Israel: Moving from Start-Up Nation to Big Company Nation

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This post comes from a bit I wrote with a friend of mine Oded Hermoni for my book, but my publisher McGraw Hill, decided to cut my chapters on Israel and Europe and save those for my next books. I wanted to share this now as we will re-write it all from scratch. Oded is a good friend, a member of the advisory board of The Founders Club, investment director of the Rhodium family office, which invests in early stage technology companies in Israel and the US, and former Head of the Israeli High Tech Industry Association. I have portfolio companies from Israel in The Founders Club and love my visits there. In addition to a book tour event in Tel Aviv September of 2014, I plan to organize an exclusive off-site summit for 50 of the most successful entrepreneurs, VCs, angel investors, lawyers and bankers in Israel to first discuss and debate and then agree on who will write what for my next book focused on the venture scene in Israel – what has happened (past successes putting Israel on the map), what is happening now and what needs to change to make Startup Nation – Big Company Nation. It’s an exciting place and an exciting topic. Here is the piece Oded and I wrote. Thank you, Oded!

Start-up Nation: The Story of Israel’s Economic Miracle is the title of the well-known book written by Dan Senior and Saul Singer in late 2009 and in a way summarized the way Israel became a landmark as a big hub for innovation in the past decade. Israel for many years has been considered a unique economic miracle, when one imagines a small desert country in the Middle East surrounded by relatively hostile neighbors. When it comes to start-ups Israel takes number two only to Silicon Valley and in fact if you were to really audit based on the number of start-ups per capita Israel might be number one.

Israel has consistently had more companies listed on NASDAQ than all of Europe combined and third place only after the US and Canada. When looking at the league tables on a per capita basis Israel scores consistently as one of the top countries for patents per capita, engineering per capita, VCs per capita, exits per capita, and so on to the point that the data can make any official representative of Israel blush like a good Jewish mother talking about her son’s achievements.

But right now at this moment in history many people in Israel are beginning to question themselves and a public debate has emerged asking if this start-up nation thing is so good for the future and the Israeli high tech industry. The Israeli economy is heavily dependent on the success of the Israeli high tech industry and a key reason Israel managed to deal so well during the 2008 global economic crisis. When the game is not per capita, but rather, per the whole population of a country, the terminology and the mentality of entrepreneurs and investors must change.

This is why for many within this industry the term Start-up Nation, is a curse where Israel serves as an R&D hub for innovation benefiting foreign companies and countries rather than the Israeli nation. The facts are speaking for themselves and telling us that Israel is very good at starting new companies, incubating amazing technology and selling these companies to foreign buyers making returns for investors and wealth for the few lucky entrepreneurs, but Israel fails to turn these startups into huge lasting companies that bring long-term benefits to Israeli society. The last vintage of Israeli companies that grew to become world leaders was in the 90’s with companies such as Amdocs, CheckPoint, Indigo (later acquired by HP), Mercury (later acquired by HP), Comverse, ECI and Nice. Since then, the number of start ups that managed to cross the Rubicon of $100m in annual sales and to become mature and independent companies that lead their market can be counted on one or two hands. We are not talking about the old debate of why Israel has no Nokia like Finland. We do have Teva, the largest generic drug company, but we cannot depend on one large company. What Israel needs now is to develop a few large companies every year out of each annual vintage of the hundreds of startups we create. Why do Israeli companies sell early on for a quick buck and not soldier on raising growth capital and developing into large companies?

Though Israel is blessed with the presence of companies like Dell, Microsoft, Facebook, Cisco, Intel, Google and even Apple which have all opened R&D centers in Israel by following acquisitions of Israeli start-ups and helped the local industry mark the past two years as record banner years in terms of exits, not much of the Israeli economy enjoys the direct fruits of those exits. The buyers of these start-ups usually keep only the R&D center in Israel and just use this as a beachhead to hire more engineers. They pretty much never keep, establish or cultivate any business activities such as sales or marketing. Therefore the true effect of the current selling off of our start-ups has less effect on the real export of Israeli goods and services or the employment and benefit of the broader workforce of Israeli society.

The amount of venture capital funding companies from non-Israeli VCs has climbed significantly in recent years and even the Israeli funds have raised the bulk of their LP cash from non-Israeli institutions. So again, much of the rewards at start-up nation leave Israeli shores and fail to properly benefit the Israeli current account or bring in foreign currency and drive GDP as it could if these companies grew into large lasting companies remaining headquartered in Israel.

Having said that, it is clear that the multi-national companies operating in Israel following their acquisitions are making a significant contribution to the ecosystem that makes Israel such a global innovative hub and accelerating the pace of the Start-up Nation reported in 2009 by Senior and Singer. Just four years after the release of that book the ability to network an idea or news of a startup to Google, Facebook, VMware, and many others is now seconds. Word in Israel spreads very quickly. The country’s entrepreneurs and investors are just very tightly networked and then very well connected to Silicon Valley, New York City and London. The key point here is that the established big balance sheet companies that acquire start-ups are now very well established in Israel and will hear about the latest innovative start-ups much quicker now than only 4 years ago.

Why did Israel become a nation of startups and not an innovation economy of big companies? Why didn’t these startups reach the next phase and mature into more established industrial players that are consolidating rather than being consolidated? A few factors lead to the answer. The first, I would dare to say, is a matter of culture. Israelis have a track record of thinking out of the box and being innovative. However, when it comes for long-term decision-making sometimes our hutzpa is not helping. Another main factor is the lack of patience of the investors for building large companies. The domestic VCs had a major contribution to the trend of companies selling too early and not growing into long-term large players. For the past 20 years Israeli VCs have struggled to return money to investors so that they could raise their next fund. This trend of being under pressure to put points on the board is not consistent with a 10, 15 or 20 year journey to create a Siemens or a Cisco. Since the establishment of this investment industry by the governmental Yozma initiative in the early 90’s, the Israeli VCs had about 50-60% market share of the investments in local start-ups. The Israeli VCs, eager to show they have good returns, had a major impact on some of the early exits of those potentially large companies and since the Israeli investment ecosystem suffered from a lack late stage funding, no one was at the gate to take those companies to the next phase. At the same time some of the local entrepreneurs pushed for early exits in order to meet with money. When a group of entrepreneurs watch their friend sell a company three to six years after founding the venture and walk away with a few million dollars, it starts to contaminate the pond of entrepreneurs who also want to get rich quick or just some cash in the door to secure their families and then consider pushing for a bigger exit on the next one. Israeli entrepreneurial culture began to agree with their investors and push for quick wins and essentially get rich quickly without putting in the 15 to 20 years to build a world beating, world-dominating company.

Essentially all of these factors mentioned can be corrected. Israel needs and will get longer term investment funds, the establishment of more later stage growth funds, the proliferation of equity exchange funds and direct secondary funds as well as a push on culture to create bigger companies led by new entrepreneurs as well as successful serial entrepreneurs that have already achieved some early exits. Despite all of this Israel faces a small handicap. The truth is that Israel is geographically in a remote location. It is harder to build a large company when you are many time zones away form your target market. The reality is that many Israeli entrepreneurs move their headquarters to Silicon Valley and New York City and keep their own developers and engineers in Israel. In the end most Israeli entrepreneurs do not let the handicap of a remote location slow them down and their companies are born with international operations, management teams and investors. I am sitting in Palo Alto, California in the heart of the Silicon Valley as I write this today.

In 2011 and 2012 we started to witness a shift and the first steps for Israel to build a wider industry, which is not only a start-up nation as it was for the past 20 years. The debate about building large companies has made everyone more aware of the problem. One of the outputs from the past exits is that in Israel a generation of second time entrepreneurs, who already made a fortune in their first company are now creating new ventures and this time with the lessons of the previous companies, they aim high to build big companies. This new wave of Israeli entrepreneurs has no pressure for money. They have the ability to get funded from top tier US VCs and their real world experience helps them to get onto the right track to building large lasting companies. VCs started to look for ways to decrease the pressure from the new entrepreneurs to get cash in their pockets by providing second market options. So when an entrepreneur is facing the decision to sell the company for $50m now or raising $30m and lead the company for another 3 to 5 years and then IPO on the NASDAQ and then survive a 6 to 18 month lockup period before he can sell his stock, the VC and the entrepreneur may agree that the entrepreneur sells some of his founder stock at the time of raising the $30m growth round. Equity exchange funds are another sensible option allowing the entrepreneur to convert some of his stock into other high potential companies without selling too early at the last or next pre-money valuation. So the establishment of secondary markets for early liquidity matches the long-term vision of Israel to transform from start-up nation to big company nation. We may also see the emergence of single secondaries as well which are cases where a larger VC or private equity fund comes in and buys some or all of the position of an early VC that needs to return funds to its LPs.

Notable changes in the investment landscape are going to help with this issue too. Large foreign investors, the VCs with the billion dollar exit tombstones have entered the market and this will have an impact. Big name VCs like Sequoia, Greylock, Benchmark and others look at each investment and ask if that single company has the potential to return their entire fund. This means that if all of their other investments went bankrupt and they lost all of their money would this one single company have the ability to return the entire fund and make a profit for their LP investors and get them into carry. This is a different approach and requires more patience to get to a big exit and therefore build a big company. American VCs are now taking about 70-80% of the investment pie. At the same time, more and more late stage funding vehicles have been founded in Israel, giving more fuel to the start-ups already on the road with revenues.

Awareness of the ecosystem through activities is also driving us further in the right direction. I personally headed up the High Tech Industry Association (HTIA) in Israel, which gives the Israeli high tech industry a place to develop a more mature industry, while maintaining it as an innovative hub for the entire world. At the end of the day, the Israeli high tech industry and economy needs only a few more large companies to grow every year in order to accomplish a more balanced industrial high tech economy. We truly have the correct mix of ingredients and a now well matured ecosystem to achieve these goals to transform start-up nation to big company nation. So get ready for the next stage as we are just on our way to achieving it. Stay tuned.

“I hate it when people call themselves “entrepreneurs” when what they’re really trying to do is launch a startup and then sell or go public, so they can cash in and move on. They’re unwilling to do the work it takes to build a real company, which is the hardest work in business. That’s how you really make a contribution and add to the legacy of those who went before. You build a company that will stand for something a generation or two from now. That’s what Walt Disney did, and Hewlett and Packard, and the people who built Intel. They created a company to last, not just to make money.” – Steve Jobs (Page 569 Walter Isaacson)

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I took this photo of Dov Moran at my Roundtable event I organized for The Founders Club in Israel. Dov sold his previous company for $1.6bn after inventing the USB flash drive. Dov Moran can afford to buck the trend of selling too early. Dov is back with another startup Comigo.

Here is a photo I took from our conference room at the offices of Yigal Arnon overlooking a helipad where I had notable leaders in the Israeli VC scene discussing what we needed to do to be more successful as part of the launch of The Founders Club in Israel. Attendees included among others: Dov Moran, Yossi Sela, Gemini Israel Venture Funds, Ophir Reshef, Bessemer Venture Partners, Hillel Milo, AquAgro Fund, L.P., Glen Schwaber, Israel Cleantech Ventures, Gera Strommer, General Manager MediGuide Navigation Systems (acquired by St. Jude Medical), Nissim Darvish, OrbiMed Israel, formerly Pitango Venture Capital and 20 other founders and lawyers…oh, and that’s the Mediterranean Sea in the background. Nice beaches, too.

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Twitter: @RomansVentures

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