Forget about chutzpah…the tech sector in Israel has two advantages- a skilled workforce and boatloads of risk-capital. This has made Israel (population, 7 million), the number three country in the world for venture capital. Last year, investors ignored weak global IPO and M&A markets and poured $1.2 billion into 391 start-ups. This approach worked very well in the past- only the US has more NASDAQ-listed companies. Unfortunately, that party ended abruptly with the 2008 financial crisis. Based on fundraising and exit activity as reported by IVC, the Israeli venture sector is undergoing dramatic, and painful, change.

Most glaring is the 20% drop in M&A. In total, 63 Israeli high-tech companies were acquired last year for $2.04 billion. As bad as that looks, the IPO market is actually worse. After having no IPO's in 2008 and only one in 2009 (D-pharm for $22 million on the Tel Aviv Stock Exchange), last year saw a slight improvement with $127 million raised from 10 IPOs. However, most of these IPO's (70%) occurred on the less attractive Tel Aviv Stock Exchange.

The number and size of exits is also diminishing. The sixty three Israeli companies acquired or merged in 2010 represent a 22 percent decrease from the five-year average of 82 deals. The size of these deals has also plummeted to $32 million.

Despite the lack of IPO's, the M&A market last quarter is providing hope for investors. Database security software company Sentrigo was acquired by Intel's Mcafee division. Facebook made its first Israeli acquisition with mobile app developer Snaptu, for an estimated $70 million. The semiconductors sector saw two acquisitions- Zoran was purchased by CSR for $679m while Broadcom snapped up Provigent for $313 million. Finally, consumer internet site Answers.com was sold to private equity firm AFCV for $127 million.

Historically, the Israeli venture capital sector has been a reasonable investment proposition. A mix of corporate, local and international VC's can select from the world's highest concentration of scientific and technical talent. They also poach executives from the 124 multinational R&D Centers operating in Israel and research institutions like Technion or Weizmann Institute. Since 2002, although returns have been substantially lower than the equity markets, venture capital investors (Limited Partners) have received more returns via M&A or IPOs than capital raised.

After Lehman Brothers collapsed in 2008, fundraising for new VC funds has ground to a halt. In 2009, the only new dedicated VC fund was $200 Million for Sequoia Israel. Even that was better than 2010- not a single Israel-focused VC Fund was raised. Ouch!!

Like the start-ups in which they invest, Israeli venture capital funds are learning to adapt. They are shunning seed stage deals, which tend to be riskier, in favor of a mid-stage. Last year, only 3 percent of total capital went toward seed companies, compared to a 7 percent average over the last seven-years. Instead, mid-stage is the new "black", representing 45% of all deals. In addition, some VC firms are innovating in different ways. For example, Genesis opened an Entrepreneurs Annex in South Tel Aviv, where any start-up can informally work and exchange ideas. Gemini Israel Funds is the sole investor in the turn-around of an existing company called Color Chip. This requires a more hands-on role than traditional portfolio investing. Finally, life-sciences fund Pontifax is addressing the entire life cycle of start-ups. In addition to holding 15 percent of Biomedix, which controls incubators ATI and Meytav, Pontifax instituted a strategic partnership in 2009 with Swiss pharmaceuticals giant Roche to make joint investments in Israeli life science start-ups..

Not all VC firms will survive the current environment. The experience in California may be instructive. According to PWC (www.pwc.com), the number of people employed in the venture capital sector there fall more than 20% between 2008 and 2010. Despite the challenges, the entrepreneurial community is eager for the next generation of venture-backed Israeli success stories like Teva ($50 Billion market cap), Check Point Software ($11 Billion market cap) and Amdocs ($6 Billion Market cap). They may have a long wait.

Levi Shapiro is a Partner at TMT Strategic Advisors, a research and strategy firm focusing on the technology, media and telecom sectors. He can be reached at levi@tmtstrat.com or via twitter: @levshapiro

Read all Levi's MediaBizBloggers commentaries at Unleavened Media.

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