The Case for International Venture Capital Firms

1 Global Innovation – The Case for International Venture Capital Firms

By Adj. Prof. Dr. Martin Haemmig, August 2004

The global economy has fuelled the growth of entrepreneurship and created investment opportunities almost anywhere in the world. Entrepreneurs continue to develop innovations that create new markets and businesses. These companies increasingly need to be global in scale, in order to successfully capture market share and build out to a sustainable business that pays solid returns to investors.

The following overview by the author is a compilation of research, think-tank initiatives, round tables, conferences and discussions over the last 6 months with investors, VC firms, corporate investors, entrepreneurs and venture capital associations in Asia, Europe, Israel and the United States. It includes the cumulative learning from the “Globalizing Venture Capital” module at NVCA’s Venture Capital Institute (graduate program), which the author designed and moderated in February 2004 in San Jose/CA.

Global Technology Demand Drives International Startups and Their VC Firms

Competition drives small and large corporations for efficiencies in any aspect of the business. Technology is one relevant factor that can assist these firms to either remain or emerge as leaders in their global environment. The pressure from shareholders on their returns forces these players to focus increasingly on their core business, speeding up time to market with new products or services, and thus search for external technologies to complement their internal R&D efforts. This provides huge opportunities for startups to provide some missing product or service pieces to help these larger firms stay competitive in their offering.

This demand spurs increasingly a circle that includes larger corporations, startup companies, their venture capital firms and fund investors. It is this environment that requires international VC firms to provide their expertise of building companies and their global network to enable startups to go international. The added value by international VCs helps build faster and more globally exposed startup companies that lead to bigger and more competitive firms and thus potentially higher returns for VC funds if executed properly.

Global Direct Investment Flows Into Startups Across Geographies

Foreign “direct investments” to local portfolio firms and investments made outside the domestic market can be significant (2003 data – VentureXpert/Venture Economics).

EU 2.8% USA 51.3% USA 96.7% USA 84.1% Asia 0.8% Asia 0.5% Asia 40.1% Israel 0.3% U.S.-based VCs invest 81% domestically Israel 0.4% Israel 0.2% EU 3.1% EU 3.7% and 19% in foreign countries. Europe’s VCs ($1.4B) ($3.2B) ($0.6B) ($1.8B) invest 88% in their region, while an additio- +6% +52% +140% +88% nal 12% goes overseas. Israel’s VCs invest 86% in Israeli and/or Israel-related startups. Asian VCs invest 71% in their region, while 88% 29% is directed to overseas companies, 81% $6.2B 86% mainly in the U.S. but increasingly in Israel. $24.2B $0.42B 71% On the other hand, U.S. portfolio compa- $2.0B nies receive an additional 6% on top by foreign VC firms. Europe’s VC-backed 19% 12% 13% 29% entrepreneurial firms obtain an additional ($5.6B) ($0.8B) ($0.1B) ($0.8B) 52% (mainly USA) on top of their VC firms, EU 10.7% USA 9.7% USA 12.0% USA 21.8% Asia 5.7% Asia 1.0% Asia 0.6% Israel 6.5% Israeli firms 140% and Asian companies Israel 1.3% Israel 0.3% EU 1.4% EU 1.3% 88% above their domestic VC volume. RoW 1.4% RoW 0.7% RoW 0% RoW 0.4%

Global Investment Flows in 2003 – USA, Europe, Israel, Asia (VentureXpert/Venture Economics, 06-2004)

2 Opportunities and Challenges for International Venture Capital Firms

Innovation in high-technology by startup companies in recent years has occurred increasingly outside the Silicon Valley and Boston’s Route 128, since governments in other parts of the world have understood the relevance of commercializing innovations as a major force for the competi- tiveness of their nation. Entrepreneurship education has gained grounds in most countries in Europe and in key countries in Asia and in Israel. America’s National Venture Capital Association (NVCA) survey in 2002 revealed that 90% of respondents wanted to know more regarding venture capital outside the United States, both for looking at investment opportunities and to access capital. This was unheard of a decade ago.

The entrepreneurial environment outside the U.S. is substantially improving and the impact of American VC firms, with their longstanding tradition of building companies with their hands-on style, has gained great acceptance, particularly through co-investment opportunities with these seasoned venture capitalists. The younger venture capital markets outside the United States have inefficiencies that can be exploited in joint efforts between the American and foreign VC firms. Governments in most countries are improving their legal, regulatory, fiscal and educational environment, which pave the wave for large business opportunities. These countries try to build some clusters of expertise with an appropriate ecosystem for venture creation, which permit their entrepreneurs to build their companies in their home country. There is no doubt, however, that the main markets for most of them will be overseas or in neighboring countries.

Israel as a small country, with virtually no local market, has proven the VC-model. Many other countries are rich in technological innovations and/or have a large domestic market, where exploi- tation of such opportunities is waiting, although cultural issues in Europe and Asia have so far been a major stumbling block. Current and forthcoming stories of successful startups in these geographies will start breaking down these cultural barriers. Key issues center on management control and lack of understanding market dynamics for building larger, global companies, because entrepreneurs are too focused on their technology and less on building a global company.

Apart from the U.S. and Israel, Europe and Asia start to see their first serial entrepreneurs on their second startup firm, a critical element of shortening the industry’s learning curve. The VC firms will be able to hire new partners with the valuable experience of building a venture-backed startup with a global market. With these elements gaining momentum and critical mass, combined with the learning of the failures during the bubble, Europe and Asia will experience a professionalization of the venture industry in the years to come and with it larger opportunities for investments and lucra- tive returns.

Most American venture firms are locally focused businesses and most European VCs concentrate at best on the European market, yet market forces pushes them to expand their international capabilities, not only to invest in foreign startups but also to assist their portfolio companies to access their global markets. Exits through public exchanges are not as liquid in Europe and Asia when compared with Nasdaq in the U.S. and thus a fast-growth company may find it crucial to go public where their main market and investors are…. the United States.

Market Dynamics

Market opportunities are the key driver for innovation. The needs and competition is often global, however, the markets to be addressed are regional or local. Especially in new emerging and inno- vative markets, it may take a few years to see the key players being active in all the larger econo- mies. Startups that concentrate solely on their less competitive local or regional market may be squeezed out later when their strong international competitor moves in. The example of Brokat proves this case: The company started in the new segment of transaction based middleware for the Internet in the European market, initially almost without competition. Potential American competitors such as NetDynamics and Kiva (later acquired by Sun Microsystems) or BEA Systems, focused initially on the large, attractive U.S. market. Only when Americas high-growth market was

3 substantially exploited, and their partners such as Sun and Hewlett-Packard targeting the under- served European market, did the young American companies start their European market pene- tration systematically and consequently, in a joint effort with their large collaborators. European local players such as Brokat got gradually squeezed out and faltered their business.

It is of crucial importance that startups understand the competitive landscape and forces in the different regions, an activity that is time consuming and often costly for individual companies but something that could done by venture capital firms, especially if they focus on certain industry sectors. Most startups don’t understand sufficiently their current and potential competitors and focus on simply building the faster “mousetrap”. If a new market seems promising, large corporations, however, can easily allocate either substantial resources to catch up and become not the first-mover but first-prover, or acquire a small, emerging competitor.

4,253 USA: Of 6,217 VC-backed companies, only 148 (2.4%) have a physical presence in Europe. 6,217 227 (5.3%) EU: Of 4,253 VC-backed companies, 30 (7.1%) only 227 (5.3%) have a physical 148 (2.4%) presence in the United States.

424 IL: Of 424 VC-backed companies 138 (32.6%) (about 1/2 of Israel’s pool), 138 (32.6%) have a physical presence in USA and 30 (7.1%) in Europe.

International Offices of VC-Backed Companies in 2003 (VentureOne)

Many startups don’t understand the nuances of power and decision making mechanisms in the different regions. Those not understanding the entities defining the requirements, the decision makers and the ones that finally procure the product or services, will hardly ever have a chance to succeed in a new market.

The example of mobile technologies is a good example, where Europe has a competitive edge. Many startups manage to capture accounts such as Nokia or Siemens but fail miserably in the American market because of the different market structure. The mobile phone manufacturers in Europe are the driving force in the value chain of the industry, while in the U.S. the mobile network provider defines all the requirements, including the design and functionality of the handset. It is of no use to employ a herd of sales executives with contacts to the Motorola’s of the world, if a strong rolodex from a venture firm to the service provider would do the job.

Finally, European startups have to adapt much more to the requirements of American customers, since they are not really willing to purchase a highly engineered product that requires substantial adaptation on their side. In addition, American customers prefer to do business with an American firm, especially when the latter is a startup company. European entrepreneurs often understand the latter, however, they fail to build a U.S. operation that looks and feels like an American firm and thus set up a barrier that could have easily been avoided from the outset.

Requirements for International Venture Capital Firms

The venture capital market has returned again to focus on investment fundamentals – great technology that addresses a pain point in a large and growing mostly global market, experienced management teams with operational background and strong track records, as well as clear evi- dence of sales or sales potential.

The Israeli VC-Model is an interesting case to study, which may be indicative for European and Asian countries with smaller domestic markets. Given the absence of a local market, over 30% of

4 all Israeli VC-backed startups incorporate in the United States within 15 months, typically the time of testing their product with a launch customer. They often leave their R&D team back in Israel and hire marketing, sales and business development managers in USA. The founders understand that the skill set for a CEO changes as the company scales rapidly, hence they hand on their helmet to a better qualified top manager who has been there in a previous position. In the case of Israeli companies, a U.S. born and educated American Jew increases the success rate of a company, since the cultural factor and the different time zones are often stumbling blocks for American managers. Israeli startups such as Checkpoint moved to the United States first before entering the European market. They have also built a truly global company from day one, with hiring local managers in all the key markets in which they expanded. The venture firms backing Checkpoint, both Israeli and American VCs, were instrumental in getting the company off ground with incorpo- rating the company, connecting them to the large U.S. customers and hiring key talents to complement the team. Although a public company today, Gil Shwed is one of the rare founders who remains Chairman & CEO from the company’s inception, to run a billion dollar revenue company.

The emergence of truly international venture capital firms, including transatlantic and transpacific, is proving a complementary source of capital for entrepreneurs to partner with a leading U.S. or European firm. In many situations, the international venture firm is uniquely placed to assess the competitive, market and growth challenges for new technology companies. Such firms can provide assistance that is both operational and international. This is especially important in a depressed market in order to win customers and a market niche. In other words, customer acquisition and retention is more difficult than it ever has been, since corporate IT and R&D budgets are being squeezed and thus they are very cautious about spending their budget on new technology.

Access to international venture firm’s partners and their network is a key asset for startup companies. Strong VC firms have well established links with larger corporations to enable partnerships for distribution, for joint projects or supplying critical technology pieces on either side to provide a com- plete offering. Global corporations prefer collaborations with international venture firms, since both sides understand global markets and may offer a single point of contact at the VC firms for global issues, which simplifies the working relationship for corporates.

100 6 0 .

. US EU IL Co-investments across geographies are an 87 Median 87 Median Median important ingredients in the international- nds non-local non-local non-local u 75 o investor = 1 investor = 1 investor = 2 ization efforts of startups. 1 R 59. y

t In 2003, 10% of all investment rounds into i

u 50 U.S. startups had a European VC firm as q

E co-investor and 2.5% had an Israeli VC, 2 . of

26 typically with 1 foreign investor if any. e

25 4 . 9 g . 4 . 15 12 ta

10 In Europe, 13% off all investments included n 5 3 e 2.

US US EU 0. US 1 American VC. c EU EU IL

r 0 e in USA in EUROPE in ISRAEL P In Israel, 26% of all investment rounds an average included an American and 15% a European venture investor, with a mean of 2 foreign investors in internationally syndic- cated deals. This is of crucial importance to Israeli startups, since foreign VC firms help $ finance their fairly expensive expansion activities into foreign markets.

International Syndication of VC Firms Into Other Geographies in 2003 – USA, Europe, Israel (VentureOne)

Expanding internationally often requires a new management team or complementing the existing one. International VC firms with a physical presence on two or more continents have their own network and often hire executives from the same industry sector, in whom they invested earlier and know them well. There is no standard template for international expansions of startups, however, history shows that some startups internationalize either too early before they get sufficient capital and management resources, while other companies wait far too long, in that the corporate culture has matured to the point where transatlantic or transpacific expansions represent a substantial

5 hurdle. Experienced venture firms have a fairly good feeling of ideal timing for internationalization activities, considering all the key issues such as: the market readiness, economics, management capabilities and their required bandwidth.

A San Francisco based attorney who specializes in bringing startups from Europe to Silicon Valley, experiences a failure rate as high as 70-80% of European startups when expanding to America, if they only have European VC firm backing. The reason is typically threefold: first, the local support of getting set up and having access to the potential customers; second, the wrong business set up in America that may hold the parent company liable when business problems occur; and third, the undercapitalization to get quickly enough off ground with their business. It is noteworthy to mention that expansions into the U.S. market is a costly undertaking and requires easily $5-15 million. European investors should remember that investment rounds in the U.S. are typically 2-3 times larger than in Europe and thus American competitors can bring much more weight to the table. Startups with “pure” European investors have hardly the network nor the financial strength to support their U.S. expansion, although there are always exceptions to the rule.

In the case of India and China in particular, successful venture firms in the next 1-3 years will set up a small team in these markets to assist the initial business development efforts on behalf of their startups and to open them the doors to their large, potential customers. A VC firm that specializes in a certain industry sector that is relevant to China’s economic development (e.g. telecom, wireless, semiconductor, etc.), is well advised to spend some money in the world’s largest market, in order to support their startups, instead of having all these small companies going through the initial headaches and making the same mistakes. As long as the Chinese VC industry is still in its infancy, where only few local Chinese VC partners have the required skill set acquired, foreign VCs are required to add the value to get their startups off ground. A number of Silicon Valley VC firms, Taiwanese, Israeli and Japanese have already a small team on ground, while the European VCs hardly consider this option at this point in time. They limit substantially the potential growth of some of their portfolio firms, specifically in the telecom, wireless, semiconductor and specialty equipment sector.

The Case for International Venture Capital Firms – Facts

There were 48 active American firms investing during 2003 and in Q1-2004 with at least 1 investment into European companies. These were either independent venture firms (30), corporate investors (9), with the balance being investment banks and others. They made a total of 145 investments in Europe during these 15 months, of which 31 investments were done as Series-A, 16 investments into Series-B and the others into later stages or other type of investments. [VentureSource (VentureOne, April 26/2004)].

Most active direct investors in 2002-2003 from USA into Europe (all industries, 5+ deals) (incl. Venture Capital, Corporate VC, Investment Bank, Other Private Equity – Source: VentureSource/VentureOne):

2002 Investor # Deals 2003 Investors # Deals Intel Capital 12 Atlas Venture 18 Atlas Venture 9 Benchmark Capital 11 Cross Atlantic Capital Partners 7 Partech International 8 Carlyle Group 6 Intel Capital 8 Partech International 5 Cross Atlantic Capital Partners 6 JPMorgan Partners 5 Crescendo Ventures 5 Johnson & Johnson Development 5 Alta Partners 5 DB Capital Venture Partners 5 Schroder Ventures Life Sciences 5 Benchmark Capital 5 Vision Capital 5 2002 All USA Æ European Investments 98 2003 All USA Æ European Investments 92

NOTE: The first 4 months in 2004 (January – April) for all industry sectors include 27 deals.

6 Most active independent U.S. VC investors for IT in 2002-2003 into European Companies (Excluding: Corporate VC, other Private Equity, US-Based VC Firms with separate non-U.S. funds and office – Source: VentureSource/VentureOne 2004):

2002-2003 U.S. IT-Investors into # Deals 2002-2003 U.S. IT-Investors into European # Deals European Companies (with U.S. fund) Companies (excl. European initial origin) Atlas 19 Crescendo 7 Partech International 11 Cross Atlantic Venture Partners 7 Crescendo Ventures 7 Accel Partners 6 Cross Atlantic Venture Partners 7 Insight Venture Partners 2 Accel Partners 6 Lightspeed Venture Partners 2 Vision Capital 5 Sequoia Capital 2 Insight Venture Partners 2 Lightspeed Venture Partners 2 Sequoia Capital 2 Sofinnova USA 2

Most active Life Science investors in 2002-2003 from USA into European Companies (incl. Venture Capital, Corporate VC, Investment Bank, Other Private Equity – Source: VentureSource/VentureOne):

2002 Health Care Investor # Deals 2003 Health Care Investor # Deals Johnson & Johnson Development 5 Schroder Ventures Life Sciences 5 Atlas Venture 4 Oxford Bioscience Partners 4 Schroder Ventures Life Sciences 2 Alta Partners 4 Alta Partners 2 MPM Capital 3 Alafi Capital 2 JPMorgan Partners 2 JPMorgan Partners 2 Atlas Venture 2 Burrill & Company 2

Most active direct investors in 2002-2003 from Europe into USA (all industries, 6+ deals) (incl. Venture Capital, Corporate VC, Investment Bank, Other Private Equity – Source: VentureSource/VentureOne):

2002 Investor # Deals 2003 Investors # Deals Apax Partners 18 3i Group 28 3i Group 17 Siemens Venture Capital 12 HBM Partners AG 11 Apax Partners 12 Investor Growth Capital 10 Star Ventures Management 10 Dresdner Kleinwort Capital 10 HBM Partners AG 9 Techno Venture Management 9 Abingworth Management 8 Star Ventures Management 7 Techno Venture Management 6 Novartis Venture Fund 7 Sofinnova Partners 6 Innovacom 7 Novartis Venture Fund 6 Societe Generale Asset Management 6 Investor Growth Capital 6 Lombard Odier Darier Hentsch & Cie 6 Innovacom 6 Healthcap Venture Capital 6 2002 All European Æ USA Investments 166 2003 All European Æ USA Investments 143

NOTE: The first 4 months in 2004 (January – April) for all sectors include 65 deals.

The most active direct investors in 2002-2003 from Israel into USA (all industries, 4+ deals) (incl. Venture Capital, Corporate VC, Investment Bank, Other Private Equity – Source: VentureSource/VentureOne):

2002 Investor # Deals 2003 Investors # Deals Pitango Venture Capital 10 Jerusalem Venture Partners 8 Evergreen Partners 7 Pitango Venture Capital 7 Jerusalem Venture Partners 6 Israel Seed Partners 5 Israel Infinity Venture Capital 6 Genesis Partners 4 Israel Seed Partners 5 Gemini Israel Venture Funds 4 Ascend Technology Ventures 5 Genesis Partners 4 Cedar Fund 4 Giza Venture Capital 4 2002 All Israel Æ USA Investments 43 2003 All Israel Æ USA Investments 34

NOTE: The first 4 months in 2004 (January – April) for all sectors include 18 deals.

The most active direct investors in 2002-2003 from Asia into USA (all industries, 4+ deals) (incl. Venture Capital, Corporate VC, Investment Bank, Other Private Equity – Source: VentureSource/VentureOne):

2002 Investor # Deals 2003 Investors # Deals China Development Industrial Bank 14 China Development Industrial Bank 19 Yasuda Enterprise Development 8 Yasuda Enterprise Development 6 Mitsubishi 8 NIF Ventures 6 Lotus Bioscience Ventures 7 WK Technology Fund 5 NIF Ventures 6 Bio*One Capital 5 Bio*One Capital 6 Vertex Management 5 JumpStartUp Venture Fund 6 Hotung Venture Capital 5 CDIB BioScience Ventures 6 WK Technology Fund 5 Sumitomo Corporation 5 Hotung Venture Capital 5 2002 All Asia Æ USA Investments 51 2003 All Asia Æ USA Investments 46

NOTE: The first 4 months in 2004 (January – April) for all sectors include 17 deals.

The author, Adj. Prof. Dr. Martin Haemmig has done extensive research over the last 3 years on over 100 international venture capital firms in Asia, Europe, Israel and the United States, and expanded since his research scope to international investors, and startup companies with joint projects between CeTIM (Centre of Technology & Innovation Management at their university sites in Munich and Rotterdam) and with Stanford University (Business School), as well as the University of California. His book on “The Globalization of Venture Capital” (ISBN 3-258-06565-9), captured over 20 sponsors and global supporters to finance the research. www.MartinHaemmig.com ; [email protected] Copyright © Martin Haemmig 2004

Adj. Prof. Dr. Martin Haemmig Neuackerstrasse 25A, 5408 Ennetbaden, Switzerland Phone: ++41-(0)79-746 76 11 Email: [email protected] Website: www.MartinHaemmig.com