Israel Vc New 6 English

SummarySummary

Venture CapitalVenture Capital’’s s Contribution to the Contribution to the

Israeli EconomyIsraeli Economy

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

222 Draft Draft Draft --- translated from Hebrewtranslated from Hebrewtranslated from Hebrew

IntroductionIntroductionWe 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


IntroductionIntroductionThis study, prepared for the IVA, evaluates the contribution of Venture Capital 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 Modelsover 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 and VC 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 VCs Total 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 and equipment).

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 this year.

We can therefore conclude that currently, VC investments have a direct contribution of over 1% to Israel’s GDP.


VC Contribution to Israeli VC Contribution to Israeli Relative Advantage Escalation Relative Advantage Escalation

The 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 animportant 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 ICTRelative 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%Is

rael

USA

Can

ada

Kor

eaSw

eden UK

Net

herl

ands

Irel

and

Fran

ceFi

nlan

dBe

lgiu

m EUN

orw

ayN

ewD

enm

ark

Ger

man

yA

ustr

alia

Italy

Switz

erla

ndG

reec

eSp

ain

Port

ugal

Aus

tria

Japa

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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

ICT

sha

re o

f GD

P (%

)


The Contribution to Human CapitalThe Contribution to Human CapitalWage payments to Israeli workers for R&D lead to an accumulationof experience and expertise and creates an intangible but important asset for the Israeli economy, even in cases of start-up closure due to 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 part of the total Israeli relative advantage in the advanced technology sectors.


The Contribution to the The Contribution to the StartStart--up Sectorup 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 the The Contribution to the Electronics and Software SectorsElectronics and Software Sectors

Currently, 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 Sectors Electronics and Software Sectors Estimated 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, by companies not supported by VC

2004 $B


IPO

Foreign M&A –operation in Israel

The Growth Model for IsraelThe Growth Model for Israel’’s Electronics s Electronics and Software Sectorsand Software Sectors,1995,1995--20042004

Foreign M&A –operation abroad

Israeli Electronics Israeli Electronics and Software and Software

CompaniesCompaniesDefense Industries Academic

Contribution Contribution –– 4% 4% Annual GrowthAnnual Growth

Israeli StartIsraeli Start--up up CompaniesCompanies

Incubators / Incubators / AngelsAngels

Ceased OperationM&A in Israel

Venture Capital

7% Internal Annual 7% Internal Annual GrowthGrowth

Office of the Chief Scientist


VC Contribution to Growth of the VC Contribution to Growth of the Electronics 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 attracting foreign investors to invest in technology development in Israel with all of its associated risks.


Implementing the Israeli Implementing the Israeli Relative AdvantageRelative Advantage

The 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 status which would allow them to continuously produce standard productsfor the international market.

Therefore, we see the Israeli relative advantage to produce unique products 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 and successful 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 and No Massive Knowledge and Technology Leakage Technology 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.


InvestorInvestor’’s Exit s 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 their operations 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 investmentin 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 action is 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 Operations

From 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 the advantages 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 established by 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 lowprices 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 theincrease in funding of VCs.


Seed

R&D

Incubator

Revenue growth

StageStage

705705

600600

160160

4545

1313

2525

VCVC1,4651,465$$ MM

OCSOCS7878$$ MM

100%

% Funded by % Funded by the 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 Yearups per YearIn 2004, the Chief Scientist awarded $25 million in grants to incubator-stage companies.

According to this model, we can double the number of new start-ups in Israel at an investment of only $25 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 Economy2. Growth Potential of the Economy


The Potential and its RealizationThe Potential and its RealizationIsrael has a tremendous potential for growth inherent in its hi-tech industries, 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 the The relative position of the Israeli economyIsraeli economy

The 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 rankingeconomies in the world, but his potential is not realized.

During this time, other economies such as Ireland, Spain and South 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 RankRelative RankAverageAverageOECDOECD

IsraelIsrael’’s Ranks RankRelative 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 high unemployment 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 since the establishment of the state though it has not managed to improve its relative international rank.


Accelerated growth scenario for Accelerated growth scenario for IsraelIsrael

In the analysis prepared by Economic Models for the HerzeliyaConference 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 HerzeliyaConference and it is being used as a basis for long-term strategic planning 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 economy within 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 Potential s Growth Potential

103%

43 %

12 %

50

16.9

115

22

CurrentCurrent20042004

Same rank Same rank scenarioscenario

Accelerated Accelerated growth growth 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 ScenarioIn 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 the import 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 indication for this process would be the fact that most workers will be employed in the commerce and services sectors.


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--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 Employed

265Hi-Tech Sector

Thousands

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