August 31, 2011 8:31 pm

Israel: Invention tension

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The high-tech sector must adapt to shifts in the industry

There are few better places to study the workings of the Israeli high-technology industry than the sleek 1930s building that sits on a hilltop overlooking the Old City of Jerusalem.

The ocean liner-shaped complex is home to Jerusalem Venture Partners, one of the country’s oldest and most successful venture capital firms. But it also contains, in miniature, the entire life cycle of Israel’s much-admired start-up economy: the top floor is where hundreds of would-be entrepreneurs come every year to pitch their ideas to the partners; close by is the fund’s “incubator”, where five teams are at work turning their concepts into early-stage products.

The rest of the building is occupied by a collection of JVP-funded start-ups at various stages of development. In one office – plastered with old movie posters and boasting a table football set – young developers are working on a new technology that allows users to search and find online film clips. Across the corridor is a company whose product helps place internet advertising more efficiently. Another door leads to a darkened animation studio.

Presiding over all this is Erel Margalit, who founded JVP in 1993 and now serves as chairman of the $900m fund. A well-known advocate of Israel’s high-tech industry, he has followed the country’s transformation into a global hub for the sector from the very start. Today, the sector accounts for more than 40 per cent of national exports. Only the US attracts more venture capital funding than Israel.

Israel-charts

The industry has transformed not just the national economy but also Israeli society. It has created new wealth, a new class of entrepreneurs and a new role model for the young. “For thousands of years, a Jewish mother wanted her son to become a doctor,” says Yossi Vardi, the man who founded the country’s first software company in 1969 and is widely regarded as the country’s original high-tech pioneer. “Now, in Israel, she wants him to become the founder of a start-up.”

Nimble start-ups struggle to walk with the giants

Israeli technology start-ups have produced plenty of innovations and plenty of money. What they have yet to produce, however, is a genuine corporate giant in the mould of Apple, Microsoft, Google, IBM or Oracle.

Even the biggest Israeli technology companies – such as software groups Check Point and Nice – are dwarfed by large US groups and European outfits such as Germany’s SAP. (Check Point registered annual sales of $1.1bn in 2010; Microsoft, in contrast, reported $62bn.)

Many Israelis, not least inside the government, regard this situation with regret. Large corporations – so the theory goes – provide employment and wealth not just to a few bright engineers but to many thousands of associated workers, from accountants to window cleaners.

In fact, just about the only complaint that Israelis ever make of their high-tech industry is that its protagonists lack the virtue of patience. Critics claim that the country’s entrepreneurs would all too often prefer to accept a cheque for $100m or even $10m from a US investor – such as Warren Buffett, who has made significant investments in Israel – than build their start-up into a world-beating group in its own right.

Among industry insiders, such accusations are mostly shrugged off. They argue that inventing a product and building a company require entirely different skills. For a small country – Israel has a population of 7.7m – to excel at one of them should be quite enough. “We are not good at building aircraft carriers,” says Yossi Vardi, a veteran of the country’s technology scene. “But we are excellent at building canoes.”

The Israeli government, however, wants the country’s high-tech sector to lift its gaze all the same. A finance ministry action plan presented last year found that the “number of large high-tech companies has not changed much in the last 15 years”, bemoaning the “significant loss of added value” for the economy as a whole.

In order to help the development of national champions, the government promised a series of tax breaks to encourage industry consolidation inside Israel and facilitate stock market listings in Tel Aviv.

For the time being, however, the biggest obstacle facing Israeli start-ups with growth potential is the lack of funding. Scaling up a company tends to be far more costly than coming out with the product in the first place. Funding, however, remains constrained by the knock-on effects of the global credit crisis. That, in turn, makes a big cheque from a Silicon Valley behemoth look all the more enticing.

Yet for all its recent achievements, there is also a growing sense that Israel’s start-up phenomenon is about to enter a new, and more challenging, phase. The sector, says Mr Margalit, has been through difficult times lately. It is still experiencing the aftershocks of a global financial crisis that has drained it of resources. The country’s high-tech businesses also need to replenish themselves – both in terms of human capital and in terms of moving beyond a reputation for creating clever technology into customer-focused innovations.

“The club where one engineer meets another engineer and a company is created needs to widen,” says Mr Margalit. “We need to bring in writers, advertisers, story-tellers.”

The way in which the industry deals with these challenges matters first and foremost to Israel itself. The sector, says Haim Shani, director-general at the ministry of finance, is of “extreme strategic importance to the economy”. It accounts for 11 per cent to 15 per cent of national output and 14 per cent of the private sector labour force. Less tangible but no less important, it is also a source of considerable international prestige: at a time when Israel often finds itself isolated on the diplomatic front, the high-tech sector stands out as a universally admired national asset.

Of broader significance is the direction that the country’s high-tech revolution, highly distinctive in both origins and nature, will take in years to come. In the past decade, the social, cultural and economic characteristics of the country’s start-up industry have been the subject of intense international scrutiny by academics and policymakers keen to emulate the success story.

Israel today consistently finds itself at the top, or very near the top, of rankings measuring the number of start-ups, patents, venture capital investment and technology listings. In the space of little more than 15 years, the country has rebranded itself, in the title of a recent bestseller, as the “start-up nation” – cranking out ideas, patents, products and companies at a blistering pace. Only Taiwan, Japan and the US register more patents per head than Israel.

Industry veterans agree that Israelis show no sign of running out of ideas. Mr Vardi says he alone receives as many as five proposals for start-ups every day. The high-tech sector in general, he says, is not only going from “strength to strength” but also retaining a crucial edge over other countries. “I go all over the world, but the amount of talent you see here is really amazing,” he says.

Experts, however, say a serious challenge is posed by the need constantly to replenish the pool of well-educated talent, especially in fields such as engineering, maths, physics and computer sciences. Not everyone is convinced a fragmented and underfunded education system is in a position to do that. The brain drain of talented graduates is another worry. Spending on education has not kept pace with rapid population growth, leading to overcrowded classrooms and lecture halls.

“Israeli kids are now doing phenomenally poorly in international rankings. We have a country of only 7.5m people but half the children receive a third-world education or worse,” says Professor Dan Ben-David of Tel Aviv University and director of Israel’s Taub Center for Social Policy Studies. “The question is: will we in future have enough people to work in this sector, and enough people to support this sector? I think we have our work cut out.”

Analysts agree that many of the ingredients for the high-tech revolution were in place well before the first venture capital fund appeared in the early 1990s. The country had, for example, long boasted a highly educated population as well as strong universities and research institutions.

What is more, a lack of nearby export markets and relative isolation meant Israel had little incentive to establish itself as a centre of manufacturing and heavy industry. Geography and politics, in short, pushed it firmly towards creating a “knowledge economy” long before the term existed.

. . .

A third, and less obvious, factor in shaping the country’s start-up sector is the army. Service in a military less hierarchical and less formal than many is compulsory, forcing Israelis to take on responsibility from an early age. The military prides itself on teaching recruits to work in teams and solve complex, indeed lethal, challenges without constant recourse to commanding officers. To thrive and survive in the army, in other words, requires a mindset and skills not so different from those that make a successful entrepreneur.

The military has also proved vital in another way: Israel’s army has never been able to match the forces of neighbouring Arab states in raw numbers of soldiers. From the outset, generals have been forced to try and cancel out numerical weakness through technological strength. In practice, that meant pouring money into special research units – most notably unit 8200 of the intelligence corps – tasked with boosting military might through clever innovation.

Today, some of Israel’s best-known companies and products are direct or indirect spin-offs from the military. The founders of Check Point, for example, the internet security company and Israel’s biggest software house, developed the idea for their firewall technology while serving in the army, working to improve the security of its computer networks.

Two additional factors were thrown into the mix in the early 1990s. First, the government launched an innovative funding programme that laid the foundation for Israel’s boom in venture capital. Second, the country decided to take in about 1m additional citizens – Jews who emigrated from the collapsing former Soviet Union. They brought with them not only a mountain of advanced science degrees, but also the risk-taking mindset often found in immigrant communities.

Today, at least some of the forces that made the Israeli high-tech story possible are still going strong. The culture, or cult, of innovation and business-friendly climate are today far more deeply entrenched than in the early 1990s. Experience also helps: Israel today boasts an entire class of serial entrepreneurs with a long list of inventions, start-ups and lucrative exits under their belts.

But there is no doubt the country’s high-tech industry faces fresh challenges. Since 2008, the most burning issue has been funding – especially at the later, and more expensive, end of the product cycle. Industry veterans complain that the financial crisis has made big investors, such as US pension funds, reluctant to commit their money to high-risk enterprises.

The recent spike in concern over European and American sovereign debt may yet prolong the suffering – though there are signs of improvement. The latest data published by the Israel Venture Capital Research Center show the country’s high-tech sector raised more than $1bn in capital in the first half of the year, an increase of 82 per cent compared with the same period in 2010. The number of companies obtaining funds was the highest in at least five years.

No less important, the sector is once again managing to secure profitable exits: MediaMind, the Israeli digital advertising company, was bought by a US rival for $517m in June. Last month, Dotomi, another Israeli advertising business, was snapped up by another American group for $275m. Deals such as these should go at least some way towards assuaging investor concern – and help persuade them to keep on funding.

The creaking education system is a matter of serious concern but industry experts say it is likely to affect the sector, if at all, only in the relatively distant future. Besides, some argue that a successful technology scene relies above all on a hyper-smart elite rather than a broad, well-educated mass of workers.

. . .

That leaves the question of whether Israeli innovators can continue to follow, and occasionally create, trends in an industry that renders products, companies and entire markets obsolete at lightning speed. There is clearly truth to Mr Margalit’s assertion that some strengths of the country’s high-tech sector, such as close links with military research and development, are likely to fade in significance as technology takes on a more consumer-centred, focus.

Yet there is, at least so far, no sign that the homegrown high-tech industry is missing any boats. Recent deals show that groups such as Facebook (which this year acquired its first Israeli company) have as much interest in the country’s start-ups today as Intel and Cisco did more than a decade ago, when the first wave of Israeli start-ups was snapped up. As Mr Shani confidently asserts: “The world will still need solutions that Israel can provide.”

Mr Margalit, too, believes Israel has ultimately more to gain than it has to lose from the relentless churning of the innovation cycle. The country’s high-tech boom, so his argument goes, was always based on more than clever algorithms and nifty chip design. “People misread Israel’s competitive advantage,” he says. “Israel’s competitive advantage is not technology, it is creativity.”

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