Friday 12.23.16

Middle East Perspectives in Venture Capital and Entrepreneurial Management

9 Theses on Israel's Startup Landscape

This post was first presented in an executive roundtable discussion at the Wharton School of the University of Pennsylvania. OHK’s Ahmed Hassan provides perspectives and lessons learned from VC expert exchanges, interviews with industry veterans, and OHK’s own insight from advisory on success in innovation and entrepreneurship.

Part 1: Background and Theses 1 to 3

Both popular and academic literature about the Israeli startup scene abounds with heady language. Israel is referred to as the “Startup Nation”; its entrepreneurial-minded citizenry lauded as an economic miracle and its landscape given the playful sobriquet “Silicon Wadi”. Authors and theorists have gone to great pains to compare Israel to Silicon Valley, seeing the former as something of a younger brother to the latter or two sides of the same entrepreneurial, late-capitalist coin. Much of the literature revolves around either a) the convergence of the two, measuring both the Israeli and American startup ecosystems against a universal, model-type, end-stage entrepreneurial ecosystem, or b) the applicability of the “Israeli model” to developing countries. Less is said about the differences between the Israeli and American models, and the extent to which those differences may be more structural than incidental (and thus problematic as templates for other countries).

In the spirit of Hall and Soskice’s pioneering work on global “flavors” of capitalism (see: Varieties of Capitalism: The Institutional Foundations of Competitive Advantage. Oxford University Press, 2001), this discussion sets out a series of hypothetical theses that aim to provide insight into the differences between the Israeli and American startup environments and to set a research agenda going forward. We proceed from the assumption that differences between the two startup landscapes are not epiphenomenal accidents of history, but rather reflect more fundamental structural differences between the two. In using the term “structural,” we are referring to unique institutional and cultural forces that are fundamental to national identities and that, while not immutable or uncontested, have come to characterize local economic landscapes. The economic phenomena we seek to highlight in these theses are slow-moving and often unwritten; to understand startup cultures, it behooves us to look not at individual companies, actors, or events, but rather institutions and regulatory regimes.

Some of the nine theses we identify have strong quantitative bases, while others are more qualitative and have emerged from various guided discussions with subjects from both Israeli and American startup ecosystems. In each case, however, we provide a lens through which to better understand the particularities of the Israeli startup landscape and predict its evolution. This is particularly useful in the context of emerging markets and the wider Middle East, and in countries like Egypt, Jordan, Morocco, and Tunisia where there is a significant potential to develop a far more developed VC ecosystem.

Thesis 1: Aspects of Israel's High-Tech Ecosystem Are Not Easily Replicable

Throughout the literature, there are ample references to Israel’s unique high-tech ecosystem. We believe that three aspects of this ecosystem and, in particular, the interplay of these factors is unique and difficult to replicate.

Much of Israel’s startup dynamism can be traced to a three-part institutional framework, which in turn is highly specific to a history of bilateral cooperation between Israel and the United States. Firstly, Israel’s "Law for the Encouragement of Industrial Research and Development—1984" encourages “raw” R&D on a national level. We believe this particular legislation departs from the more common paradigm of economic promotion through FDI, tax breaks, clustering, and attraction of mature “anchor” enterprises, focusing rather on raw research and tech development. Secondly, Israel has created an Office of the Chief Scientist populated by startup and private sector veterans that coordinates support for and resources to tech entrepreneurs in Israel. Thirdly, funds like the BIRD Foundation, a product of US-Israeli bilateral ties, directs funding to tech companies to support R&D and has had a hand in many of Israel’s largest startups. It is essential for the student of the Israeli startup ecosystem to understand the extent to which these regulatory and institutional bodies are unique to Israel and would be unfeasible in other countries, whether because they are at odds with broader cultural attitudes toward legislation (as in the regulation-averse United States) or because prerequisite institutions or bilateral relationships are absent (as in any number of developing countries). As a result of this interplay and supportive environment, expenditure on R&D in Israel as a percentage of GDP is the highest in the world, as noted by Orna Berry, Former Chief Scientist, to OHK’s Managing Partner, Ahmed Hassan.

In interviewing various Israeli startup founders in Palo Alto, we noted that the Israeli military is a unique onramp for talent, while Israel’s compulsory military service ensures that virtually all Israeli startup founders have military experience, it does not explain why a preponderance of successful entrepreneurs come from elite units like Unit 8200 of Israel’s Intelligence Corps. Not only are founders commonly alumni of such units, but many of Israel’s leading startups are in industries that parallel the unit’s specialization, including security, telecommunications, and encryption. Over the course of a week spent engaging with Israeli startup veterans, our estimate for the number of startups with founders coming from Unit 8200 ranged from 25% to 90%. This highlights the need to better understand the role of entities like Unit 8200 in Israel’s entrepreneurial ecosystem and how they supports entrepreneurship in tangible terms. Exactly how much of Israel’s startup talent comes from such an alumni pool? And how precisely do such units create and maintain this startup elite? Do they function as an MBA providing leadership skills and holistic critical thinking, as a technical undergraduate degree providing foundational and top-notch technical training (i.e., an MIT), or as an incubator attracting existing talent and providing hard and soft resources for improvement? Further research is needed.

Israel’s universities were founded as early as 1912 with the Technion. Today there are eight, three of which are ranked in the world’s top 200 universities, per QS World University Rankings. In 1959, the Weizmann Institute established the Israeli Technology Transfer Office (TTO) marking academia’s ingress to research transfer. Since then, every leading university in Israel has created technology transfer companies. Presently, Israeli TTOs generate around NIS 1 Billion in royalties, license 150 new technologies, and support 15 new research-based companies every year. “Yissum” of the Hebrew University and “Yeda” of the Weizmann Institute rank among the top ten in terms of revenue of global TTOs, notes Yaacov Michlin in “Where Science Means Business–Technology Transfer: The Secret Engine Behind Israel’s Success.”

Although this aspect is not dissimilar from elite universities in the United States, again the focus of the government shines through in the founding and support of these institutions and how intricately they fit into the high-tech ecosystem, factors more unique to Israel.

Thesis 2: Lower Pre-Money Valuations are Indicative of Brand Challenges

Despite the breathless praise of Israel’s startup culture as an economic miracle rivaling that of Silicon Valley, and despite anecdotal evidence that Israeli technical talent often exceeds that in the United States, pre-money valuations of Israeli startups are persistently below those of comparable startups in Silicon Valley. We believe that any student of the Israeli startup ecosystem must understand the extent to which this devaluation is a function of Israel’s brand; that is, its perception among the various players within global finance. Do Israeli startups suffer from a geographical discount much in the same way that startups based in peripheral American markets are valued less than those in Silicon Valley? Or do lackluster pre-money valuations reflect perceptions of Israeli startups’ market viability?

On the latter, there is growing evidence; data suggests that Israeli startups are 46% more likely to take on smaller markets relative to startups in Silicon Valley, and that Israeli startups are 5% and 33% less likely to take on USD 1 to 10 Billion and over $10 Billion markets, respectively, as noted in “The Startup Genome, Startup Ecosystem Report 2012”. This corresponds well to remarks made by Gil Ben-Artzy who suggested that US venture capital funding of Israeli startups should “redefine success,” move away from traditionally smaller exits, and expect bigger returns and shorter times to market (reflection from meeting with Gil Ben-Artzy, Founder, UpWest Labs Headquarters, Palo Alto).

Thesis 3: Israelis Frame the "Founder's Dilemma" Differently than Americans and Other Leading VC Markets

When asked about the challenges they face, American entrepreneurs frequently focus on difficulties related to career decisions and transitions – the difficulty of leaving a high-paying job for an uncertain venture, the challenge of balancing their family’s needs with the founder’s business imperatives, and choices around managing risk. In addition, US startup founders amplify the importance of “getting the team right,” while their Israeli counterparts hardly mention it. To wit, Israeli founder challenges appear 67% less likely to be team related and 39% more likely to be product centric. In a meeting with Gil Ben-Artzy, he noted that age may well play a factor given that on average founders in Israel are in the mid 30s.

Our experience with Israeli founders is that the question of personal risk is far less salient. Indeed, some are downright dismissive of the “founder’s dilemmas” that preoccupy American founders. We propose that it is necessary to frame these discussions with further insights into the perceived and real opportunity costs and demographics of Israeli founders. Are Israeli founders less saddled with debt? Are their families more receptive to riskier career choices? Is there some nebulous “survivor mentality” among Israelis that reframes the founder’s dilemma in a way unintelligible to American founders?  We suggest that the answers to these questions are as much ethnographic as statistical.

Thesis 4: Execution-oriented Israeli Team Structures Are Good for Prototyping But Bad for Scaling

Perhaps no issue has more existential significance to a startup than that of its team structure. However, Israeli and American founders take very different approaches to building teams. From an early stage, American startups will seek to build a team that mimics the functions of a more mature company, with a broad division of labor among technical, executive, sales, and other silos. Our immersion in the Israeli experience showed us that Israeli founders take a more execution-oriented and product-focused approach to team building and that reliance on technical founders to run all aspects of the business is retained for longer than in American cases. We suggest that this lends itself to faster team formation, quicker prototyping, easier evaluation of team member contribution, and easier team management (including the relatively straightforward dismissal of team members for non-performance). We also suggest, however, that this approach to teams can lead to difficulties in scaling and going to market, as such issues require non-technical but still specialized knowhow. It is thus important to understand whether the Israeli approach to team formation results from founders’ temperaments, a lack of MBA or managerial training, broader cultural conventions, or some other structural factor.

Thesis 5: Tech Development Costs in Israel Are Uncertain but Are Changing Rapidly

Israel is often touted as an ideal off-shoring destination for technical work or for the placement of an offshore development center, boasting excellent technical skill at a lower cost basis and possibly higher skilled than the United States. However, there is relatively little data available about the actual cost basis of Israeli tech production. Our Israeli interlocutors gave contradictory responses as to the cost basis in Israel, with some saying that Israeli development is cheaper than US development across the board, some saying that costs in Israel had caught up to the US and were comparable, and some saying that routine development work remains cheaper in Israel but higher-level development is on par with the US. At the same time, we hear of an increasing number of Israeli startups themselves outsourcing tech work to cheaper locales. While considerable ink has been spilled on Israel’s general macroeconomic competitiveness on a national level, less has been written about startup competitiveness.

Thesis 6: Israeli Startups Disrupt Existing Technologies but Not Existing Business Models

A question resounds when talking about Israeli entrepreneurship: why has Israel, for all its innovation and entrepreneurial character, not produced a Google, an Uber, a Dropbox, or an AirBnB? Why has Israel yet to produce a multi-billion dollar business that becomes a household name? A number of our theses thus far have hinted at an answer. We suggest that Israeli entrepreneurs excel at technological innovation, but lag in business model innovation. Israeli technologies may disrupt existing communication protocols, for instance, but are less likely to disrupt entire business models like logistics, healthcare, or hospitality. We suggest that Israeli innovation tends to entail improving upon an existing business model, rather than upending it. Consequently, a preponderance of Israeli ventures is in the B2B space rather than B2C or C2C models.  

This thesis is supported by strong recent statistics. In 2013, of the 1100 Israeli start-ups formed, failure among B2C startups was roughly double that of B2B startups, while 16% and 9% of B2Cs and B2Bs shut their doors within one year of operations, respectively (source: “Mapped in Israel.” http://blog.mappedinisrael.com). Concomitantly, the customer ratio of B2C versus B2B is 1.6:1 in Israel and 2:1 in the US (source: Start-up Ecosystem Report for 2012, page 19 and Startup Genome. January 2013), thereby increasing the chance of failure.  This pattern is less surprising given insights from our previous theses – purely technical teams are better positioned to improve upon their narrow specializations rather than reimagining entire industries, or, as explored elsewhere in this paper, improving on incumbent technologies facilitates acquisition by said incumbents, as opposed to inherent growth, which may in fact be generally more appealing to Israeli founders.

Thesis 7: Israeli Startups' Geographical Separation from the American Consumer Causes Self-sorting into Oversubscribed Verticals

A surprising number of Israeli startups move to Silicon Valley. There is an increasing personal desire and resonance among Israeli entrepreneurs to measure their success by close proximity to Silicon Valley, and to seek mentorship from their network in the US (from remarks by Oded Hermoni, Rhodium Ventures and Gil-Ben Artzy, UpWest, interviews in Palo Alto). Personal reasons aside, there is however little quantitative understanding of why these startups move from a business sense. We propose that much of this movement is motivated by two factors; firstly, Israel’s small domestic market together with historical ties to America means that America becomes the prime market for Israeli businesses looking to scale. Secondly, however, the geographic and cultural distances between Israel and America pose serious challenges in understanding and responding to American markets. This is a critical point, as it calls into question the traditional narrative in which America and Israel enjoy a unique cultural and structural closeness. To what extent is the movement of Israeli startups to Silicon Valley a function of pursuing proximity to the venture’s opaque end market in America, as opposed to funding or clustering effects? In meetings with Oded Hermoni, Rhodium Ventures and Eyal Shinar, FundBox, both emphasized this as “Israel is a small domestic market which means that start-ups naturally look at the US for global growth” and “the US is the largest finance market in the world so if you are serious you need to raise money here [US]”, respectively (from various interviews in Palo Alto and San Francisco).  

Moreover, we believe there to be a focus among Israeli startups on what we consider oversubscribed sectors and applications. While technology and communication sectors contribute over 22% of the companies listed in the Tel-Aviv stock exchange, VC funds predominately invest in technology and communication related companies with over 73% of the investment going into life sciences (21%) and clean technology (6%). This is a remarkable contrast to earlier Israeli innovations in agriculture, water management, and civil engineering, most of which today is the purview of large, incumbent companies as opposed to startups. We hypothesize that this self-sorting into a relatively limited number of fields – particularly enterprise-facing applications – reflects a broader ignorance of the American consumer market that we highlighted above, as well as the aforementioned tendency of Israeli startups to focus on narrow technical specializations. There are large gaps, however, in our understanding of the sector-wise distribution of Israeli startups and the impetus for entry into those sectors. We argue that this information is critical to understand the startup landscape’s longer-term trajectory. We surmise that Israeli startups (particularly those with a Silicon Valley connection) will shift focus to more under-indexed and more “high touch” sectors such as Internet of Things, healthcare, SaaS, and consumer-facing apps (meeting with Gil Ben-Artsy, UpWest Labs). 

Thesis 8: Israel Has Succeeded in Creating Massive Value through Early M&A Exits

We have found that Israeli startups tend to follow a standard narrative in which early technical innovation and development is done in Israel, but scaling (and real economic return) is achieved by relocation to Silicon Valley or/and acquisition by a US firm. Extending on the failure rate comparison made earlier to take on value creation, it is noteworthy in this thesis to point out that when Israeli startups succeed, they do better than their US counterparts in VC exit valuation. Israeli M&A exit valuations are 2X return on the invested fund versus just 0.7X in the US. Exit duration is comparable, with an average exit taking .9 years more than the five year average for US counterparts.

While much has been written about the Israeli startup miracle, less reflection is devoted to the failure of Israel to retain the value these companies create as they grow in funding to mature enterprises. It is unclear – and yet critically important to understand – what drives this failure. Is it a fundamental challenge of geography, whereby Israel is too small to support large enterprises itself and unable to integrate with surrounding economies, thus precluding it from becoming the Singapore of the Middle East? Is it rather that Israel struggles to provide managerial and marketing talent needed to grow ventures into enterprises? Has the Israeli government overemphasized support of R&D and underemphasized regulatory and market reforms that would support growing businesses rather than creating them? Or does this preference for being US-sheltered lie within the mindset of Israeli founders who see their acquisition as the “perfect choice”. In reviewing one specific acquisition with its founders, we noted in discussions with Cyvera CEO Uri Alter evidence of this notion. He described the acquisition by Palo Alto networks as a “perfect marriage,” and that while Cyvera founders needed to retain some control over operations, they saw the acquisition as having a “big brother that protects us.” (meeting in Palo Alto Networks Headquarters). In our discussions, we found that startups overwhelmingly prefer to be acquired, and that it is exceedingly rare for ventures to turn down a foreign acquirer in order to retain the "Israel-ness" of the company. The answer to this question is of tremendous policy value to Israel, insofar as it wishes to capture more of the value that its citizens create and move abroad.

Thesis 9: Israeli VCs are Not Converging on a United States Model

Considerable attention has been paid to the similarities of American and Israeli VCs, and many argue that the Israeli model increasingly resembles the American VC model. It is interesting to note, however, that the Israeli venture capital industry has suffered persistent losses and is poised to experience a major downsizing. Israel VC investments have declined by 10% in last four years, from a USD 1.9 Billion in FY2010 to USD 1.7 Billion in 2013. When comparing quarterly investments over this period of time, VC investment has been relatively flat in recent years (37 and 38 deals in Q1’14 and Q2’14, respectively), a decrease of 20% when compared to the year before (51 and 43 deals in Q1’13 and Q2’13, respectively).  Interestingly, the total initial investment dropped by 20% in recent quarters from USD 300 Million in Q4’13 to USD 238 Million in Q2’14.

While the VC industry is inherently prone to fluctuations in returns regardless of geography, we surmise that there are persistent structural differences between Israeli and American VCs that account for this flight from Israeli venture funding. We suggest that further research is needed into the qualitative perception of Israeli VCs by Israeli founders. Are Israeli VCs difficult to work with, whether because they demand harsher deal terms, are less likely to participate in follow-up rounds, or are more prone to short-term returns over longer-term growth? We maintain that it is not sufficient to assume that the Israeli and American VC contexts are converging; rather, we believe that fundamental differences between the industries play an important role in emerging venture finance trends.

Closing

We believe that an understanding of the Israeli startup landscape (as well as its likely trajectory) requires a sober and meticulous look at the structural factors that make the Israeli ecosystem enduringly unique, whether for better or worse. While we have tried to quantify some of our hypotheses, and have relied on intensive engagements with subjects deeply embedded within the Israeli startup landscape, each of our theses can be supported or clarified with further additional qualitative and quantitative data. The implications are myriad, and have consequences not only for the future of Israel’s startup culture, but for other countries that ardently seek to replicate Israel’s “startup miracle”.

OHK’s Ahmed Hassan would like to thank colleagues from the Wharton School, namely Vijeta Johri, Bruno Samuel, Richard Tsai and Jian Zheng, and special thanks to insights by Professor Rafi Amit, Founder and Director of the Wharton Global Family Alliance at the Wharton School.

For more information about OHK's work in venture capital and entrepreneurial management, contact us.