Israeli venture capitalists smile a lot these days. As the global economy picks up and the recovery works its way through the U.S. (see “Risky Returns”), Israel’s venture industry has mirrored the renewed optimism, with 2004 proving to be a turnaround year.

In a country of just 6 million, some 113 startups raised $438 million in the third quarter, a 30 percent increase over the second quarter, and the best quarter for the technology sector in three years. According to the Israeli Venture Capital Research Center (IVC), investors have raised more money in the first three quarters of 2004 than in all of 2003.

Impressive numbers for a country with a smaller population than Los Angeles. Despite Israel’s size, its VC community traditionally ranks fourth behind California, Massachusetts, and Texas.

“Israel is not only maintaining this position, its high-tech industry only got stronger from the years of crisis,” says Eli Barkat, managing director of BRM Capital Advisors, the first fund to invest in security company Check Point.  

And the Israeli-Palestinian conflict hasn’t scared off foreign VCs. “Terror has become a worldwide problem that is not only related to Israel, and investors do understand that,” says Chemi Peres, founder and managing partner at Pitango Venture Capital, Israel's largest VC fund with $1 billion under management.

Venture capital investments are returning to 1999 and 2001 levels, but are still nowhere near the 2000 peak, when Israel’s VC funds raised $3.6 billion, according to IVC. Analysts expect $1.2 billion to $1.3 billion in new investments by year-end, up from around $1 billion in 2003.

Roughly half of the 2004 investments are coming directly from foreign investors, and the rest from local VC funds largely funded by international investors, according to IVC.

With more money, more exit opportunities, and a string of IPOs in 2004 and acquisitions by large U.S. companies like Cisco Systems, Israel has its edge. 

Recent rounds

After three years of financing, the industry has launched its fourth generation of funds since it began in 1992. At least 17 Israeli VCs are raising new funds.

Pitango, which backed some of Israel’s most successful IPOs, including security applications provider Radware and VoIP providers AudioCodes and VocalTec, recently completed a $300-million round. Giza Group and Genesis Partners, each with over $300 million under management, expect to close new funds of $200 million by year-end. All of these funds invest in a variety of fields, including communications, wireless, enterprise and IT software, Internet infrastructure, and semiconductors.

Morgan Stanley, which was very involved in Israeli technology through local VC funds until 2001, has come back with a $35-million investment in new funds from Pitango and Gemini.

Fighting its battles

The Nasdaq Composite Index, not the war, was most responsible for Israel’s economic downturn, say industry leaders.

“People here were so depressed because of the Nasdaq but there was no time to be depressed because of the terror attacks and the political issues,” says Gilai Dolev, founder of D&A Hi Tech Information, a research firm that monitors the Israeli technology industry.

“Once the worldwide economy and the markets picked up, investors filled the planes to Israel, ignoring the political situation,” says Mr. Dolev.

In response, “the VC funds have regained their self-confidence,” says Mr. Dolev.

“The industry has matured and become more rational,” he adds. Startups that wanted $50 million to $60 million to launch a company in 2000 now are satisfied with half of that amount.

“The parameters of the market are returning to 1995 and 1996 in terms of company valuations and public and private markets,” says Yoram Oron, founder and managing partner of Vertex Venture Capital, which has $700 million under management. Vertex invested in PowerDsine, a power-over-ethernet company that recently went public on the Nasdaq. 

Six Israeli VC-backed companies have had successful American IPOs so far this year, along with one in Europe, and several more are expected by the end of the year.

“The deal of the year,” says Mr. Dolev, is Syneron Medical. Headquartered in Israel, the medical product maker went public in early August on the Nasdaq, raising $60 million on a market value of $263 million; today its market cap is nearly double that, at $421 million. Investors put only $4 million to $5 million into the company.

Another local star: online price-comparison company Shopping.com. Co-based in California, it is the largest Israeli Internet company to go public this year, raising $90 million on the Nasdaq at a market value of $504 million. Its shares rose 60 percent several days after the IPO.

Cisco, which acquired three Israeli startups for a total of $339 million, has also provided a welcome exit route this year.

The fact that behemoths including Intel, IBM, Microsoft, and Cisco all have R&D centers in Israel also helps the exit process in the region, notes Mr. Barkat.

More varied sources of funding have emerged. Whereas startups were largely limited to venture funds in the past, new private equity funds offer secondary loans, mezzanine loans, and buyouts.

“Israel became such a central place for investments that it attracts investors who had no presence here before,” says Pitango’s Mr. Peres, who also serves as the Chairman of the Israeli Venture Association. Seed investors, rarities in the past, have become more prominent, says Mr. Dolev. With all the fresh cash, the VC funds are “trying to grow a new generation of successful startups.”

Israeli investors are also taking their money abroad. “But they are still looking for some connection to Israel, and Israeli VCs are willing to invest in them,” he adds.

Struggling with the follow-through

There are still major challenges. Besides the fear that a drawn-out conflict in Iraq will undermine investor confidence, techies in Israel also worry about competition from Asia.

VC funds will have to learn to make more money, says Mr. Dolev.

VCs also need to think long-term – and think big. “They definitely know how to find innovations to invest in, but they should look more into a sound business model.”

“I would like to see an Israeli Nokia one day,” says Mr. Barkat. “It requires more patience out of the entrepreneurs and a willingness to say ‘no’ to temptations on the way.”