July 17, 2000

By Hanan Sher
The Jerusalem Report
Copyright The Jerusalem Report

Erel Margalit, a key figure in the biggest deal in Israel business history,plans to keep on riding the technology boom

IN THE PAST, ADMITS EREL Margalit, his Jerusalem Venture Partners was something of an oddity: an Israeli high-tech venture capital firm which barely invested in Internet content companies. "We were kind of ashamed thatwe did not have a bunch of dot.coms in our portfolio," says Margalit. "Now people aren't so proud about having them."

Instead of the dot.coms - which have gone out of fashion after taking a beating on the stock markets - JVP's long-run has concentrated on another segment of the exponentially growing information technology world: the enabling technologies that get data from place to place on the Internet. The star in its portfolio is Chromatis, a Petah Tikvah-based pioneer in fiber optical networking equipment that transmits signals to large numbers of users in metropolitan environments. JVP helped nurture Chromatis from its birth in 1998. And on May 31 Lucent, the world networking leader, purchased Chromatis for an eye-popping $4.5 billion in shares; based on that valuation, JVP's 15-percent holding was worth $675 million - a return of about 89 times the $6.2 million that JVP invested in Chromatis for one of its funds in 1998, and 30 times the $3.2 million investment made in 1999.

The Lucent purchase was the biggest deal ever involving an Israeli company, a coup by any standard. But Margalit insists that the money isn't the most important thing. "Someone in the industry said the Chromatis sale was like selling ice to the Eskimos," he says proudly. "Lucent is AT&T and Bell Laboratories, the cornerstone of the world's communications. They have More technology than they can dream of. What's more, their plan is not to integrate Chromatis into Lucent. On the contrary, they are taking the Chromatis product to lead them into the optical world, as their vehicle For leadership in optical networking. That's the real accomplishment." What made Chromatis worth $4.5 billion was an important step it took in The process of transmitting data at high speeds. Briefly, it made wave Division multiplexing (WDM), the ability to multiply the capacity of optical fiber By the colors of the spectrum, available to individual users in a metropolitan environment. Lucent, and a company called Siena, invented WDM and developed the technology to take data from point-to-point, rather like long-distance phones. Chromatis translated that development into point-to-multipoint capacity, the equivalent of local calls.

These technologies are vital in data transmission, the real growth area. "Bell Atlantic of the United States," says Margalit, "is establishing separate data rings, instead of putting the Internet data transmission on top of the existing voice equipment. Building a new highway for data requires state-of-the-art equipment."

For years, Margalit has pushed the idea of creating a big business with Real sales, one that can become a world leader in its specific field, rather Than seeing Israeli companies sell out the first time a buyer with a lot of cash comes down the pike. Chromatis had the prospect of becoming that kind of company: It had established a very respectable customer list, and projections were for hundreds of millions of dollars' worth of revenues in the next couple of years. So why sell?

"I know this seems a bit arrogant, but we had mixed feelings. Investment bankers talked about stock market offerings, at higher valuations than what the Lucent deal gave," he observes. "But something happened in the last few months with NASDAQ," raising the possibility that a Chromatis initial public offering would have valued the firm at less than $4.5 billion. According to published reports, Chromatis founders Rafi Gidron and Orny Petruschka will each get Lucent shares worth over $700 million, with another couple of hundred million going to other staff members.What's more, offers like Lucent's are a bird in the hand. "Gidron and Petruschka had a responsibility to the employees they brought into the company, 150 people who believed in them, who could get rich overnight, and as venture capitalists, to our investors," says Margalit. "It is irresponsible not to think very seriously about this kind of offer."

JERUSALEM HAS SEVERAL VC firms, most of which have large numbers of new immigrants from the West on their staffs. In contrast, JVP's flavor is distinctly local. Managing partner Margalit, 39, grew up in the middle-class French Hill neighborhood, studied philosophy at Columbia University in New York and business administration at the Hebrew University of Jeru-salem, and in his late 20s went to work for then-mayor Teddy Kollek as director of business development for the Jerusalem Development Authority. "We were enthusiastic about taking this region and turning it into a high-tech area," he recalls. "We were instrumental in bringing 72 companies to the city, a place that had only government, academia, tourism and God."

The product Margalit and Kollek sold was brainpower, in which they argued that Israel, and particularly Jerusalem, had a competitive advantage. Most of the new companies were clustered around the plant of Intel, the PC chipmaker, in the Har Hahotzvim industrial park on the northern edge of Jewish Jerusalem in the early 90s, or, a few years later, at the Technology Park near the shopping mall in the Malhah neighborhood of southwestern Jerusalem. Margalit left JDA in 1993, and created one of the first firms in the then-infant Israeli venture capital industry, with investors from the U.S. West Coast and Japan. "I saw," he recalls, "that the big boom was going to spring from inside Israel, not from bringing in microelectronic companies from abroad." He raised $20 million for JVP's first venture capital fund, in 1994, $75 million for its second fund, and $160 million in a third fund in late 1999 - from a list of investors that include Lazard Freres, Boeing and France Telecom. "We limited our third fund to $160 million, though we had about $300 million on the table," Margalit says. "If in the beginning, with the first fund, it was hard to raise money, it's almost as difficult to say no to people now."

Why not take more money, make a bigger fund? Growth is limited by the personnel available - the 10 "principals" in Jerusalem, New York and London, who screen and manage investments can't handle more deals. "You have to be very disciplined about what you do, and what you don't do," he says. "At any given time we have a certain number of deal-makers, and a certain tempo for each."

And while he sees no shortage of new technology, Margalit doesn't think that's what sets Israel apart. "There's a depth of technology in other parts of the world as well. What we are seeing now, in Israel, isn't the tech phenomenon but the entrepreneurship phenomenon. And it's a contagious disease, which has already affected a lot of people," he says.

The classic example of how one firm can transform a small country's economy is Nokia, and Finland, which built an entire industry around the cellphone firm. Israel "is just beginning to create the next generation of Nokias. Chromatis was supposed to be a Nokia, but stopped in the middle," he says. But there are some key fields, he believes, from which the Israeli Nokia could emerge:

Optical networking: "It's an area that has just begun; relatively few places on the Internet are enabled by optics. What exists now is like an interchange, while there are so many cars that you need an entire highway system," Margalit says. Eventually, optics are expected to replace most of the existing infrastructure inside cities - first to businesses and large buildings, and eventually to individual homes.

Wireless data transmission: Local transmission networks based on fiber optics, copper wire, cable or other technologies can grow much faster if they are topped off by wireless communication, Margalit contends, giving this example: "AT&T plans to bring broadband Internet service to 30 million homes in America in the next two or three years, using the cable infrastructure. That's possible because many residential buildings are already hooked up to cable. But businesses, which are the big growth area, generally don't have cable." One possible solution: Replace the expensive process of wiring entire buildings, or entire neighborhoods, with wireless transmission in the final stage, at one-tenth of the cost. Netro and Bridgeware, two JVP investments, are active in this growth sector (see The Portfolio, page 33).

The cellphone: The next stage in the information revolution is bringing the Internet to every cellphone user, all the time. "In five years," says Margalit, "the Internet will be coming to us, via our little portable phones...When we have a big screen, and time, we can do things in certain ways. But if all we have is a small cellphone screen and no time, things must be crystallized. And that takes technology." Celltick, a JVP investment, is working on a way to transmit brief commercials to cellphones when they're not being used for voice or data communication. "These things can be very local," he says. "Let's say you are in the area of the Opera in Tel Aviv, and there are 15 tickets left for 'La Traviata' that night. The Opera could send messages to people in the area, who could get a bargain."

The dot.coms: E-commerce is certainly the wave of the future, with limitations. "People will look critically at e-stores," Margalit says, "and those who will dominate are those who find new ways of doing things - like amazon.com, some of the women's portals, or Charles Schwab, in electronic stock trading. If someone develops a new concept of distance learning, that's valuable, just like ICQ [the Israeli developer of an Internet instant-messaging software, sold to America Online in 1998 for $409 million] was valuable."

PERHAPS THE MOST SINGULAR thing about Chromatis is that it's a second-generation success story. Founders Petruschka and Gidron sold their previous company, Scorpio, set up in the early 90s, to U.S. Robotics in 1996 for $72 million. They came back to JVP, a Scorpio investor, which nursed Chromatis from its conception. Margalit thinks there's a great advantage in working with entrepreneurs who've been there before. "You're dealing with people who can afford to take a deep breath and look at what they are doing. They're not just looking for a company that's OK, or about staying on as CEO," he says. "They understand that what they need is to create value, not just control. And that will get them so much further along the road."

Experienced entrepreneurs, he adds, "are not afraid to be a benchmark by which others can measure themselves. And that's not easy, getting to the top of the hill. Others will, inevitably, challenge you; in trying to become the 800-pound gorilla, you are going to be attacked by the chimps..."

Margalit doesn't speculate on whether the Chromatis founders will try a third time. But he doesn't rule it out either. And when he talks about them, he may give a clue as to why - even though he's undoubtedly made a great deal of money for himself already - he still spends a great deal of time on the road and gets phone calls from investors and partners on the U.S. West Coast and in the Far East, well into the early hours of the morning.

"Think of a great violin maker, who's just sold a great violin and made a lot of money," he says. "Making violins is what he really enjoys. How could you even conceive of him not making another violin? It's what he lives for, a creative process where he expresses himself. Money? It's nothing more than a measurement. Can you imagine Michael Jordan playing only because of the money he'd make, if he could still play ball?