Benchmark and Others Still Believe in Israel –

With the drumbeat of war growing louder in Iraq, venture capitalists have one more reason not to invest in Israel. Many U.S.-based venture firms have already retreated, fearful of terrorist activity. Add those factors to the global technology downturn, and you have a tiny country with lots of promising startups that can’t get funded.

However, Benchmark Capital is working against the trend. Rather than turn its back on the region like so many others have, Benchmark raised another $40 million to fund Israeli-based startups.

The new money, raised in October, increases the size of the Benchmark Israel fund by 18% to $260 million, General Partner Andy Rachleff told Venture Capital Journal in an exclusive interview on Nov. 26.

“We think there is an awfully interesting opportunity in Israel because of people exiting the market,” Rachleff says. “We went to our LPs and asked for another $40 million, and we got it.”

Since it was raised in 2001, Benchmark Israel has invested more than $20 million in seven startups, according to market researcher Venture Economics (publisher of VCJ). Benchmark’s decision to put more money to work in Israel runs counter to what it did with Benchmark Europe I in the spring. At that time, it trimmed the vintage 2000 fund to $500 million from $750 million, citing a significant decrease in both valuations and the amount of capital needed to start new companies in Western Europe.

As in Europe, Benchmark continues to see “revenue-stage companies at startup prices.” But while the opportunity is there, not everyone is willing to take the risk. “Few people are willing to lead financings,” Rachleff says.

That has resulted in a tepid investment pace. During the third quarter, local and foreign VCs invested $266 million in Israeli startups, down 48% from the same period a year earlier and off 9% from the second quarter of this year, according to the IVC Research Center, a venture capital/high-tech research center that tracks Israeli investment activity in cooperation with the Israel Venture Association. The number of companies that raised money stayed relatively flat at 92, but the size of the average financing round declined from $3.2 million in the second quarter to $2.9 million in the third.

Terrorist activity plaguing the country only adds to its difficulties. “The global crisis in the high-tech industry and the political situation in Israel continue to have strong influence on investment activity, resulting in the investment falloff continuing in the third quarter,” says Zeev Holtzman, CEO and chairman of Giza Venture Capital, an Israeli-based VC firm with $316 million under management. “But I would blame the crisis in the global high-tech industry more than anything else.”

The increase in terrorist activity and the threat of war in Iraq may explain why non-Israeli venture firms are pulling back. “Since the beginning of 2002, foreign investors have tended to reduce their involvement in the Israeli market,” says Racheli Er-el, director of research at IVC. Foreign investors put up 56% of the total ($148 million) in the third quarter, but that was 10% less than they committed in the second quarter.

In fact, at least one U.S.-based VC turned down a deal in Israel because of the threat of terrorist violence. “Although I have never seen anything in the venture community run amuck because of what is going on, it just didn’t make sense for us to get involved there with what is going on when there are plenty of good deals right here,” says the source. Another U.S.-based VC says: “I just wouldn’t want to be traveling to and from Israel that often at this point in time.”

Additionally, the increase of terrorist activity in the region may explain why non-Israeli investors in the area invested 10% less than the quarter before.

The communications sector has been the hardest hit. In the third quarter of 2000, communications companies in Israel raised just over $554 million from venture capitalists local and foreign IVC. In Q3 2002, communications companies took in $80 million in venture funding, a decrease of 86% from two years ago.

Additionally, at least one Israeli VC firm cut its fund. At the request of its limited partners, BRM on July 8, 2002, slashed its Israeli vehicle. It returned $100 million from a $253 million emerging tech fund, making it the third-largest cut globally this year at 40%.

At the time, Charlie Federman, a managing director at BRM-a VC with headquarters in Fort Lee, N.J., with offices in Jerusalem and Herzelia, Israel-said he had expected other Israeli funds to follow in BRM’s footsteps. None have. Nevertheless, Federman doesn’t believe the threat of fund cuts in the region is over. “Mid-size and large funds that are 50% invested are candidates for reductions,” he says. “Many LPs are stressed and would prefer to be released from some percent of commitments made during more heady days.”

If Israel’s third quarter results are any indication of what the region has to offer going forward, perhaps more firms will cut their funds. The decline in communication spending is only the tip of the iceberg. During the third quarter, 92 Israeli high-tech companies raised $266 million from both local and foreign venture investors. That’s a 9% drop from the second quarter and a 48% decline from the third quarter of last year. While the number of companies raising money remains unchanged, the average financing round in the third quarter was $2.9 million, down from Q2’s $3.2 million.

So when is the venture capital industry in Israel going to be healthy again? The answer is simple-if you know when the venture climate is going to warm up in the United States. The consensus among venture capitalists who invest in Israel is economic improvement in America means economic improvement in Israel. In fact, some VCs think that Israel will get back on track as soon as three months after the United States does.

That theory might not be totally off. Most countries’ economic health depends on the revival of the United States’ economy. Additionally, Israel and the United States are experiencing similar political situations. While both are on the brink of war, American and Israeli investors view the issue differently.

Several Israeli VCs don’t see its country’s ongoing battle with Palestinians as part of the problem in the venture sector. “War is not a big issue for VCs in Israel,” says Micah Avni, a partner with Jerusalem Global Ventures. “While politicians around the world are certainly preoccupied with the topic, our portfolio companies remain focused on their businesses. Remember, we have spent much of the past 50 years building a country under the constant threat of war and enjoyed unprecedented economic growth.”

Despite the dour numbers and some investors’ ambivalence toward Israel, Avni, Holtzman and others say plenty of U.S. investors, like Benchmark, are still friendly toward Israeli companies. “War with Iraq and the Palestinian situation have minimal impact,” Holtzman says. “We still see $1 billion or $2 billion coming from U.S. investors like Intel and Cisco. … Even if there had been a full peace with the Palestinians, the level of venture activities would not have been different. All the leading technology companies and investors that have known Israel for years continue to be active.”

“There is no question that Israel would reap a huge economic benefit from peace in the region,” he says. “This is something we all pray for. However, the Nasdaq has a much more significant impact on the Israeli markets than the political and security situation.”