1. INTRODUCTION

This paper analyzes the process of development of a Venture Capital (VC) industry in a new geographical market, based on experience that has been accumulated in Israel in the last 17 years (1991-2007). Within this analysis, we examine the changes that have occurred in the Israeli VC market since its creation in the early 1990s, through its growth stage in the mid-late 1990s and up to its current mature stage. The paper focuses on the transition to the maturity phase of industry development. We identify changes in the market structure, stages and areas of VC investments, and VC performances.

Avnimelech and Teubal (2006) have analyzed the process of the emergence of Israel's high tech cluster in terms of a cluster life cycle comprising four phases of development: Background Conditions (1969-1985); Pre-Emergence (1986-1992); Emergence (1993-2000); and Post-Emergence (since 2001). A significant event in this development process was the successful emergence of the VC industry, which took place during the years 1993-2000. The VC emergence was an outcome of supportive internal background conditions developed after 1969 (based on government support and market forces; see Avnimelech & Teubal 2004b, 2006), the significant global growth of ICT industries and VC investment during the 1990s, and a targeted VC policy--the 'Yozma' program implemented during the years 1993-1997 (see Avnimelech & Teubal 2004a, 2008). Accompanying the process of VC emergence was the transformation of Israel's high tech industry from a military-oriented sector to a dynamic 'Silicon Valley' type of cluster, involving considerable entrepreneurial and innovation activities. The VC industry co-evolved with the high tech cluster, triggering and significantly contributing to the rapid development and growth of the startup segment within the high tech cluster.

In this paper we shed light on the later stage of VC industry development--the VC industry maturity process. Within this phase of development we present various qualitative changes. We also suggest potential weaknesses of this stage of development, such as conservative behavior and reduction of innovativeness of VC companies, which may lead to a decrease in its contribution to the regional high tech cluster and increase the risk of cluster (1) lock-in (e.g. barriers to cluster renewal). In the discussion we also suggest potential collective actions for decreasing these risks.

2. LITERATURE REVIEW

2.1 Venture capital

There are three main approaches to the analysis of VC: the finance perspective, often focusing on the operation of existing VC markets and incentives for VC investment; the geographical perspective, focusing on the impact of VCs on regional agglomeration and innovation; and the systems-evolutionary perspective focusing both on the emergence of new VC industries and on processes associated with the development of VC-related capabilities and institutions. The financial perspective has become the dominant strand of the VC literature since Gompers and Lerner (1999). Its policy implications, however, are relatively static. The geographical perspective adds a clear regional aspect to the research of VC. However, this perspective often does not focus on VC per se but on agglomeration effects on innovation in general. The evolutionary perspective, which adds an implicit dynamic viewpoint, has its origins in the geographical perspective of innovation (Audretsch 1998; Feldman 1994; McCann & Shefer 2005; Powell et al. 2002; Zook 2000), and in other VC-related research focusing on Silicon Valley and the history of the VC industry in the US (Florida & Kenney 1988; Saxenian 1994). It recently received a new drive from research on high tech cluster development in various other countries (Avnimelech & Teubal 2006; Bresnahan et al. 2001; Feldman 2001; Feldman et al. 2005).

2.1.1 VC value added

VCs are financial intermediaries that aim at fitting startups' unique needs. Significant VC literature considers the nature of VC companies and the impact they provide to their portfolio companies. Within this stream of literature, research has usually compared the performance of VC-backed versus non-VC-backed startups (such as Barry 1990; Brav & Gompers 1997; Gompers & Lerner 2001; Kortum & Lerner 2000; Megginson & Weiss 1991). These studies suggest that VCs have significant added value to startups. Their results are also supported by the theoretical VC literature (e.g. Hellmann 1998; Kaplan & Stromberg 2001, 2003; Wright & Robbie 1998), which explains the role of the unique VC structure, contracts, operation, routines, expertise, and networks in dealing with informational, agency, and operational problems at early stages of R&D performing firms.

A significant challenge for entrepreneurs in starting a new venture is to build a resource base that will allow them to develop their innovation into a product, and one, which will penetrate the market. This challenge is particularly difficult when the innovation is extremely risky in terms of technology or market. Thus, VCs are not merely suppliers of capital for the new ventures, but they also supply non-financial added value. Their expertise is in their ability to select firms with growth potential (Jain 1999), to provide these firms with the resources they lack, and to increase their access to external resources.

The VC literature suggests that VC investment activities enhance innovation. Kortum and Lerner (2000) analyzed a number and quality of patents and found that both measures are higher for VC-backed firms compared with non VC-backed firms. Hellmann and Puri (2000) found that VC-backed firms have shorter time-to-market and are more innovative. Finally, Ueda and Hirukawa (2004) analyzed innovative activity and showed that VC has a significant impact on innovation, but that it differs dramatically across industries. These results could be attributed to VC operational and strategic added value, to adverse selection of companies raising capital from VCs, to successful selection processes by VCs, or to effective monitoring activities by VCs. Whatever the cause, VC makes a significant contribution to the regional high tech cluster development.

2.1.2 VC exits

VC funds invest in firms with the objective of achieving the maximum capital gains during their lifetime. The VC does not take a permanent stake in a firm--they exit from all of their investments as the fund life expires or earlier in the fund's life. Exit from the investment can be achieved in a number of ways:

* IPO--the firm goes public and the VC sells its stocks;

* Trade sale (M&A)--another high tech company acquires the firm;

* Secondary sale--the firm is sold to another VC or to another institutional investor;

* MBO--the firm's management buys back the stake of the VC;

* MBI--the firm is sold to a group of managers that will run it in place of the current ones; and

* Liquidation (and closure)--the firm's assets are liquidated and the firm close its operation.

The means by which exit is actually realized depends upon many factors, and each solution has different costs and benefits that vary from case to case. In Israel, IPOs and trade sales (M&As) are usually the most profitable exit options for successful investments. The choice between these two options depends on many factors, such as the type of industry and technology, the current market conditions, and founders' and investors' preferences. In Israel, all the other exits and liquidation mechanisms are used by startups for less successful investments, and do not bear significant returns (2).

2.2 Regional VC industry development

The identification of new forms of intermediation lies at the heart of the creation of a VC market. Gompers and Lerner (1999) and others have made it very clear that VC (a new supply agent') mediates between capital and startups in ways that the traditional banking system (the old 'supply agent') did not, thereby overcoming specific market failures related to the startups' development. Gompers and Lerner (1999) also observe that the VCs themselves have undergone significant transformations, with limited partnerships eventually becoming the dominant form of organizations, and certain other specific VC contracts, practices, and expertise becoming common. Moreover, the VC emergence is also linked to the transformation of 'demand agents' (startups), that is, founders had to accept VC involvement, ownership dilution, and the potential transformation of their companies into public companies. A final transition in the process of the VC industry development is adaptations and changes in the market structure and institutional framework. All of these conditions require long processes of experimentation by all relevant agents within the regional high tech cluster. Therefore, we suggest that it is appropriate to analyze the development of a VC industry in a new geographical market as an innovative service/product life cycle.

2.2.1 Product/Industry life cycle

Abernathy and Utterback (1978) presented a descriptive model of industry evolution. The model identifies three stages of evolution of an industry: fluid, transition, and maturity. The fluid phase is stimulated by technological breakthroughs that are followed by intensive radical product innovation. Low entry barriers, innovative agents, generalized complementary assets, and a variety of product designs characterize this phase. The emergence of a dominant design (3) characterizes the beginning of the transition phase, which constrains the development of future product innovation, triggers massive process innovation, and shifts the industry's focus toward economics of scale. Very low product and process innovation, large plants, economics of scale, high barriers to entry, and specific complementary assets characterize the mature phase.