Part 3: Lessons 7 to 9 and Closing
This is the final part of a three-part post by OHK’s Ahmed Hassan, providing perspectives and lessons learnt from VC expert exchanges, interviews with industry veterans, and OHK’s own insight from advisory on success in innovation and entrepreneurship.
WeWork, a global co-working startup in its own right, has Israeli-founder roots but has chosen as many of Israel’s ventures to be US-based. There are many lessons for emerging countries especially in the SEMED region on why WeWork and other Israeli ventures have been successful. Photo courtesy ofWeWork.
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).
In 2013, Google acquired the Israeli-founded Waze, one of a handful of its competitors in the mobile mapping space, for a reported US$1.3 billion. Photo shows Angela, an Uber driver in Hong Kong that uses Waze to maneuver the city’s traffic. Photo © OHK Consultants.
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.
Tel Aviv, Israel’s hotbed of startups and VCs is a global emerging tech innovation ecosystem that is defying the region’s perceptions and making a name for itself on the world stage. Photo © OHK Consultants.
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.