[FIGURE 1 OMITTED]

During the development of a new industry we often see the following process: Some of the early entrances grow significantly and start to enjoy economics of scale, while other small agents develop unique services for niche markets. This occurs in the Israeli VC market. Table 5 shows that the average size of a management company was multiplied by 4.4 between 1991 and 2002 (from $23m to $102M), and since 2002 it has stabilized. The ratio between the average sizes of the Top-10 management company and the average management company grew from one in 1991, to 4.2 in 2000, and to 2.8 in 2007. Moreover, among the Top-10 management companies in 2007, six were created up to 1993, an additional two were created in 1996 and the last two are subsidiaries of large United States VCs. This resembles the pattern described in Klepper (1996) in which the long-term winners of a new industry are a sub-group of the first entrants, and many of the late entrances eventually exit the market.

4.5 Startup's profitability--successful exits and closures

As mentioned, one of the processes that occur during market development is the reduction in innovativeness. In the VC market this may lead to a reduced contribution to the cluster and lower levels of profitability. In the following, we present evidence that this process occurred in the Israeli VC market, that is, the required investment prior to a successful exit increased more rapidly than the average exit valuation (see Tables 6-7). This led to reduced profitability of the VCs in Israel and represents lower added vale to the portfolio companies.

In this section we present indicators of the VC level of profitability--their multiplier to successful investments. A startup that has been closed down will be referred to as an unsuccessful investment, while a startup that undertook an IPO or was a target of a significant acquisition (trade sale) will be referred as a successful investment. It is important to mention that we focus on IPOs and trade sales due to the fact that in the startup segment of the Israeli high-tech cluster other types of exits, such as leverage buyouts, are uncommon.

4.5.1 Closures

The level of startup closure, which is presented in Table 3, was very low (and unrealistic) in the early 1990s, but after the shakeout period in 2001-2002 it seems that the market stabilized on a more realistic closure level, with approximately a 40% long-run survival of startups (at the same time the percentage of companies that had successful exit did not change dramatically). To understand these changes, it is important to remember the operational logic of VC funds. VC funds have a determined life span of 7-10 years; at the end of this period the fund is liquidized and distributed to the investors. Therefore, during the initial years there are fewer incentives to close down unsuccessful portfolio companies. However, as the fund moves toward its termination, investments that could not be liquidated are closed down. In addition, as the VC industry matures, fund managers understand that early closure of non-successful investments is more efficient. Therefore, during the 1990s there was a very low closure rate, and approximately 7-8 years after the first funds were created (in the year 2000) we see the first significant wave of startup closure. The sobering of the bubble significantly enhanced this process.

4.5.2 Successful exits characteristics

Since the mid-1990s the cost of bringing a startup toward a successful exit has continuously grown--from $17.4m on average in 1997 for a successful M&A to $29m on average in 2007 (see Tables 6a and 6b), and from $3.4m on average in 1997 for an IPO at NASDAQ to $65m on average in 2007 (see Table 6c). This process led to a continuous decrease in investment's multipliers of successful exits and therefore to decreases in the VC funds' profitability (see Table 7). Although we see a similar picture in the US VC market, the growth in the cost of bringing a startup toward a successful exit in the USA was less dramatic than that in Israel. Therefore, while in the mid-1990s the performances of the Israeli VCs were outstanding compared to the US VC market, after 2000 the Israeli and the US VC investment's multipliers of successful exits became quite similar (Tables 8a and 8b). These results support the research hypothesis regarding the growth of the Israeli VC market and its consequences on the VC funds' profitability (12).

5. CONCLUSIONS AND DISCUSSION

This article deals with the development of the VC industry in a new geographical market, based on the Israeli case. Israel is well known for its entrepreneurial culture, its strong technological capabilities, and its dynamic startup-intensive high tech cluster (Bresnahan et al. 2001; Carmel & de Fontenay 2004; Fiegenbaum 2007). The success of the Israeli high tech cluster was highly influenced by the emergence of the Israeli VC industry (Avnimelech & Teubal 2006).

The Israeli VC industry presented dramatic growth in capital raised and invested throughout the 1990s. Since 2004, after the shakeout and the dramatic decrease in the bust years (2001-2003), this industry gradually became mature. The maturity of the Israeli VC industry implies, on one hand, a more global and professional industry, and on the other hand, a less innovative and more conservative industry. Correspondingly, we presented evidence that currently Israeli VC agents are more conservative--they invest less in early stages (in relative terms), invest mostly in previously successful technology sectors, and their investments are becoming extremely geographically concentrated (Schwartz 2006; Schwartz & Bar-El 2007). Gompers (1994) presented a similar pattern of the US VC during the late 1980s. However, during the early 1990s it seems that the US VC industry succeeded in overcoming this potential lock-in process. Gittell and Sohl (2005) found similar patterns of low diversity in VC activity in same regional clusters in the US during the early 2000s. This pattern present one of the most challenging tradeoffs within mature VC industries--on one hand they tend to became more focused in terms of technology and other types of knowledge in order to increase efficiency and increase returns, and on the other hand low diversity bears the risk of slow learning, low innovation, and cluster decline (see also Avnimelech & Teubal 2006 and Menzel & Fornahl, 2007). The decreasing returns of the Israeli VC industry (presented in section 4.5) in the last several years may be the first sign of this potential threat. On the other hand, the increased role of other types of VC agents such as business angels, corporate VCs, technological incubators and different types of technology-oriented investment companies, may moderate this process.

To sum up, we suggest that when a regional VC industry matures, the major VC agents become less innovative and more conservative. Consequently, the contribution of the VC industry to the regional high tech cluster may be reduced. While this natural process of maturity in 'regular' industries should not lead to great concern, in the VC industry it should lead to significant policy concern due to the unique role of VC in cluster development and enhancement. Moreover, there is a real danger that a mature VC industry will eventually become an obstacle to cluster renewal. Therefore a significant challenge in the mature stage of VC industry development is to create mechanisms to increase industry diversity in terms of types of VC agents, diversity of knowledge and knowledge sources, and innovativeness of VC agents (Menzel & Fornahl 2007). This is related to the argument that is suggested by cluster life cycle theories (Avnimelech & Teubal 2006; Menzel & Fornahl 2007) about the changing role of knowledge diversity during cluster development. Accordingly, in the early stages of cluster growth, increasing knowledge is important in order to create a focal point with critical mass and thus to enhance self-reinforcing positive externalities. However, as the cluster matures it is essential to increase diversity in order to enhance new knowledge absorption, learning and innovation within the cluster.

Government policy and market agent's collective action can significantly reduce the risk of low level of seed investment, decreasing diversity of knowledge and innovativeness, and eventually cluster decline. Government policies in this direction include incentives for seed investments through matching government funds for seed investments with upside incentives (such as the Israeli Haznek fund), encouragement of entry and development of business angels through subsidizing angel networks or tax incentives for angel groups, tax incentives for corporate VC activity, subsidizing technological incubators, direct government support for new technological entrepreneurs and increased R&D subsidizes for new emerging areas such as Nanotechnology, and Clean Energy technologies (Cleantech). We believe that these potential policy actions should be further analyzed, developed, and discuss, in future studies.

Received 30 October 2007 Accepted 6 August 2008

References

Abernathy WJ and Utterback JM (1978) Patterns of industrial innovation. Technology Review June-July: 40-47.

Audretsch DB (1998) Agglomeration and the location of innovative activity. Oxford Review of Economic Policy 14: 18-29.

Avnimelech G and Teubal M (2004a) Venture capital--startup co-evolution and the emergence and development of Israel's new high tech cluster. Economics of Innovation and New Technology 13(1): 33-60.

Avnimelech G and Teubal M (2004b) Strength of market forces and the successful emergence of Israel's venture capital industry: Insights from a policy-led case of structural change. Revue Economique 55(6): 1265-1300.

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