ISRAEL AND THE INNOVATIVE IMPULSE: SPECIAL REPORTS FROM WHARTON
From Haifa to Herzliya, the Fertile Ground of Israeli Innovation
Published in Knowledge@Whartonhttp://knowledge.wharton.upenn.edu/
What do website gadget developer LabPixies and insulin pump maker Medingo have in common? It’s not only that both companies are based in Israel. They also are among the country’s start-ups that have attracted the attention of international investors, with U.S. Internet giant Google recently snapping up LabPixies and Swiss pharmaceutical multinational Roche buying Medingo, a subsidiary of local medical device conglomerate Elron Electronic Industries. Israel is indeed becoming fertile ground for the likes of Google, Roche and other companies looking to acquire innovative businesses to add to their portfolios.
That’s why when U.S. software firm Microsoft was scanning the globe for new sites to expand its international research and development presence a few years ago, Israel was on its itinerary, according to Zach Weisfeld, the firm’s country director of business development and strategy.
“Innovation, together with the engineering excellence and the very quick-to-market production of … high-quality products, really makes Israel shine,” Weisfeld noted at a recent conference in Washington, D.C., sponsored by the U.S. Chamber of Commerce titled, “The United States and Israel: Building Business Through Innovation.” Based in Haifa and high-tech hub Herzliya, the Israel site has become one of Microsoft’s three strategic global development centers since opening in 2006, responsible for much of the new technology which the firm is now known for, such as its free anti-virus software.
In becoming a hotbed of global high-tech innovation, Israel has made a virtue out of necessity, turning its small size — and the fact that it is based in one of the most politically charged regions in the world — to its advantage, according to other conference participants. “We live in a small country of 7.5 million people and we don’t have neighbors to trade with and don’t have many resources of our own,” said Nechemia “Chemi” Peres, chairman of the America-Israel Chamber of Commerce and managing general partner and co-founder of Pitango Venture Capital in Herzliya. “The only way to face the world market is through innovation and technology.”
But even with noted innovative efforts in sectors ranging from solar energy to electric vehicles, Israel has paid a high price for its economic dependence on the world market. For one thing, foreign direct investment in the country dropped dramatically during the global economic downturn, from $10.9 billion in 2008 to $3.9 billion in 2009, according to the World Bank.
Meanwhile, according to a November report from The Economist Intelligence Unit (EIU) in London, weak global demand for Israel’s exports has also hit the country hard. But recovery — although slow — is on the way. With growth in exports having dropped 11.4% in 2009, an increase of 6.3% is forecast for 2010 and 6.9% in 2011. Overall, GDP will grow 3.7% in 2010 and a “respectable” 3.4% next year, according to the EIU report. That’s good news for the country’s entrepreneurs, the EIU’s report noted: “After pausing last year, consumption per head — measured in U.S. dollar terms — is set to resume its upward trajectory in 2010, helped by a recovery in household incomes and a strengthening shekel.”
Calling on Support
Israel now has the second largest number of start-ups in the world, after the U.S., and the largest number of Nasdaq-listed companies outside North America. One of those is Given Imaging, a Nasdaq-listed medical technology company, based in Yoqneam, a city southeast of Haifa. The company got much of its initial funding in 1998 from Elron Electronic Industries. With markets now in 60 countries and offices around the world, revenue for the first nine months of 2010 increased to $112.9 million, up 11% from the same period the previous year. Asked about the key to the company’s survival, panelist Nachum Shamir, its president and CEO, was unequivocal: Israel’s small, tight-knit business community. “All you have to do is make a few phone calls to get the funding you need,” Shamir said. For that reason, about 90% of Israel’s start-ups raise at least some of their seed money locally, according to Pitango’s Peres.
Entrepreneurs have had another source of support: the government. The country is ranked number three in Southwest Asia and number 29 overall in the World Bank’s recent Ease of Doing Business Index, which considers, among other things, the simplicity and transparency of local business regulations. “I think the Israeli government has put tremendous resources into innovation,” Peres said.
One way that has been happening is by offering conditional grants to cover 50% of a company’s R&D costs, to be repaid if a project is successful. About 500 companies receive such grants each year. Other costs of getting a business up and running are covered as well. For example, through a partnership with Microsoft, the government offers start-up companies free Microsoft software for three years. According to Weisfeld, 700 start-ups have taken the government up on that offer.
But Peres, for one, wants the government to do more, particularly when it comes to encouraging companies from outside Israel to increase the flow of foreign direct investment. A step in that direction was taken over the summer, when the government launched a program to pay as much as half the salaries of bankers employed in Israel by international banks if they establish R&D centers in the country.
An additional step involves Pitango. Earlier this year, the VC company was part of a winning bid for an innovative joint government-private sector fund called Al-Bawadir (or “buds” in Arabic), beating out 11 other firms. The first fund of its kind, Al-Bawadir will soon invest in a range of start-up and mature companies belonging to minorities, a much-neglected part of Israel’s workforce. According to a report about the fund on news website Haaretz.com, Israel has 1.5 million Arab, Druze and other minority citizens, or 20% of the population, but their contribution to output is just 8%.
Peres, the son of Israeli President Shimon Peres, expects the fund to invest about $50 million in 20 to 30 manufacturing, service and high-tech companies over five years and mature in 10 years. “We’re already planning the sequel funds,” Peres told Haaretz newspaper in March.
Battlefield to Boardroom
Panelists at the conference also explored a different — and arguably unique — factor influencing innovation in Israel: how future business leaders and entrepreneurs, while conscripts in the country’s military service, pick up a raft of skills that are as useful in the boardroom as they are on the battlefield. With all young Israelis required to serve in the Israel Defense Forces (IDF) — 36 months for men, 21 months for women — “military service is so important here for getting young people to think outside the box and lead others,” Microsoft’s Weisfeld noted.
Gideon Argov, president and CEO of Entegris, a Massachusetts-based technology manufacturing company, listed six values he learned while serving in Israel’s army as a tank commander and operations officer that have been crucial to his success in business: clear thinking, resourcefulness, stamina, an ability to improvise, teamwork and leading by doing. “These are not values you learn at [business school] and they do not happen through an academic environment. But they do relate to entrepreneurial success and should be implanted in business,” said Argov, who, following his military service, went on to earn a bachelor’s degree at Harvard and an MBA at Stanford.
According to Argov, the first lesson he learned upon entering the IDF in 1974 was that “you have to question everything.” He described the environment then, when the surprise attack of the 1973 Yom Kippur War was still fresh in everyone’s memory. After the fighting ended, a government commission found serious flaws in the army’s intelligence branch, which had ignored various warnings of an attack. That failure, Argov said, encouraged a culture of questioning.
But there is one critical entrepreneurial value that isn’t — and shouldn’t — be taught on the battlefield: A culture of risk-taking, added Guy Filippelli, a former U.S. military intelligence officer who is CEO of Berico Technologies, a Virginia-based company providing analytic and technology services to U.S. intelligence and defense agencies. He conceded that even if risk-taking in boardrooms might not lead to success, it’s one of the necessary hazards of being at the cutting edge. “I always try to encourage failure,” he said. “You cannot be innovative without doing that.”
Forging Deals with U.S. Partners: A Case of Mutual Benefit
Published in Knowledge@Wharton
After inventing the ReWalk, a device that allows paraplegics to move about in an upright position, in 2006, Amit Goffer, the CEO of Israel-based Argo Medical Technologies, needed a partner to secure funding for clinical trials and to provide access to technical support. So Goffer looked to the United States, where a rehabilitation hospital was interested in testing the product. Through various connections, Argo partnered with Allied Orthotics and Prosthetics in Mount Laurel, N.J. The two companies are now running clinical trials, and the ReWalk is expected to soon be ready for sale to the public.
“We looked into it and thought it could be a profitable venture for us,” said Howard Brand, managing partner of Allied Orthotics. A device to help paraplegics walk had not been available previously, so the product was “important to an industry and to people.”
Hundreds of other U.S. and Israeli companies have formed partnerships in the last several years, and more are forming every day. The dynamics of these partnerships and the resources available to create them were examined by Brand and other panelists at the conference, “The United States and Israel: Building Business Through Innovation,” held recently in Washington, D.C., by the U.S. Chamber of Commerce.
Trade Access, Cost Cutting and Jobs
All of the panelists pointed out that while the United States overshadows Israel in many ways, including the size of its companies, these partnerships are typically balanced and mutually beneficial. Eitan Yudilevich, executive director of the BIRD Foundation, which provides conditional grants to support business partnerships between the two countries, said that one of the benefits is better access to export markets. Not only does an Israeli company get easier entrée to the North American market, but the American company can leverage its Israeli connection to improve access to challenging markets like India or Turkey.
According to Yudilevich, the BIRD foundation (Binational Industrial Research and Development) only gives funding — ranging from up to $1 million or 50% of the total cost of the project — to partnerships in which the pluses for each side are clear. “The BIRD model is mutually beneficial for U.S. and Israeli companies,” Yudilevich said. “We look at the balanced interest when we judge a project and will not approve a project where there is an imbalance.” Since it was founded 33 years ago, backed by funding from the governments of both countries, BIRD has supported 813 partnerships and awarded $282 million in grants.
Yoram (Jerry) Wind, a Wharton marketing professor and director of the SEI Center for Advanced Studies in Management, said that another mutual benefit is cost savings. In an interview after the conference, he noted that American companies typically provide the marketing expertise, saving the Israelis money on that front, while the Israelis handle product development and manufacturing at a lower cost for the Americans. Given this cost advantage, more U.S. companies are now looking to Israel for manufacturing partnerships, Wind said. “Because of its high-tech population, [Israel] offers high-tech and high-quality manufacturing. And relative to the U.S., it’s still cheaper to [manufacture products] in Israel.”
Another panelist, Donald Plusquellic, the mayor of Akron, Ohio, said that a benefit he sees from Israeli-American partnerships is an increase in jobs in both countries. In 2006, Akron became the first American city to invest directly in a technology business incubator in Israel. Since Akron’s initial $1.5 million investment, 15 Israeli businesses have emerged from the Targetech incubator. Under the terms of the investment, the new businesses have to open offices in Akron while also building an Israeli presence — and some have already done so. In exchange for its investment, Akron not only gets some jobs, but it also receives dividends from the new companies as a part owner. “This is not a one-way deal — it’s of mutual help for our communities in the United States and the businesses in Israel,” Plusquellic noted.
Drawn by Innovation
The idea to invest in Israeli businesses came to Plusquellic after he toured Israel in 2005 as president of the U.S. Conference of Mayors.He was taken aback by all the innovation and development that he saw there, and was impressed by “the resiliency of a nation and the commitment to develop high-tech companies.”
Among the companies that graduated from Targetech, thanks in part to Akron’s investment, are Scentcom, which provides digital scent technologies for cell phones, toys and video games, and NI Medical Ltd., which makes a non-invasive device for early screening of heart disease. NI Medical recently set up shop in Akron, while Scentcom has yet to do so. “This risk, we believe, is going to pay off dramatically,” Plusquellic said of the decision to invest in the incubator. “Every city in the U.S. should look into these kinds of investments.”
Access to innovation is the reason that many U.S. companies seek out Israeli partners, noted Yudilevich, who added that innovation is simply ingrained in the Israeli culture. As many panelists at the conference pointed out, the innovative impulse comes from Israel’s small size and location, which foster a need to be self-reliant. “Israel absolutely has something unique,” Wind noted. “It offers high-quality innovativeness in terms of both scientific and technological areas.”
One example of the Israeli need for innovation, which Yudilevich highlighted, is a partnership between TransBioDiesel of Israel and U.S.-based Purolite to create a biodiesel fuel enzyme. BIRD is helping to fund this project, but Yudilevich said it would not be possible without strong support from the Israeli government to promote breakthroughs in alternative fuels.
Cultural Differences Can Cause Problems
While Israel has many attractions for U.S. businesses, observers are quick to note that partnerships do not come without complications.
According to Brand, when Allied Orthotics was looking into partnering with Argo, the biggest surprise was the expectations from the Israeli executives. “We were miles apart on the relationship,” he said. “They thought we would invest and fade away, and that, of course, was not our intention at all.” Brand added that in order to solidify the relationship, he went to Israel to see Argo in operation. Consequently, he recommends that any U.S. company looking for an Israeli partner should go for a site visit before making a decision.
Understanding the Israeli culture is key for any U.S. company considering a partnership, Wind noted. Unlike their counterparts in the United States, he added, CEOs in Israel will tell anyone exactly what they are thinking, and lower-level employees will not hesitate to share their opinions, either. “Israeli business culture is dramatically different. It’s more informal, much more direct and less rigid.”
As many panelists at the conference pointed out, much of the cultural difference comes from the required service in the Israel Defense Forces (IDF) and the training that is received there. Respectful questioning of authority is encouraged, and there is much less hierarchy than in the U.S. military.
Booky Oren, chairman of WATEC Israel, an annual global conference on water technology, and chairman of the Miya Arison Group, a consulting firm for municipal water companies, said that it’s simply the nature of Israelis to be upfront and direct. He added that when he has worked with American companies he has often gotten in trouble for being what Americans perceive as “rude.” “As an Israeli, we don’t understand enough of American culture,” he noted. “We push too hard and don’t understand that [Americans] run [their] business in a different manner.”
Israeli Venture Capital: Between a Rock and a Hard Place
Published in Knowledge@Wharton
This has been a bad year for Israeli venture capital funds — but then 2009 was a bad year, too. That alone can go a long way to explaining the angst gripping much of the VC industry in Israel.
But the soul-searching now under way in Herzliya, the sleepy seaside town just north of Tel Aviv that has been transformed into the heart of the Israeli high-tech and venture sectors, suggests that something deeper is amiss. Perhaps the most dramatic public expression of this growing groundswell of gloom and doom came in a letter sent in May by Ze’ev Holtzman, founder and chairman of Giza Venture Capital and former chairman of the Israel Venture Association, to Prime Minister Benjamin Netanyahu and Minister of Finance Yuval Steinitz. Holtzman’s message was blunt: “Israel’s venture capital and start-up industry is heading for collapse…. The industry, which is the economy’s growth engine, is liable to be irreversibly damaged.”
Nor is Holtzman a lone voice. A growing number of experts, inside but especially outside the industry, believe that Israel’s VC funds are an endangered species and, if they are to survive at all, their accepted business model must be scrapped and replaced with something more suitable to today’s business and financial environment.
A Major Success Story
The “history” of Israeli venture capital effectively began in 1992, when the Israeli government kick-started the domestic venture sector by launching a prototype government-owned fund called Yozma (it seeded other funds, which were privately owned, and was itself ultimately and successfully, privatized). Since then, the VC-driven business model has dominated Israeli high-tech and become firmly implanted in the public mind as a major success story.
The model works like this: A seemingly endless stream of technology entrepreneurs — encompassing nerdy high-school kids, highly qualified scientists and academics who had immigrated to Israel from the former Soviet Union, and graduates of elite military intelligence units — generate a flood of ideas for products, programs and systems. They market these ideas to Israeli venture capital funds, and those that the funds choose to back receive financial — and often managerial — support which, typically, requires several rounds of investment. Often, the original fund will bring in others along the way to share the burden and the risk — and also the profits, if all goes well.
Typically, “going well” means going public, preferably via an IPO on the Nasdaq market in the United States. This path became so well-trodden that between 1985 and 2003, some 120 Israeli companies issued shares on Nasdaq — more than any other foreign country except Canada. (Prior to 1992, Israeli start-ups largely sought funding from VCs and individual investors in the United States, who continue to be a significant source of financial aid.) Additionally, several larger Israeli companies were registered on the New York Stock Exchange and many smaller ones went public via issues on European “wannabe” Nasdaqs, such as the Alternative Investment Market (AIM) in London.
Problems with the Model
What has gone wrong with this model? David Rosenberg, a veteran journalist covering Israeli technology and author of the forthcoming book, “Israel: The Knowledge Economy and Its Costs,” says the villain is a “two-sided squeeze” of the VC funds. At one end of the VC activity cycle, the firms cannot raise money for new funds, while at the other end, they can’t exit their investments via IPOs because the global financial crisis of the last two years has largely shut down the market for new issues.
Raphael “Raffi” Amit, a Wharton management professor, notes that although this year has proven to be much better than 2009, that’s because 2009 was the worst year for IPOs in more than 40 years. The improvement in 2010 was from such a low base that it still left this year weak by historical standards, he says.
Amit, who sees strong parallels between the state of the Israeli VC sector and that of the sector in the U.S., questions whether the IPO market will ever return to boom conditions. Given the statistical fact that most IPOs of technology companies generated poor returns for the investors who bought the shares, he says he is very doubtful that it will. Right now, many companies are sitting on prospectuses for share flotations that they have prepared, but market conditions have prevented them from activating those, Amit notes. This overhang of supply acts to depress prices and will continue to do so for a long time — hardly good news for VCs eager to exit from their successful investee companies.
The tough market conditions raise the question as to whether the VC funds are victims of circumstances or the cause of their own problems, experts say. In other words, has the model been undermined by developments outside the venture sector, or is it inherently flawed? Not surprisingly, opinions vary depending on where you sit. Many VC fund managers see themselves as victims, although there are those who are prepared to admit to systemic problems and who also propose solutions, some of them radical.
But people outside the industry tend to be more critical. Andrew Fine, who has worked with numerous venture-backed start-ups both as a CFO and as an outside consultant, believes that the problems with the business model begin with the accepted fee structure. This structure typically awards funds a fee of 2% per year of money under management, irrespective of their performance, and a hefty success fee when they realize a profit from an investment. However, the poor — in some cases abysmal — record of the VC fund industry over the last 10 years, since the Internet/telecom boom collapsed in 2000, has forced even the most apathetic and gullible investors to ask whether the fees are justified, Fine notes.
By the same token, the entrepreneurs in the investee companies who sell the VC funds large equity stakes in return for their cash feel that they are also getting a raw deal. Money is essential for start-ups, but it is not sufficient: They need professional and managerial help, contacts and guidance, and they expect their investors to provide them. Many funds have failed to do so, experts point out.
Just a Cyclical Downturn?
That these are hard times for VCs is uncontested — and just how bad things are can quickly be ascertained from some key statistics: Capital raised by Israeli high-tech companies from venture capital funds fell last year to $1.12 billion — some 55% less than 2008 — and ran at a similar annual rate in the first half of 2010, when it totaled $577 million. These are the lowest levels of capital raised since 2002-2003, when the aftermath of the dot-com bust saw a collapse of high-tech investment flows.
More critically, the percentage of the investments being made in these Israeli start-ups specifically by Israeli VC companies has fallen dramatically. Between 2000 and 2006, Israeli VCs were responsible for 40% to 45% of total investment by VCs, with the 49% level recorded in 2005 marking a high point, according to the IVC Research Center, an arm of the Israel Venture Association. From 2007, their share eroded at a steady one percentage point per year, reaching 37% in 2009. But in January-June 2010, the share plunged to an unprecedented low of 29%
The critical question is this: Is the weak period that the sector is going through merely a cyclical slowdown, or is it something more fundamental and hence more far-reaching?
Observers inside and outside the industry have diverging views on the issue. Len Rosen heads the Israeli office of Barclays Capital and, in both his current and previous positions (at Lehman Brothers), has been a leading player in the involvement of foreign investment banks in Israeli high-tech. He suggests that the sector’s current state represents a cyclical downturn — and he even identifies a silver lining around the current black cloud. “There is a general problem in high-tech, which is especially acute in Israel, of start-up companies that want to go to market too early in their development path,” Rosen says. “If an exit option exists, companies take it — whether because of pressure from their VC investors or because the entrepreneurs want to ‘meet cash.’ But we have found that the best IPOs were those made after an enforced hiatus when the market was closed to new IPOs.”
According to Rosen, “the cyclical dynamic will continue and good IPOs will return.” Indeed, recent months have seen the IPO window opening and the first Israeli IPOs since 2007 being floated on Nasdaq — although with decidedly mixed results. Yet even Rosen concedes that there are structural problems in the Israeli high-tech sector, such as the absence of funds specializing in “mezzanine financing,” which employs a mix of debt and equity to help existing companies expand. An infusion of mezzanine money would enable start-ups to hold off from going public prematurely, Rosen says, noting that this structural issue reflects a cultural problem prevalent in Israeli business — a lack of patience and an unwillingness to allow the natural process of development and maturity to run its course.
A Smaller Role?
Yossi Vardi, an angel investor and one of Israel’s first high-tech entrepreneurs, maintains that Israeli start-ups can comfortably survive an existential crisis in the VC industry, because their future financing will come from angels and from larger companies, with VC funds playing a much smaller role than in the past.
Vardi’s view of high-tech’s future resembles a barbell: At one end are the hundreds of start-ups operating in the Internet and mobile sectors. At the other end of the corporate spectrum are the major multinationals such as Intel, IBM and Motorola — all of which have large facilities in Israel for R&D and, in Intel’s case, for manufacturing as well — that each employ thousands of people.
He dismisses the idea that there is a shortage of financing available for start-ups. There is indeed less money available than before the financial crisis, he notes, but the sums that are required for seed financing and for later rounds have also shrunk. “I see an endless flow of new ideas being generated here, and an ongoing parade of foreign companies coming to Israel to find the ones that meet their needs.”
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