How should 3i enter the Israel VC market? Briefing Report.

How should 3i enter the Israel VC market?Briefing Report

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TABLE OF CONTENTS

I. Opportunity for 3i Page 3

II. Key Issues for 3i Page 4

III. Overview of Israel VC Industry Development Page 11

IV. Israeli VC Players Page 15

V. Foreign VC Players 2

VI. VC Market Trends Page 28

VII. Other Structure and Economic Issues Page 49

VIII. 3i Israel Entry Strategy Page 51

IX. Appendix Page 54

X. Sources Page 63

XI. Methodology Page 65

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I. Opportunity for 3i

Market Israel has a vibrant high tech entrepreneurial culture with several hundred start ups every year Approximately 30% of Israeli entrepreneurs are repeat entrepreneurs Typically lower valuations than US or Europe

Structural Advantages for 3i The imperative for Israeli companies to develop overseas markets and networks and succeed

outside Israel plays to 3i’s strengths and can provide significant leverage. The need for follow on investments for mid and late stage expansion plays to 3i’s strengths The imperative to exit through overseas listings or M&A plays to 3i’s strengths and can provide

significant leverage Co-investment and collaboration opportunities available with local funds: Israeli VCs and

companies need foreign funds because of a very miniscule domestic funds base

Structural Disadvantages The imperative to go overseas for markets and exits can also result in significant expense and

risks The insider networks may be an impediment to establishing a strong independent presence The overseas orientation for product markets, capital markets and M&A is more targeted towards

the US rather than Europe.

Profitability There is very little hard data available on profitability of VC investments. Profitability is dependent upon the Nasdaq and the M&A appetite in the US and Europe.

Implication: 3i’s structural advantages coupled with its tech sector expertise make it attractive to explore investment opportunities in Israel. The logical initial entry route would be as co-investor or partner with local funds, unless 3i has significant in-house Israel expertise.

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II. Key Issues: Is Israel’s Hi Tech Scene Different?

Israeli Defense Force (IDF): the perfect nurturing ground for technologists Israel has compulsory military service. Historically the national mindset is characterized by

defiance and fighting against odds – crucial for entrepreneurs, ventures. Best science brains are picked from schools for elite hi tech divisions of IDF like 8-200. IDF now develops new non-defense technologies and components for businesses Israeli technologists don't transfer R&D abroad easily. Result: R&D centers in Israel remain active,

as the core part of the subsidiary of a global business (examples: HP-Indigo, Intel-DSPG, Veritas-Precise and CA-Memco).

The IDF background also nurtures frugality and discipline. VCs don’t have to worry about the entrepreneur squandering money.

Focus on technologies in demand in the medium-long term. Less impact of short term market shocks. Deep technology focus which is less affected by global slow-down. Firms are strong on

technologies in demand (e.g., security, bio-diagnostics). Fewer temptations for quick bucks. During the entire market hype of dot-coms, there was not a single Israeli company listed on Nasdaq that was built on the “eye balls” business model.

Innovation remains strong even after the tech meltdown Network Outlook 2004, an annual trade conference of the U.S. venture capital industry, voted

three non-U.S. companies among the 10 start-ups most likely to succeed. All three were from Israel: Actelis Networks, BitBand and P-Cube.

Serial Entrepreneurs create intense hi tech market In Israel, nearly 30% of entrepreneurs are on their second or third start-ups compared to 5% in the

US. A few would have even run $500 mn businesses, but they come back to start and rebuild businesses out of cutting edge technology.

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Is Israel’s VC Market Different?

More than a mere funding role due to lack of contiguous market: Israeli start-ups have to export all of their products. This means networks to find and establish early adopters and sales abroad - much more so than in the case of a European start up.

VCs’ options: Fund a repeat entrepreneur who’s been there or put in place a system to develop overseas networks.

Need for presence at the seed and early stage: A start-up that lacks an intense ‘export or die’ approach is unlikely to succeed in Israel. That attitude does not develop at later stages. Most Israeli VCs prefer early stage and seed investments.

Proximity, geographical cluster akin to Silicon Valley, easier access to talent: Any two points in Israel’s tech cluster are within an hour's reach. Given that all the leading technology companies in the world have facilities in Israel, VCs have easy access to would-be entrepreneurs employed in a geographical cluster with a critical mass similar to that of Silicon Valley.

Overseas funding plays a crucial role: Only 40% of total capital raised by Israeli high tech companies comes from Israeli VCs; 60% comes from other entities, most or all of which is from foreign co-investors. The actual percentage of foreign investment is higher than 60%, since most Israeli VCs raise money from foreign funds and foreign LPs. Domestic institutions, such as Israeli pension funds, contribute only modest amounts of capital to Israeli VCs and companies.

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Is Israel’s VC Market More Risky?

Israel specific market risks include:

Lack of a domestic product market. Technology and product innovation alone are not sufficient for success. Companies need to develop export markets and overseas networks.

Lack of a vibrant, domestic stock market. The government’s efforts to woo companies to get listed on the Tel Aviv stock exchange (TVSE) by offering simple dual listing procedures has not helped. Trading volumes in TASE were at a low $ 100 mn a day in 2003. There is complete lack of portfolio investment flowing into Israel, making it imperative for IPO exits to happen on the Nasdaq.

Corporate governance may not be up to US or UK standards. Anecdotal evidence suggests that Silicon Valley investors view Israeli companies as not fully up to US corporate compliance standards.

However, several foreign investors, including risk-averse investors such as Calpers, have committed capital to funds and ventures in Israel.

No impact of Middle East political crisis: Security risk does not appear a major concern for foreign investors, and hi tech ventures seem the most immune.

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Is Israel’s VC Market More Profitable?

No hard data on returns: there is no hard data available to suggest that investing in Israel is more profitable.

Anecdotal evidence suggests that many US venture investors are still waiting to see the results.

Lower valuations: Israel has typically lower valuations and smaller financing rounds which could yield greater returns.

Anecdotal evidence suggests that Israel has lower valuations which are attractive to investors

The average financing round is $2.5 – 3 million; the average seed financial round is <$1.5 million

However, exit values are also small: typical exits and M&A values are also small in comparison to the US and Europe.

Since 1995, there were have been a total of 94 venture backed Israeli firms that have done US or European public offerings, raising a total of $5 billion. However, excluding 1999 and 2000, which accounted for 68% of total capital raised (over $3.4 Billion), the average capital raised is $230 million per year and $35 million per company. No capital was raised by venture backed companies in 2002 and 2003.

Since 1996, total M&A transactions of Israeli high tech companies are valued at $20.5 Billion. However, excluding 2000 which accounted for a full 51% of the value (over $10 Billion), the average M&A value per year is only approximately $1.4 Billion.

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Is Israel’s VC Market Dominated by Insiders?

Many Israeli entrepreneurs and venture capitalists share a common background as alumni of the IDF, Tecnion, Yozma “daughter” funds and other such institutions.

The Israeli VC community is extremely tight knit and very well networked with management of high tech companies.

Evidence suggests that the majority of foreign VC investment is done in collaboration with Israeli VCs: According to IVC, only 14% of total capital invested in Israeli high tech companies from 2001 to 2003 ($610 million out of a total of $4.3 Billion) has come from financing rounds without Israeli participation.

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Is Israel’s Experience Replicable?

• Israel VC experience has too much of a systemic perspective:. Israel succeeded because the emphasis was on developing a system (Technion Institute, IDF, Yozma) favorable for emergence of VCs.

• VC emergence was not market-led: It was a result of a directed policy.

• Timing: Yozma was implemented at a time when the global technology and capital markets began to expand. The timing was perfect. It coincided with the beginning of the expansive phase of global tech capital market. Even if everything else is replicated, timing may not be as right as in the case of Israel.

• Entrepreneurial DNA: The entrepreneurial dynamism demonstrated by Israel may not be replicable. Particularly in areas like risk taking and failure acceptance, Israel scores.

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Is there a Preferred Entry Model for Foreign VCs?

• Co-investment appears to be the preferred strategy: Current evidence suggests that significant majority of foreign investment into Israeli venture backed companies between 2000 and 2003 (83.3%, 241 out of 288 deals) was done through co investments with Israeli VCs.

• Few foreign VCs with local offices: A very small number of foreign VC have set up local offices; some who had local offices have reintegrated back into larger European or US offices.

• Easy to cooperate: Cooperating with Israeli VCs and venture backed companies is relatively easy, because of the need to foreign markets and foreign funding – Israeli VCs are always actively seeking foreign partners to help build market and funding networks.

• Independent strategy could work with Israeli expat team: An independent Israel strategy could also work if is is run by a foreign-based dedicated team of Israeli expats with strong connections with the Israel VC and high tech community. Such a team can be based in Europe without the need to set up a local market presence.

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III. Overview: Basic Facts

Macro

At 1.3% (2002), Israel has a higher level of VC investment as a share of GDP than any OECD country.

A Morgan Stanley report in 2003 noted that if Israel were to be a US state, it would rank 2 nd or 3rd in VC investments.

After the US, Israel possesses the second highest number of start-up companies in the world—over 600 a year.

National expenditure on R&D, as a % of GDP was 2.8% in 2001, higher than 2.2% for US and Germany. Israel has 140 scientists per 10,000 people, which is higher than any country in the world.

VC Investment Activity and Structure

In 2003, 371 firms raised $ 1.01 bn from Israel and overseas-based venture funds. There are about 80 VC funds in Israel, with approximately $ 6.5 bn under management. The

largest fund has about $ 700 mn under its management. Approximately $1.15 bn is still available for investment.

Israel has only 2 of the 3 essential ingredients for a successful VC market: high-tech activity and VC availability. It lacks the third—deep and liquid local stock markets . Nasdaq has substituted for the lack of a local, liquid stock market with the result that Israel has the largest number of companies on Nasdaq (over 100) besides the US and Canada. About 97 analysts in the US track at least one Israeli stock.

Foreign funds and investors provide more than 70% of the total investment in companies. Most tie up with or invest in Israeli funds.

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Historical Perspective

Demand Side factors that created a vibrant VC market:

Changes in national priorities away from defense Arrival of highly qualified Russian migrants in the 90’s Globalization of tech capital market with Nasdaq Steadily growing population of tech talent Relatively dense catchment area for Hi Tech talent – IDF, Technion institute Innovation spread from agriculture (60’s), to defense (70’s and 80’s), to hi tech (90’s)

Supply Side factors:

Yozma funding Expatriates interested in investing US and other overseas funds beginning to scout around for investment opportunities in Israel

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Four Phases of VC activity

First Phase (1993-96) Dominated by Yozma program, low valuations of start-ups

Small funds (~$20mn), small amounts invested in start-ups, co-investment with other Israeli VCs

No specialization in areas

Goal: to make fast exit through M&A (in low valuations of about $10mn to $70mn).

Second Phase (1996-98)

First round of private VC funds not related to Yozma; low valuation continued

Medium sized funds (~$100 mn); increase in amounts invested, fewer portfolio companies

Increase in seed investments and beginning of specialization in areas

Third Phase (1998-00)

Higher specialization and increase in seed investments

Increase in VCs added value capabilities.

Israeli VCs Increase co-investment with US VCs.

High valuation exits.

Fourth Phase (2000-03)

Tech meltdown closes IPO routes; few exits

Lack of fresh funds make VCs prefer later stage investments for quick exits

Israeli VCs retain interest while that of foreign VCs has come down significantly

Low valuations of Israeli firms but with fewer exit options for investors

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How it worked in Israel

Incubators

Result:

600Start-Ups Annually

Talent for TechnologicalInnovations

andManagement

Technology Infrastructure

Repatriate Israelis

Russian Immigrants

Skilled Employees

IDF

CorporateR&D

Technion & Others

in research Corporate

Spin-OffsEntrepreneurial Attitude

Yozma and Daughter Funds

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III. Israeli VC Players: YOZMA

Description

• Started by the government in 1993 with a corpus of $100 mn to invest in other VC funds

• In each of the 10 Yozma ‘daughter’ funds the government invested 40% of the capital raised by the fund up to $ 8 mn

• Other investors in each ‘daughter’ fund had a 5-year call option to buy the government share at initial value plus nominal interest or 7% of future profits; Yozma did not make management decisions

• Investments were in Israeli entities; foreign partners accepted

• The call option to the fund (rather than to the entrepreneur) to buy out Yozma’s stake proved a great incentive

• After the VC market acquired a critical mass, Yozma was privatized in 1997; continues to be managed by its founder Yigal Erlich

Daughter Funds & Foreign Partners

Eurofund Daimler-Benz, DEG (Germany) Gemini Advent (US) Inventech Van Leer Group (NL) JVP Oxton (US/Far East) Medica MVP (USA) Nitzanim-Concord AVX, Kyocera (Japan) Polaris (Pitango) CMS (USA) Star TVM (Germany) & Siemens Vertex Vertex international Walden Walden International US

Source: IVC Research Center

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Israel-based VCs – The Top Ten in Assets

Name of the Firm Assets in $ mn Investments in 2003 Investments in 2002

Pitango 720 18 21

Evergreen 675 13 17

Vertex 650 11 7

Genesis 364 18 10

Gemini 350 9 10

Giza 316 12 14

Concord 286 8 NA

Israel Seed 262 14 9

Challenge Fund Etgar

242 12 13

Cedar 225 9 6

Yozma NA 8 5

Source: Venture One, IVA 2003 Yearbook

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VC Players - Size of Funds Raised


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Notes to VC Players – Size of Funds Raised

1. Includes Apax’s two Israeli funds (Israel Growth Fund - $40 million and Apax Israel II - $100 million) together with an estimated allocation of $600 million from Apax’s European funds (Apax Europe IV - €1.8 billion and Apax Europe V - €4.4 billion). The amount allocated to Israel includes investments in technology companies and LBO deals.

2. Refers only to Benchmark’s Israeli fund, which has a local management team.

3. Includes an Annex Fund to JVP III ($14 million), and 50 percent of JVP IV ($405 million), the estimated allocation to Israel.

4. Includes $50 million of Vitalife, which was acquired in 2003 from Discount Capital Markets & Investments; Does not include $450 million managed for other entities: $330 million for Vertex Europe, $70 million for Vertex International, $50 million for UBS Capital.

5. Includes SVE X ($6 million) and 50% of Star’s other managed capital, the estimated allocation to Israel.

6. Includes an Annex Fund to Israel Seed III ($4 million).

7. Carmel invests a part of its capital outside of Israel. Since there is no stated allocation between investments in and outside of Israel, the entire amount is allocated here to Israeli investments.

8. $100 million was returned to investors in 2002. BRM Fund invests part of its capital outside of Israel. Since there is no stated allocation between investments in and outside of Israel, the entire amount is allocated here to Israeli investments.

9. Refers only to Sequoia’s Israeli fund, which has a local management team.

10 Includes an estimated $20 million reduced commitment to a limited partner.

11 Does not include Evergreen’s secondary funds, fund of funds, ceased and acquired funds.

SOURCE: IVC Research Center

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Movers and Shakers

Dr. Ed Mlavsky, Chairman and Founding Partner, Gemini: One of the founders of the modern VC industry in Israel. From 1979 to 1993, as executive director of BIRD Foundation, he was responsible for investing more than $100 mn in over 300 joint project projects between Israel and the US. An influential member of IVA. Holds 25 patents.

Chemi Peres, Managing General Partner & Founder, Pitango: Son of leading politician Shimon Peres. Lobbies aggressively with the government as well as the American Jewish community. His current focus is on raising $ 300 mn from American Jewish donors for nanotechnology development in Israel to desalinate water and create military units without soldiers. He is the chairman of the Board of Directors of IVA and also serves on the Board of Directors of Ramot, the commercial arm of the Tel Aviv University that focuses on Technology Transfer. Email: [email protected]

Yigal Erlich, Chairman and Managing Partner, Yozma: Founding father of VC industry in Israel. Set up Yozma in 1993. After its privatization in 1997, continues to head it. Between 1993 and 1995, Erlich was involved in setting up 10 venture funds through Yozma including Gemini, JPV, Concord, Pitango and Walden Israel. Founder of IVA. Between 1984 and 1992, he was the Chief Scientist of Israel’s Ministry of Industry and Trade. Also started a technology incubator program that led to the creation of 24 incubation centers throughout Israel. E-mail: [email protected]

Matty Karp, Managing Partner, Concord: A star in the VC market in Israel. Served as CEO of the Nitzanim Venture Fund and CEO of Kardan Technologies. Co-founded Concord. Prior to joining Nitzanim, Matty spent fifteen years at Elbit Computers Ltd, an Israeli high-tech company with worldwide activities in the defense and healthcare sectors. Was a jet fighter pilot in IAF.

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Movers and Shakers

Yossi Sela, Managing Partner, Gemini: a former major of the IDF, he worked at Daisy Systems Inc. as Director for CAD development and Marketing Manager, Europe. His importance stems from his investment expertise in software, communications equipment and semiconductors, the three areas Israel Hi Tech is known for.

Yoram Oron: Founder and Managing Partner, Vertex Israel and President, Vertex Europe: Has an impressive record as founder and manager of several successful high technology companies. Was previously President and CEO of Aryt Industries; Co-Founder of Geotek Communications; Co-Founder, President and CEO of Reshef Technologies; and Co-Founder and Chairman of Telegate Ltd. He is also the chairman of IVC Research Center.

Jacob Burak, Chairman, Evergreen: Has been personally responsible for many of the investments made by Evergreen. Became a member of the transition team appointed by Shimon Peres prior to Peres' becoming Prime Minister of Israel, where he had primary responsibility for industrial and trade issues.

Eyal Kishon, Managing Partner, Genesis: Is known for his technical knowledge and an intimate understanding of Israel's VC industry. For three years prior to co-founding Genesis, he was the Associate Director of Pitango. Earlier he was CTO at Yozma Venture Capital.

Ehud Olmert, Minister of Industry and Trade: A former IDF veteran, he is also the Deputy Prime Minister. Is in charge of shaping the government’s policy towards VC industry.

Allan Barkat, Apax: A prominent investment manager of Apax Leumi between 1995 and 2000. Partner at Apax Europa V, managing $ 600 mn in investments, also in Israel.

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Movers and Shakers

Shuly Galili, Executive Director, California – Israel Chamber of Commerce: Shuly is actively promoting Israel and VC opportunities in Israel in Silicon Valley.

Efrat Zakai, Director of Research, IVC Research Center: Efrat is a key individual with extensive knowledge related to venture capital in Israel.

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IV. Foreign VCs active in Israel

Apax Partners Has $ 12 bn under advice or management around the world In Israel since 1994. Has invested over $160 mn in more than 30 companies Initially, Apax used to invest in Israel via two local funds: Israel Growth Fund and Apax Israel II. In October 2000,

Apax Partners in Israel joined with Apax Partners in Europe. There is no separate Israel team now. Apax focuses on six global industry sectors of specialization, including in Israel.

• Accel Runs a $ 3 bn fund globally. Earlier, investments in Israel used to be made out of office in Palo Alto The current model differs. In Jun 2001, Accel raised a $ 500 million fund for European investments including in

Israel. 2 of Accel’s partners manage Israeli investments out of its London office; Accel’s declared strategy in Israel is to

stay close to Israeli funds and invest together with them in their companies, nurturing close cooperation.

Alice Milan and Tel Aviv based firm. Hired a former Walden Israel person to handle investments Is the advisor of the venture capital funds promoted by MB Venture Capital and of Alicelab, a seed fund investing

in technology only projects Invests only in early stage European and Israeli companies operating in information and telecommunication

technologies, internet technologies, media and life sciences

Atlas Venture Spun off from ING group, has $ 2.1 bn under management, and offices in Munich, London, Boston and Paris Investments in Israel form part of Europe investments Invests in early stage in life sciences, IT and communications

Benchmark Israel Full fledged office in Tel Aviv with 3 partners located in Israel. Team led by successful veterans of the start-ups who understand what it takes to build enterprises. Key Strength: facilitates transition of Israeli startups to US markets

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Foreign VCs active in Israel

Greylock Boston based fund, had committed $100 million for Israel investments in 2001 Greylock believes that Israel VC structure makes cooperative model advantageous; unnecessary to have a

local office in Israel

Intel Since 1996, has invested over $100 mn in Israel, almost all jointly with local VCs Focuses on Internet infrastructure technologies at seed and early stages Intel Israel Innovation Center (I3C) nurtures seed ideas

Star Ventures Munich-based fund with over $ 1 bn in management. Among others, Siemens, Swiss Life PE and Morgan Stanley are investors Operates out of Munich, Dallas and Herzliya 52 M&As and IPOs, including from Israel

Sequoia Raised its first Israeli fund for $ 150 m in 2001 2 of Sequoia's 14 partners manage Israeli investments Total of 12 Israel related investments; most recent investment in US/Israel company Invests in telecom, chip design and software

Vertex Israel Part of Singapore-based Vertex group with offices in Tel Aviv, Singapore and London Focuses on IT and enterprise software, emerging technologies

Walden Israel A part of San Francisco-based Walden group that manages over $ 3 bn Has over $ 185 mn in management in Israel Focuses on communications, e-commerce, internet infrastructure and healthcare

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Foreign Investments in Israel: 2000-03

• Active foreign investors of all types – VCs, CVCs, Investment Banks and Corporations - preferred to go jointly with Israeli VCs. Out of approximately 288 investments made, 241 (83.3%) were made with Israeli VC participation.

• 11 out of 35 foreign VC investors went ONLY with Israeli VCs, i.e., they did not make any investment directly.

• No investor, VC or otherwise, went only for direct investments. This indicates that even if a firm prefers direct investments as a global policy, and does not invest jointly with other VCs, in Israel, it would prefer to go with Israeli VC participation in most deals.

• Global Catalyst Partners (GCP) is only VC that invested in more deals directly than through or with Israeli VCs. Of its 5 investments, 3 were made directly. But with Dov Mishor (Member of the Board, Bank Leumi; former Director General of the Israeli Ministry of Industry & Trade) as an advisor for its Europe operations, which includes investment in Israel, GCP has in-house talent to identify ventures in Israel. In a sense, there is a strong Israeli connection.

• Benchmark and Sequoia do not make the list of active investors in this period; Accel invested with Israeli VCs in 8 out of 9 deals.

84%

16%

Co-Investments vs. Direct Investments in IsraelBy Foreign VC Investors, 2000 – 2003*Percent

Total = 288 Investments

Co-Investments

Direct Investments

*List of Top Foreign Investors with 5 or more investments

Source: IVC Research

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Most Active foreign investors in Israel 2000-03

Rank Fund Type Co Investments with Israeli VCs

Direct Investments

Total

1 Intel Capital CVC 29 6 35

2 JP Morgan Partners

IC 16 0 16

3 Goldman Sachs

IC 13 2 15

4 Shamrock Holdings

IC 10 2 12

5 Deutsche Bank Alex Brown

VC 8 2 10

6 Accel Partners

VC 8 1 9

6 Bank Am Equity Partners

VC 9 0 9

6 Jafco Ltd, Japan

VC 7 2 9

6 AOL Time Warner Ventures

CVC 9 0 9

Source: IVC online

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Direct Investments

Total

6 Bank Boston Ventures

VC 9 0 9

6 RBC Dain Rauscher

IC 9 0 9

7 Harbourvest VC 6 2 8

7 Lightspeed VC 5 3 8

7 China Devt Ind Bank

IC 8 0 8

7 Morgan Stanley Pvt Equity

IC 6 2 8

7 JK&B Capital

VC 8 0 8

7 Cisco Systems

Corporate 6 2 8

8 Greylock Mgt

VC 5 2 7

Source: IVC online

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Direct Investments

Total

9 CSK Venture VC 5 1 6

9 Hitachi CVC 4 2 6

9 Draper Fisher Jurvetson VC 4 2 6

9 Holland Ventures VC 4 2 6

9 Lucent Ventures CVC 5 1 6

9 Nomura IC 5 1 6

10 Ridgewood Capital VC 3 2 5

10 Global Catalyst Partners VC 2 3 5

10 Oxford Bioscience Partners VC 5 0 5

Source: IVC online

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Rank Fund Type Investments with Israeli VCs

Direct Investments

Total

10 Carlyle Group VC 4 1 5

10 CDB Tech IC 5 0 5

10 Dell Ventures CVC 3 2 5

10 Lewis Trust Group IC 3 2 5

10 Mitsubishi Corp Corp 5 0 5

10 Soros Private Equity IC 5 0 5

10 West Steag Partners VC 4 1 5

10 Young Associates Limited VC 4 1 5

TOTAL 241 47 288

Source: IVC online

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V. Market Trends: Venture Capital Fund Raising

According to IVC Center, in 2003, capital raised by Israeli venture capital firms was $118 million, netting $28 million.

IVC Research Center estimates that capital availability in Israel’s venture capital industry is $1.15 billion, of which $750 million is intended for First high-tech company investments.

The center forecasts that Israeli VCs will raise between $1.5 billion and $2 billion in 2004-05.

The 20 largest Israeli venture capital funds raised around $ 6.5 bn exclusively allocated to investments in Israeli tech companies. Of this, around $ 4.3 bn had been raised between 2000 and 2003 (representing 83% of capital raised by all Israeli VC funds in the period).

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Venture Capital Fund Raising Expectations

According to Deloitte and Touche VC Indicator Survey of 48 Israeli VCs released in March 2004, there has been a dramatic improvement in confidence in the ability to raise new VC funds. 57% think that it will be easy to raise new funds in the next six months.

According to the same survey, 67% of respondents expect to raise their next fund within 2004-2005.

Degree of Difficulty in Funding RaisingPercentage of RespondentsDeloitte VC Indicator Survey, March 2004

Source: Deloitte VC Indicator Survey, March 2004 Link to Deloitte VC Indicator Survey

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Venture Capital Fund Raising

• Evidence suggests that Israeli VCs primarily raise funds from foreign sources.

Big international LPs include JP Morgan Chase, HarbourVest, AOL, TIF (Singapore), IBM among others.

JPMorgan alone contributed over $100 million to Pitango’s $500 million Fund III.

Institutions in Israel take less risk: In the 1990s, Israeli insurance companies and pension funds invested just 0.2% of their holdings in venture capital outlets. If Israeli pension funds were to emulate the actions of foreign investors, by investing 5% to 10% of their funds over the next four years in VC market, that will amount to an average investment of about $ 400 mn a year over the next 4 years.

• 33% of the VCs surveyed by Deloitte expect that European investors will play a larger role in fund raising. Of this, 46% expect the UK to be the primary source of funds from Europe.

Yozma B: IVA and the Ministry of Finance are working on a ‘Yozma B’ intended to encourage foreign investors to invest in Israeli VC funds, under a format similar to the original Yozma fund. Yozma B plan states that the state should budget $1.2 billion in 2004-06 for loans to Israeli venture capital funds that manage to raise additional capital for their activities. The loans would reach 35% of the total amount raised by each fund, up to a maximum of $75 million for each fund. The loans would be repaid in 12 years. Under the plan, the funds are expected to raise an additional capital $2.2 billion from foreign investors.

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Venture Capital Raised by Hi Tech firms

371 companies raised $ 1011 mn from Israeli and foreign VCs in 2003, roughly equal to the 1999 levels.

The average amount ($2.7 mn) raised per company in 2003 is marginally below the 1999 level.

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Venture Capital Raised by Hi Tech firms

Financing with Israeli participation accounts for 85% of total financing raised by high tech companies in Israel between 2002 and 2003.

According to the Deloitte VC Indicator survey, 58% of VC respondents expect raising new funds by companies from VCs to be “less difficult” in 2004.

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Israeli VCs’ Investment Level

Capital invested by Israeli VCs in 2003 ($421 million) was approximately the same amount as in 1999.

Israeli VC share of total capital invested has remained at 40-42% between 1999 and 2003.


Israeli VC InvestmentPercent of Total Capital Invested, 2001 - 2003

0

200

400

600

800

1000

1200

1400

1999 2000 2001 2002 2003

Israeli VC InvestmentTotal Capital Invested in Israeli High Tech Companies$ Millions, 1999 - 2003

0102030405060708090

100

1999 2000 2001 2002 2003

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Israeli VCs’ Investment Level

A PWC survey confirms that except for 2000, which was an anomaly, the Israeli VC share is relatively constant at 42 – 45%.

Source: Money Tree Survey. Price Waterhouse Coopers

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Israeli VCs’ Level of Activity

A Money Tree Survey (Price Waterhouse Coopers) shows that the number of funds that are NOT investing is on a steady decline. Inactivity peaked in Q1 2003, surprisingly a little higher than in Q4 2001, which followed 9/11 shocks.

Source: Money Tree Survey. Price Waterhouse Coopers

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Israeli VCs’ Level Of Activity Expectations

Recovery of public markets is key to increased Israeli VC activity.

The Deloitte Survey suggests that activity may not pick up significantly until 2005.

Source: Deloitte Link to Deloitte VC Indicator Survey

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Israeli VCs’ Level of Activity

• Some Israeli VCs have started investing overseas in non Israel related companies

• Israeli VC investments in foreign companies (companies with no Israeli connection) soared 63% in 2003 as $101million was invested, compared to $64 million in 2002.

• VCs such as JVP and Pitango are not restricting investments to Israeli firms. These VCs aspire to be global with investment focus on sector rather than on the geographic region, and are trying to break out from their existing Israel focus.

However, experts in the Israeli VC industry question the global VC aspirations of these firms.

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Israel VC Backed Company Valuations

Median Pre-Money Valuations, IT CompaniesSecond Round and Later Stage$ Millions, 1999 - 2003

$.00

$5.00

$10.00

$15.00

$20.00

$25.00

$30.00

$35.00

$40.00

1999 2000 2001 2002 2003

Second Round Later Stage

There is no hard data available on profitability.

Data from Venture One suggests that median pre money valuations for second round and later stage companies are fairly low, and have come down since 2000.

This could contribute to higher VC returns, assuming a robust Nasdaq and M&A Environment.

Note: 2002 data seems anomalousSource: Venture One

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No IPO exits in 2002 and 2003

Capital Raised by Israeli Venture Backed Companies in US and European Public Offerings (1995-2003)

YearNumber of Offerings

Capital Raised($M)

Number of Offerings

Capital Raised ($M)

1995 14 719 8 2451996 32 959 17 6381997 23 798 10 3081998 19 993 8 2201999 32 3,821 20 1,3822000 40 5,001 28 2,0652001 6 1,259 3 2012002 2 522 0 02003 5 1,143 0 0Total 173 15,215 94 5,059

All offerings Venture Backed

There were no VC backed IPO exits in 2002 and 2003.

In addition, many Israeli companies that dual-listed in Nasdaq and European bourses have lost their sheen. For example, companies such as VocalTec, Camtek and Commtouch have been forced on to the Nasdaq SmallCap.

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VCs’ Expectations of IPO Exits

As another indication of changing sentiment, over 60% of Israeli VCs surveyed by Deloitte expect up to 10 Israeli companies to go public in 2004.


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M&A as an Exit Option

0

2000

4000

6000

8000

10000

12000

1996 1997 1998 1999 2000 2001 2002 2003

Mergers and Acquisitions of Israeli High Tech Companies$ Millions, 1996-2003

The M&A exit route has only generated approximately $1 Billion in value in each of the last three years.

Source: IVC Research

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VCs’ Profitability Expectations

The Deloitte survey suggests that the number of VCs expecting to get >3x return has gone up to over 60% in the last two quarters.


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Companies Opened and Closed

In 2001 and 2002, there were more Hi Tech companies in Israel that closed than opened. In 2003, the trend has been reversed, which may signal an improving market and also profitability environment.

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Average Deal Size

The average deal size in 2003 was $2.7 million, approximately the same as 1999 levels, as is the case with many other indicators.

1. Source: Money Tree Survey. Price Waterhouse Coopers

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VC Investments by Stage

Note: R&D stage and Revenue Growth Stage numbers for 2003 are estimates.Source: IVC Research

95

811

632

447

23399

614

102

58353

496

104

0

500

1000

1500

2000

2001 2002 2003

Seed Early Stage / R&D Mid Stage / Initial Revenue Revenue Growth

1986

11381011

Total Investments by Stage of Financing$ Millions, 2001 -2003

5%

41%

32%

23%

2%

35%

54%

9%

6%

35%

49%

10%

0%

20%

40%

60%

80%

100%

2001 2002 2003

Seed Early Stage / R&D Mid Stage / Initial Revenue Revenue Growth

Total Investments by Stage of FinancingPercent, 2001 -2003

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VC Investments By Stage

• The four stages of investment as defined in Israel are i) seed, ii) R&D (but no revenue), iii) initial revenue, and iv) revenue growth

• Stages 2, 3, and perhaps even 4, could all be defined as “early stage” in the European and the US context

• Israeli VCs tend to account for 80+% of total seed stage capital, 50% of R&D stage investments, and 35% or less of initial revenue and revenue growth stage investments.

• Efrat Zakai of IVC suggests that the pick up in seed investments in 2003 signals a “brighter” investment future.

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VC Investments by Stage

• Expressed in terms of % of investments, Israel’s VCs focus more on seed and early stage investments as compared to European VCs. .

Total Investments by Stage of FinancingPercent

Source: Evergreen Ventures presentation, 2002

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VCs’ Investment by Stage Expectations


• The Deloitte survey suggests that VCs expect seed and first round activity to pick up in 2004.

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.

836

397

309182261

418

20417641299

34719218241249

0

500

1000

1500

2000

2001 2002 2003

Communications Software Life Sciences Internet Other Technology

VC Investments by Sector

1986

Total Investments by Sector$ Millions, 2001 -2003

Total Investments by SectorPercent, 2001 -2003

Communications has been a key sector over the last 3 years; the Internet sector has declined from 33% of total capital invested in 1999 to 4% in 2003.

Other technology includes semi conductor sector which is growing.

42%

20%

16%9%

13%

37%

18%

15%4%

26%

34%

19%

18%4%

25%

0%

20%

40%

60%

80%

100%

2001 2002 2003

Communications Software Life Sciences Internet Other Technology

11381011

Note: Communications and Other Technology numbers are estimates for 2003.Source: IVC Research

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VCs’ Investment by Sector Expectations


• The Deloitte survey suggests that transactions will increase broadly across all sectors.

• However, 94% believe that the Internet sector will make a comeback, which is higher than for any other sector.

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VII. Other Issues: VC Structure Issues

Fewer handovers: All VCs find it difficult to find takers to take the baton through the next stage. Therefore, VCs face the burden of leading their portfolio companies through several stages and a number of financing rounds. Some funds will feel this burden more heavily than others. For example, Carmel, Gemini and Evergreen invest in certain technologies only at the seed and early stage. Their exits will be delayed if handovers are difficult and if they are unable to raise fresh funds.

Israeli VCs losing steam in raising fresh funds: Net funds raised in 2003 barely touched $28 million. While VCs’ expect better times ahead, there could be a short term drought in VC money available, though this raises the opportunity available to foreign investors.

Less money for start-ups: When fresh capital accretion falls, VCs tend to move up to later stage investments so that rewards could be reaped quickly. This could happen in Israel. It will lead to a mismatch with more start-ups looking for more funds but VCs looking at later stage investments.

Incubators’ trouble: 12 out of 24 incubators have been privatized. It is feared that the government would go back on its commitments to privatized incubators. Since these have raised funds also from overseas investors, Israel risks adverse perceptions.

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Other Economic Issues

Mixed signals on Credit Risk: Some indicators show that Israel’s credit risk has gone up, while others show that it has gone down. For example, the gross external debt/GDP ratio climbed from 60% at the end of 2001 to 65% in 2002, an upturn for the second consecutive year. (The higher this ratio, the worse the credit risk). However, the net external debt/GDP ratio, an indicator that points to a decline in Israel’s credit risk, continued to fall in 2002 and ended the year at only 1%.

In terms of overall assessment, according to the Economist Intelligence Unit, Israel is rated at B (where E is most risky) with a score of 33 (where 100 is riskiest). In terms of financial risk, it is B/25.

S&P lowered its Israel outlook in October 2000 from positive to stable and from stable to negative in April 2002; Moody’s lowered its outlook from positive to stable in February 2001. Although the outlooks changed, ratings have not. S&P and Fitch left the sovereign rating at A- and Moody’s kept its rating firm at A2.

However, investments and Growth have not stopped: Investment in Israel has continued to grow over the years - in 2002 it was over $ 2.5 bn up from $ 537m 1992. Most of this is technology-related. Leading tech multinationals such as Intel, Microsoft, Cisco and Motorola, maintain core development centers in Israel. New businesses are being founded and built as they have been since the 1980s - over 1,000 in 2003.

Favorable Tax policy: Foreign firms can repatriate profits and dividends out of Israel. There is no capital gains tax on profits of foreign VCs. (There was a 20% tax which was later scrapped).

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VIII. 3i Entry Strategy and Potential Partners

• 3i can enter Israel following a number of different strategies, including:

a) Co-investments with multiple Israeli VC fundsb) Formal alliance or partnership with a particular Israeli VC fundc) Dedicated team for Israeli investments staffed by well-connected Israeli expats located in Londond) Independent strategy with fully staffed office in Israel

• Evidence suggests that options a,b, or even c (above) might serve as a profitable entry strategy for 3i. The small number of independents and the lack of current demonstrable success, suggests that option d should be pursued at a later stage.

• Option a may be the most simple way of testing the waters in Israel; however, this assumes that most Israeli VCs and foreign investors co-invest with multiple partners. This needs to be researched in more detail.

• Given the outward focus of Israeli VCs’ and venture backed companies for markets, exits, and funding, it seems reasonable to assume that most (or all) Israeli VC firms could benefit for 3i’s participation:

3i has a global presence and networks in all major markets 3i has proven expertise in IPOs and M&A in Europe (and US) 3i has money to enter at an early stage, can hold investments for till 2005 and beyond, and can

provide follow on funding

• We have identified funds that match 3i’s sector and stage investment criteria; however, more research is required to evaluate potential partners in-depth, including track record, deal origination, fit with 3i, as well as potential conflicts based on arrangements or alliances with other foreign investors

• JVP and Pitango, though included in the list, have global aspirations which may conflict with 3i’s potential role.

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Potential Partners for 3i

Source: Venture One, VC Fund Web Sites

Name of Israeli VC Core Strengths / track record

Areas of common investment interests with 3i

Stages Offices outside Israel

Remarks

Pitangowww.polarisvc.com

Over $ 700 mn, helped over 80 firms grow, led by Chemi Peres,

Optical networks, cellular technologies, e-business applications, internet security, medical devices

All US, Europe, Asia

Claims to be a global VC, but solid Israel focus

Evergreenwww.evergreen.co.il

Highest cash on cash returns for any Israeli VC, 25 successful exits through IPOs

(In general) software, communications, life science

Mostly early stage

Genesiswww.genesispartners.co.il

11 exits, including 5 IPOs

(Usually seeks lead role) software and communication

All

Geminiwww.gemini.co.il

At least 6 IPOs and 7 M&As, led by veteran Ed Mlavsky

Wireless tech, enterprise software

Seed Silicon Valley

Giza

www.giza.co.il

21 exits Enterprise software, communications

Early Stage

London, Singapore, NY

JVPwww.jvp.co.il

11 exits

Enterprise software, mobile infrastructure

Early Stage

London, Tokyo, NY

Claims to be a global VC

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Potential Partners for 3i

Name of Israeli VC Core Strengths / track record

Areas of common investment interests with 3i

Stages Offices outside Israel

Remarks

Cedar Fundwww.cedar.co.il

Pioneered Pre-seed investments in Israel

Communications, internet infrastructure

Pre-seed and Seed

Cayman Islands,

NY

Israel Seed

www.israelseed.com

10 M&As and 1 IPO Communications, internet infrastructure, medical devices

Seed

Yozmawww.yozma.com

6 M&As, 4 IPOS, led by Yigal Erlich

Communications, medical devices, Internet infrastructure

All, primarily early stage

Concordwww.concord-ventures.co.il

Led by Matty Karp, at least 10 IPOs and 1 M&A (including under Nitzanim fund), one of the best track records in Israel

Data communications, medical devices, internet infrastructure

Mostly Seed and Early Stage

Also invests in US firms with Israeli-connections

Source: websites

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Appendix 1

Fund

Description

Vintage Year *

Capital

Committed

Cash In ** Cash Out Cash Out and Remaining Value

Net IRR

****

Investment Multiple***

Apax Israel II 1999 5,000,000 3,725,000 713,624 1555108 (39.50) 0.42x

Carmel Software Fund

2000 2,500,000 937,500 0 461374 (33.80) 0.48x

Gemini Israel III 2000 2,500,000 1,375,000 0 1045013 (17.0) 0.76x

Israel seed IV 2000 2,500,000 1,187,500 0 669418 (31.80) 0.58x

Jerusalem Ventures

2001 7,500,000 2,250,000 0 1520334 (24.90) 0.88X

Pitango Capital Fund III

2000 5,000,000 2,500,000 0 1588880 (26.20) 0.63x

Polaris Venture Partners IV

2002 10,000,000 300,000 0 242800 (60.60) 0.81x

Book Values reported by CalPERS (LP) of Returns on Investments in Israel Funds

1. * Vintage Year: Determined on the basis of latter of the: I) the date of first contribution of capital to the fund or ii) the date on which the fund made its first investment. ***Multiple is “Cash Out + Remaining Value / Cash In”

2. **** IRR is based on actual dates of cash flows and quarter end valuations. IRR calculation includes interest paid. (But IRR and Investment Multiple are not really meaningful for these funds since the vintage year is post-1998).

3. **Cash in was drawn for organization costs and management fees only.

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Appendix 2: Potential Hits of 2004 – survey

According to a survey by Globes magazine, the start-ups the venture capitalists in Israel believe will be the hits of 2004 are: Finjan Software, Kashya, PowerDsine, Saifun Semiconductors, Schema, Shopping.com (formerly DealTime) and Wintegra

1. Finjan Software

Product: Anti-virus security. Shareholders: Benchmark Capital, Star Ventures, Israel Seed Partners, and CSK Venture Capital. Reasons for ranking: The company switched its technology direction to security.

2. Kashya Product: Data protection applications. Shareholders: Battery Ventures and Jerusalem Global Ventures. Reasons: Kashya has launched a product and has sales, reaching top-tier customers. Its sector,

remote replication of storage, is very hot. Has a superb management team. 3. PowerDsine

Product: Power over Ethernet (PoE) technology that allows power to be transmitted over the same network cable as data.

Shareholders: Ampal - American Israel Corporation (Nasdaq: AMPL), Argoquest Holdings, ASB Ventures, Clal Industries and Investments (TASE:CII), Challenge Fund, JVP, Vertex, Plenus Venture Lending Fund, Poalim Capital Markets RBC Capital Markets (formerly Dain Rauscher Wessels), and Yozma.

Reasons: PowerDsine is profitable, has tens of millions of dollars in annual sales, defined the industry standard, has substantial growth, has sufficient cash, and can approach the capital market.

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Potential Hits of 2004 – a survey

4. Saifun Semiconductors Product: Non volatile memory (NVM) technology for flash memory processors for mobile devices Shareholders: Concord, Gemini, Israel Infinity, STI Ventures, Infineon Technologies (NYSE;

XETRA:IFX), Morgan Stanley, Bank of America Equity Partners, and Advanced Micro Devices, Inc. (NYSE: AMD)

Reasons: Leading technology, initial sales, active in a growing market, strategic partnerships, well-connected and well-known among all investment banks.

5. Schema Product: Network planning and optimization solutions for wireless operators. Shareholders: BRM Capital, Docor International B.V (a subsidiary of the Van Leer Foundation),

Challenge Fund, EnerTech Capital Partners, Gemini Israel Funds, TL Ventures, Walden Israel, and Yozma.

Reasons:Schema is profitable, has a large amount of cash, a good penetration of the US market, good and attractive technology, and fast growing sales.

6. Shopping.com Product: Formerly DealTime. Price comparison technology for e-commerce. Shareholders: America Online (AOL), Israel Infinty, Israel Seed Partners, Odeon Capital Partners,

Nomura Holdings (TSE:8604; NYSE:NMR), Bank of America, Singapore Telecom, and others. Reasons: $75 million has been invested in the company. It is profitable, expects to post $70 million

in sales in 2003, active in the hot market of online price comparison, and able to approach the capital market.

7. Wintegra Product: Single chip solutions enabling communications infrastructure equipment providers to

migrate their product lines to the next generation of access networks. Shareholders: Concord, Genesis, Magnum Communications Fund, Taiwan's China Development

Industrial Bank (CDIB), Texas Instruments, and Marvell Technology Group (Nasdaq: MRVL). Reasons: Proprietary technology, the right target market (access networks), growing sales, and

exceptional entrepreneurs and managers.

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Appendix 4: Israel, EU, US VC markets (Flows)

• Israel market is More volatile: In 2002, VC investment volume in Europe (excluding buyouts and restructuring) was down by only 50% from its peak in 2000, versus 63%in Israel.

• US-based VCs invest 84% domestically and 16% in foreign countries. Europe’s average 80% is invested domestically within each country, while an additional 17% flows intra-Europe and just 3% goes overseas. Israel’s VCs invest 94% in Israeli and/or Israel-related companies.

• US portfolio companies receive an additional 8% on top by foreign venture capital firms. Europe’s VC-backed firms obtain an additional 29%, Israeli firms 137% over their domestic VC volume.

SEE CHART ON THE NEXT SLIDE

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Israel, US, EU VC markets - Flows

Source: A Management Study of International Venture Capital Firms – a 13-country study of 100 international VC firms in Asia, Israel, Europe and US in 2003. By Dr. Martin Haemmig. E-mail: [email protected]

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Appendix 5: Comparison of Different Geographic Markets

India Ireland Russia Singapore Israel China

Labor cost A D A C D A

Cultural Fit. B A B B A B

Infrastructure (including tax&legal)

A A B A A C

Skills and Training A B A+ B A B

Intellectual Property Protection

B A C A A D

Political stability C A B A D B

Process maturity A+ A B B A C

Overall +4 +3 +2 +2 -1 -3

Israel’s labor costs are a blot on what is otherwise a perfect picture. Though ‘political stability’ appears a concern here, most VCs dismiss it as irrelevant. Tech development or VC activity do not seem to have been impeded by political crises in the Middle East. Thus, it is the labor cost that makes Israel relatively unattractive.

Source: Presentation by Valentin Makarov, President, Russoft, Dec 2002. www.russoft.org

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Links and sources

1. http://www.ivc-online.com/ (Israel Venture Capital Research Center)2. http://www.pwcmoneytree.com/moneytree/index.jsp (PWC)3. http://www.pwcglobal.com/il/eng/ins-sol/survey-rep/moneytreeQ303.pdf4. http://www.israelventure.com/ (facts about VCs in Israel)5. http://www.science.co.il/VCFund.asp. (list of VC funds in Israel)6. http://www.oecd.org/dataoecd/41/56/2491258.pdf (OECD working paper)7. http://www.ebusinessforum.com/index.asp?doc_id=5529&layout=rich_story 8. http://www.v1.com/9. http://sfgate.com/cgi-bin/article.cgi?file=/chronicle/archive/2004/04/02/BUG675V5L41.DTL&type=tech 10. http://www.google.co.in/search?q=cache:Pc8jSSeSUWAJ:www.ishitech.co.il/septmeet.HTML+venture+capital+%2B+isr

ael&hl=en&ie=UTF-811. http://www.globes.co.il/serveen/globes/NodeView.asp?fid=965. (Very good report on list of VC firms in Israel with short introduction)

http://www.globes.co.il/serveen/globes/docview.asp?did=744788&fid=942. http://www.israelbiz.org.sg/news/israel0204.doc http://www.innovation.lt/files/technology%20incubators-%20nurturing%20small%20firms.pdf http://trendchart.cordis.lu/Reports/Documents/Best_Practice_Report_2002.pdf http://www.immaginazioni.it/circo/circo_est/GREEN_PAPER.doc

http://trendchart.cordis.lu/Reports/Documents/Synthesis_Report_2002.pdf ifise.unipv.it/ Convegno/Evolution%20of%20th%20-%20Kaufman.ppt http://www.un.org/esa/ffd/business/1200hearings/rind(ii)/rind(ii).ppt www.turkishdefense.net/reference/ ISRAEL/Israel_FinancingHT.ppt http://www.altassets.com/casefor/countries/2004/nz4506.php ht

tp://www.altassets.com/pdfs/The%20Israeli%20Market_April2003.pdf (Morgan Stanley report) http://www.altassets.com/pdfs/Israeli_MoneyTree_Q1_03[1].pdf http://www.coudert.com/publications/articles/040328_35_israelvc_ivc.pdf (Israel from a silicon valley perspective) http://vx.thomsonib.com/NASApp/vxWebWAR/vxWeb.jsp http://www.globes.co.il/serveen/globes/docview.asp?did=744788&fid=942.

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Links and sources

References:

1. A Management Study of International Venture Capital Firms – a 13-country study of 100 international VC firms in Asia, Israel, Europe and US in 2003. By Dr. Martin Haemmig. E-mail: [email protected]

1. Venture Capital Policies in Israel – OECD unclassified paper by Gunseli Baygan, 2003

2. “Venture Capital Funds and Post-IPO Performance in Booms and Busts: Evidence from Israeli IPO’s in the US in the 1990s”. By Hedva Ber and Yishay Yafeh. Discussion Paper No. 2003.12 (September 2003 Bank of Israel)

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Methodology

The research was conducted out of information gleaned from websites of venture capital associations, venture funds, publications, regulatory authorities, research organizations and others.

Proprietary sources such as Dialog and Nexis were also used to access information. Information that is broadly about private equity but not exclusively about venture capital

has not been included. There was no comparable information available on profits that funds are making on their

investments in Israeli companies.

How should 3i enter the Israel VC market? Briefing Report.

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