

not have developed to the current level.

The electronics and software sectors include a range of companies that

began as start-ups and matured.

Growth of the electronics and software sectors is influenced by the

maturation of start-ups which rely upon VC investment.

Vast majority of VC investments (over 90%) is in the electronics and

software sectors (including medical equipment and other

implementations).




The Contribution to theThe Contribution to the

Electronics and Software SectorsElectronics and Software SectorsCurrently, over 40% of the electronics and software sectors product

is in companies that were invested by VC (during the first decade of

their operation), compared to about 10% in 1995.

The electronics and software sectors have grown during the last

decade (1995-2004) in an average annual rate of 11%.

We estimated that internal processes in these sectors allowed it to

grow in a high 7% annual rate, however, an addition of 4 percentage

points was created by maturity of Start-up companies.

Therefore, we see the major VC indirect contribution as about 35%

of the electronics and software sectors growth.




Electronics and Software SectorsElectronics and Software SectorsEstimated ProductEstimated Product

* Companies supported by VC during the first decade of the company’s operation.

Source: CBS (Isr.), Economic Models

4.5

5.9

10.4

20042004

0.4

3.5

3.9

19951995

Total electronics and software sectors product

Electronics and software sectors product, by

companies supported by VC*

Electronics and software sectors product, bycompanies not supported by VC

2004 $B




IPO

Foreign M&A –

operation in Israel

The Growth Model for IsraelThe Growth Model for Israel’’s Electronicss Electronics

and Software Sectorsand Software Sectors,1995,1995--20042004

Foreign M&A –

operation abroad

Israeli ElectronicsIsraeli Electronics

and Softwareand Software

CompaniesCompanies

Defense Industries Academic

ContributionContribution – – 4%4%

Annual GrowthAnnual Growth

Israeli StartIsraeli Start--upup

CompaniesCompanies

Incubators /Incubators /

AngelsAngels

Ceased OperationM&A in Israel

Venture Capital

7% Internal Annual7% Internal AnnualGrowthGrowth

Office of the

Chief Scientist




VC Contribution to Growth of theVC Contribution to Growth of theElectronics and Software SectorsElectronics and Software Sectors

*We assumed that 20% of VC investments would find alternative funding

11.4%

4.2%

7.2%Growth of the Electronics and Software Sectors, without

VC investment*

Growth of the Electronics and Software Sectors

Growth due to VC Contribution

Average annual growth rate, 1995-2004

Source: CBS (Isr.), Economic Models




Summary of the Total ContributionSummary of the Total ContributionUnder current economic conditions in Israel, it is necessary for 1.5

$B to be invested in start-ups on an annual basis to achieve 11%

continuing growth of the electronics and software sectors.

This ambitious level of growth is necessary for GDP growth to

reach over 6% a year, allowing Israel to reach 15th place in the

world in 20 years time (Israel today is in 22nd

place).

Under current conditions, it is difficult to see an alternative route

to the unique contribution of VC investments in supporting start-

ups. This is an unusual situation where few succeed in attractingforeign investors to invest in technology development in Israel with

all of its associated risks.




Implementing the IsraeliImplementing the Israeli

Relative AdvantageRelative AdvantageThe scale of the Israeli economy is small and it lacks the critic mass

for local market “merchantable products” production.

It’s hard for Israeli companies to reach a major international statuswhich would allow them to continuously produce standard products

for the international market.

Therefore, we see the Israeli relative advantage to produce uniqueproducts and to sell the knowledge and technology to third party.

This situation, in witch there’s a wide variety of knowledge and

technology allows part of the companies to become major andsuccessful companies in Israel (Ishkar, Teva, Check point and other)

Additionally, an industry of advanced products does not have to be

based on Israeli companies. (Intel, Motorola, Vishay)




Knowledge and Technology ExportKnowledge and Technology ExportAs mentioned before, the relative advantage of the Israeli economy

is development of ideas and technologies and production of unique

products.

Therefore, we believe that a major export sector in Israel for the

long run would be new ideas and technologies (the overall

production potential would be much greater than the local

production potential).

We hope that this sector would expand and encourage Israel to

become an international center for ideas and technologies (the

“Silicon valley” is a development center, not a production center).




No Massive Knowledge andNo Massive Knowledge and

Technology LeakageTechnology Leakage

In vast majority of VC investments, the development activity stays

(at least at this point) in Israel.

We believe that most of the developers stay in Israel, even though

some of the projects leaders stop dealing with the projects

development after the exit.

As much as the start-up companies in Israel succeed, it stimulates

Israelis to return to Israel and establishing the development centers

in Israel.

Most of the Israelis who are part of the development procedures

stay in Israel even if the operations move abroad.




Investor Investor ’’s Exits Exit

1. IPO (mostly in the US).

2. M&A with Israeli based company.

3. M&A with foreign based company, which continue their operations

in Israel.

4. M&A with foreign based company, which discontinue theiroperations in Israel.

The foreign investor’s objective is to sell their part in the projects with profit(Exit). That’s the basis for their entry to the VC funds and their investment

in Israel. The Exit in case of a success is made in one of 4 options:

Each one of the options described above is legitimate and the actual actionis selected by the investors according to the best market value. About 75%

of the exits are made with options 1 and 2.




The Fear of Transfer of The Fear of Transfer of

Manufacturing OperationsManufacturing OperationsFrom our analysis, less than 10% of companies that have received VC

investment have transferred activities abroad.

In most cases, the main activities remain in Israel and definitely the

development capabilities.

Location of manufacturing in Israel is in accordance with theadvantages of the location and we see the transfer of some

operations abroad as a natural process.

We are of the belief that operations in Israel can also be establishedby foreign companies (Intel, Motorola, etc.) and the opportunity to

expand these operations are in accordance with the economic

advantages of the location (government policies).




The Technology Sales PriceThe Technology Sales PriceU.S. data shows a long-term average yield of investments in VC at

13% annually in real terms, with a high component of volatility

(since 2000, yields have remained negative).

We believe that this rate is reasonable for high risk investments,

therefore it represents a reasonable price for the projects.

Most VC investments in Israel have been made since 2000 and

have not yet accumulated high yields and the complaint that

foreign investors are acquiring Israeli IP and technology at low

prices does not accord with reality.




OCS Grants and VC InvestmentsOCS Grants and VC InvestmentsVC investments are in most cases made in new start-ups at various

stages of research and development.

The greater the supply of start-ups, the more Israel is attractive and

the greater the amounts of VC investment in Israel.

At the incubator stage, VC’s usually do not invest as they are unable

to evaluate the potential risks involved.

At this initial and critical stage, the start-up is usually funded by the

entrepreneur (and close friends) and by OCS grants.

The more start-ups at incubator level, the more start-ups there will

be for VCs to invest in. We therefore view favorably an increase in

OCS grants to new entrepreneurs as a necessary condition for the

increase in funding of VCs.

S i




Seed

R&D

Incubator

Revenue

growth

StageStage

705705

600600

160160

4545

1313

2020

VCVC1,4651,465$$ MM

OCSOCS7878$$ MM

100%

% Funded by% Funded bythe OCSthe OCS

7%

7%

0%

StartStart--Up FundingUp Funding

* Excluding Magnet and international cooperation projects. Source: IVC Research Center, OCS,Economic Models

US$ Millions, 2004




# of New Start # of New Start--ups per Year ups per Year

In 2004, the Chief Scientist awarded $20 million in grants toincubator-stage companies.

According to this model, we can double the number of new start-

ups in Israel at an investment of only $20 million per year.

As criteria for initial start-up success is vague, the second group of

start-ups (if doubled) may have less chance of succeeding to create

businesses.

We are of the opinion that it is preferable for VCs not to be

involved at the initial stage as this is where Chief Scientist funding is

most beneficial and where it can best contribute to the economy.

We believe that an increase of $80 million in the Chief Scientist’s

budget to support new start-ups can lead to a multiple increase of

VC investments in Israel in a few years.



2. Growth Potential of the Economy 2. Growth Potential of the Economy




The Potential and its RealizationThe Potential and its Realization

Israel has a tremendous potential for growth inherent in its hi-techindustries, being the main “growth engine” of the economy. Israel

belongs to a small group of countries that excel in this area.

Fuelling the growth engine is the combination in Israel of a high level of technological ability in electronics and software companies, together

with enormous research capabilities, globally-embracing export ties,

and a rare ability for fund raising.

While the risk in technological developments is high, the reward is

proportionately high. In the past, mainly institutional bodies supported

development but in recent years, private entrepreneurs and private

investors have entered the arena.

Israel has succeeded to attract foreign investment at a level unmatched

elsewhere. The result is the high growth of the technology sector in

Israel.




The relative position of theThe relative position of the

Israeli economyIsraeli economyThe Israeli economy is ranked 22nd in the world by GDP per

capita. Israel’s relative rank is unchanged since 1980 (the

bottom third of developed countries).

When evaluating Israel’s ranking, we see that Israel is among

the leaders in the world in many areas of technology.

In terms of potential, Israel is able to be among the 15 ranking

economies in the world, but his potential is not realized.

During this time, other economies such as Ireland, Spain andSouth Korea, have improved their relative rank significantly.




79.3

26%

4.5%

440

38.0

10.4%

16.9

IsraelIsrael

12.0%R&D Expenses (% of GDP)

27 (of 28)500Science Achievements of 8th Graders (2000)

215%University Education (% of 25-64 year olds in 2002)

777.5Life Expectancy (2002)

2226.6GDP per capita (US$ 2004)

257.5%Unemployment (2004)

25 (of 28)35.8Gini Index of Distribution of Wealth (2002)

Relative Rank Relative Rank AverageAverage

OECDOECD

IsraelIsrael

’’s Rank s Rank

Relative to the 30 developed OECD economies




Macroeconomic Conditions in IsraelMacroeconomic Conditions in Israel

Israel has no foreign debt, no deficit in its balance of payments, an

enormous Forex reserve, the lowest inflation in the developed world and

a budget deficit that is low in comparison with many developed

economies.

The Defense budget has diminished drastically to 5.5% of GDP (vs. 13%

in the ’80’s) and is expected to further decline to 4% in about 10 years

(over 3% in the U.S.).

Israel’s manufacturing potential is very high due to the current highunemployment and the low output per worker.

Israel has a high level of accessibility to global equity markets though the

level of investments in the economy remains very low.

Glancing at macroeconomics, the Israeli economy is at its best sincethe establishment of the state though it has not managed to

improve its relative international rank.

i fA l d h i f




Accelerated growth scenario for Accelerated growth scenario for

IsraelIsraelIn the analysis prepared by Economic Models for the Herzeliya

Conference in Dec. 2004, we showed that Israel has the potential to

reach the 15th place in the world in terms of GDP per capita, in 20

years time (2025).

The Finance Minister, Mr. Binyamin Netanyahu, and many economic

leaders have accepted the approach we presented at the Herzeliya

Conference and it is being used as a basis for long-term strategicplanning at a national level.

This scenario targets 6% average annual growth over the next 20

years and will realize most of the potential of the Israeli economywithin 20 years.

The main growth engine for achieving this goal is the export of the hi-

tech sector, based on the electronics and software sectors.




IsraelIsrael’’s Growth Potentials Growth Potential

103%

43 %

12 %

50

16.9

115

22

CurrentCurrent20042004

Same rank Same rank scenarioscenario

AcceleratedAcceleratedgrowthgrowth

scenarioscenario

48%

34%

14%

124

3.8%

27.7

250

22

20252025

21 %

30 %

17 %

196

5.9%

42.4

383

15

Export, $B

Investment (without residential), % of GDP

Government spending, % of GDP

National Debt, % of GDP

Average Annual Growth Rate (since 2005)

GDP, $B

GDP per capita (US$ 2004)

Relative Rank

Source: Economic Models project prepared for the Herzeliya conference, Dec. 2004




IsraelIsrael

’’s Accelerated Growth Scenarios Accelerated Growth Scenario

In the accelerated growth scenario, 70% of the export would be

advanced technology based, still, only 11% of employees will these

sectors.

Most workers will work in commerce, services and industry for the

local market.

The export of the advanced technology sector would allow theimport of products in witch Israel has no relative advantage.

The high productivity of the advanced technology sectors would

allow a continuous improvement in the quality of life. The indicationfor this process would be the fact that most workers will be

employed in the commerce and services sectors.

Projected Technology ExportsProjected Technology Exports




Projected Technology ExportsProjected Technology ExportsAccelerated Growth ScenarioAccelerated Growth Scenario

*In 2004, there was no exports from Start-ups 52.6

60%

31.4

40%

21.3

3.7

5.8

11.7

0.0

4.3

7.4

2004

6.8%

‐

3.4%

‐

9.6%

6.2%

8.0%

10.9%

12.7%

9.8%

11.2%

Average

Annual

Growth Rate

208.3

31%

63.7

70%

146.9

13.3

29.5

103.2

9.7

24.5

69.0

2025

3.6Start-Ups*

44.0Total Electronics and Software

11.2Software Services

113.4Total Exports

42%As a % of Total Exports

29.1Electronics

15.2Chemicals and Pharma

7.8Metals, Machinery and Avionics

Other Sectors

As a % of Total Exports

Hi-Tech Sector

2015

59%

47.1

67.1

US$ Billions of 2004

Projected Employment in HiProjected Employment in Hi--TechTech




Projected Employment in HiProjected Employment in Hi--TechTechAccelerated Growth ScenarioAccelerated Growth Scenario

2.5%

2.5%

‐

2.6%

1.3%

2.6%

3.3%

5.8%

2.6%

3.2%

Average

Annual

Growth Rate

4,033

3,576

11%

457

121.1

50.3

285.3

53.4

109.4

122.5

2025

3,280

2,904

11%

376

107.1

41.4

227.9

36.8

88.4

102.7

2015

2,136Other Sectors

16.4Start-Ups*

143.9Total Electronics and Software

64.0Software Services

2,401Total Employed

63.5Electronics

29.5Chemicals and Pharma

91.5Metals, Machinery and Avionics

2004

11%As a % of Total Employed265Hi-Tech Sector

Thousands

venture capital’s contribution to the israeli economy, by yacov sheinin and chen herzog

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