Startup/Seed Stage Investment By Venture Capital

STARTUP/SEED STAGE INVESTMENT BY VENTURE CAPITAL

FUNDS (IN ISRAEL): ENTREPRENEURS IN RESIDENCY AND

EXECUTIVE IN RESIDENCY PROGRAMS

ABSTRACT

What constitutes venture capital and what constitutes angel financing is a natural question. In the time period after the bubble burst in 2000 it became easy to differentiate:

1. Angel investors: usually “high status” individuals, former successful technology entrepreneurs who use their financial wealth, which financed birth and initial growth of ventures.

2. Venture capital (VC): independently managed, dedicated pools of capital that focus on equity-linked investments in privately held, high growth companies needing mid stage financing. Startup/seed financing were usually not acceptable VC funding phases, because of the greater risks involved.

The growth in “Startup/Seed Financing” by VCs (almost 100% in Israel during FY 2004 alone), shows that Israeli VCs contrary to their Silicon Valley counterparts are interested in participating earlier in the venture’s life.

In the post Google IPO era, since 2004, Israeli VC partnerships are eagerly pursuing “good” startup/seed ventures, by using a combination of new programs like the “Entrepreneur/Executive in Residency (EIR)” programs among others. No academic papers that analyze these phenomena or even describe it have been found. On the other hand, newspapers and VC magazines have mentioned and described the work of EIRs in the VC industry in Israel.

The purpose of this paper is to conceptualize the characteristics of and relationships between: “VC partners” and the “Entrepreneurs” who received financing in the startup/seed phases. This will allow comparison between many types of VC-Entrepreneur relationships in startup/seed stage ventures and shed light on the nascent entrepreneurs and the EIR programs in particular. We believe that knowledge concerning this type of program will help VCs in other countries by either encouraging them to adopt this practice or to abandon it. The question of how VC equity financing will evolve over the next decade and how it will work with startup/seed ventures is a particularly critical one.

TABLE OF CONTENTS

Abstract 2

Introduction 4

Discovery, Innovation and Entrepreneurship 13

The Conceptual Model 18

Variables 19

Research Questions 34

References 37

List of Figures

Figure 1: Amount Raised by Israeli High Tech Companies ($M) 7

Figure 2: Capital Raised by Israeli Seed Companies ($M) 8

Figure 3: Number of Israeli High-Tech Companies by Sector and Stage (2/05) 9

Figure 4: The Conceptual Model 19

INTRODUCTION

Venture capital has proven to be one of the most capital efficient mechanisms for building high-tech companies and job creation in Israel. Since 1995, the Israeli economy has experienced an inflow of $43 billion ($16 billion through VC investments, $20 billion in proceeds from these ventures and $7 billion from VC backed IPO’s) (IVA 2005 Yearbook).

A combination of regional advantages and historical accidents conspired to produce in Israel the second greatest (after Silicon Valley) "Science Park" in the world. In terms of recent patents per capita, Israel stands third after USA and Japan (Trajtenberg, 2001). During the last three decades, Israel has shown dramatic growth in technological startups and is one of the world’s largest recipients of venture capital financing. By virtue of Israel’s entrepreneurial culture and close ties to America, Israeli startups have a strong presence in the United States. Check any technological start-up in the USA, and odds are that one of its competitors is an Israeli company (Bednarz, 2005). More Israeli companies are listed on NASDAQ than those of any other country outside North America- 70 out of 340 foreign listings (Canada has 80). Israeli start-ups have raised more than $5.2 billion in initial public offerings on NASDAQ in the last 5 years. This continued growth is directly related to the number of serial entrepreneurs getting back in the industry (IVC Research Center Surveys). The size of the venture capital pool available for early-stage (both startup/seed and R&D stages) financing has grown in only two countries: USA has $3.65 billion and Israel has $.55 billion, while the rest of the world together has less than $.4 billion (Acs & Audretsch; 2003)

Venture money is not long-term money. The concept is to invest in an idea or new technology, create a company and as soon as it reaches a sufficient size and credibility sell it to a corporation or to the public-equity markets. Venture capitals’ niche exists because of the structure and rules of capital markets (Zider, 1998). Banks will only finance a new business to the extent that there are hard assets against which to secure the debt. Most startup/seed ventures have few hard assets. Usury laws limit the interest banks can charge on loans and the risks inherent in startup/seed ventures justify higher rates than allowed by law. Usually, in return for financing one to five years of a company’s start-up, venture capitalists expect a ten-fold return of capital. Combined with the preferred position and stock options this is a very high cost on capital. This equity investment is like a loan with a 60%+ annual compound interest rate that cannot be prepaid (Zider, 1998).

Venture capital fills the void between personal sources of funds for innovation (usually provided by friends and family of the entrepreneur, government programs or corporate venture funds) or angel financing (former successful technology entrepreneurs that use their financial wealth) and later-stage traditional sources of merchant capital available to ongoing enterprises.

The VC industry has three “clients” it needs to satisfy in order to succeed. The fund is required to: 1) provide