Start-up Nation

by Dan Senor, Saul Singer

  “This was a rare government program that had a built-in get in and get out,” said Jon Medved. “This was key to its success.” And it was also rare for a government program to actually disappear once it had served its initial purpose, rather than continue indefinitely.

  At the time, most business-savvy Diaspora Jews were not investing in Israel. They viewed philanthropy and business as two distinct activities. While they would make huge donations to not-for-profit organizations that benefited Israel, for the most part they were reluctant to invest in Israel’s high-tech endeavors.

  There were exceptions, of course.

  Stanley Chais, a money manager in California, helped raise money for the first round of Yozma funds by setting up parlor meetings in California with wealthy Jews. He raised millions of dollars for the funds. Erel Margalit, who left the Jerusalem Development Authority to manage one of the first funds, said that most of the first round of funding was raised from people who had a “warm place in their heart for Jerusalem or Israel.” Margalit’s first institutional investor was the French insurance giant GAN, whose chairman was a French Jew Margalit met by chance on a flight to Paris.

  “The government was used as the catalyst,” said Erlich. The first Yozma fund was created in partnership with the Discount Israel Corporation, an investment bank, and Advent Venture Partners, a premier VC firm from Boston. It was led by Ed Mlavsky, the longtime director of the BIRD Foundation, and Yossi Sela.

  Clint Harris, a partner at Advent, said he knew something was different about Israel on his first trip. In the taxicab on the way from the airport to his Tel Aviv hotel, the driver asked him why he was visiting Israel. Harris replied that he was there to get a sense of the venture capital industry. The driver then proceeded to give Harris a briefing on the state of VC in Israel.

  The Advent-sponsored fund would be called Gemini Israel Funds. One of its first investments was in November 1993, when it allocated $1 million to Ornet Data Communications. This investment, as well as the managerial help, was just what Ornet needed to succeed. Recognizing the company management’s lack of business experience, Mlavsky and Sela helped recruit Meir Burstin to serve as chairman of the board for the new company. Burstin was an old hand in the high-tech entrepreneurial world, having founded and led Tekem, one of Israel’s first software companies, and then served as president of Tadiran, one of Israel’s big defense-technology companies. Burstin brought instant credibility and experience to Ornet.

  When the company was teetering on the brink of closing down after wasting the first big financing round, Yossi Sela from Gemini took over as interim CEO of the company and commuted from Ramat Hasharon to Karmiel, a two-hour drive, four days a week. “It took six months of single-minded determination,” Sela recalled, “from both Gemini and the Ornet founding team, to sell the company and keep the management team from splintering—not to mention more hours driving from Ramat Hasharon to Karmiel than I’d like to remember—but we did it.”14

  The other piece that was critical to the company’s success was Gemini’s ability to bring Walden Venture Capital in as an investor. Walden, an established firm in Silicon Valley, had experience in the kind of technology Ornet had developed. Returning over three times its investment in about two years made Ornet Gemini’s first success story.

  The ten Yozma funds created between 1992 and 1997 raised just over $200 million with the help of government funding. Those funds were bought out or privatized within five years, and today they manage nearly $3 billion of capital and support hundreds of new Israeli companies. The results were clear. As Erel Margalit put it, “Venture capital was the match that sparked the fire.”15

  Several of the Yozma funds had high-profile successes early on, with investments in companies such as ESC Medical, which designed and built light-based medical solutions like lasers; Galileo, a high-end semiconductor firm; Commontouch, an enterprise e-mail and messaging provider; and Jacada, which builds online work spaces for customer-service employees at leading companies.

  Along the way, others jumped into the venture capital world—even without the government’s Yozma backing. Jon Medved just missed the Yozma financing. Years after he sold the company he and his father had built, he heard that there was a $5 million Yozma allotment available to invest in very-early-stage companies. Known as seed funds, these investments tend to be considered the riskiest, so Yozma offered a one-to-one match: investors had to bring $2.5 million to the table to get the government’s $2.5 million.

  Medved went to Yigal Erlich with investors ready to write checks and asked for the grant. Unfortunately, it was too late. But it didn’t matter. The Yozma program was generating the buzz in the U.S. venture community to overcome investors’ reticence about doing business in Israel. “Israel had excited investors enough that we were able to bring in the $2.5 million and start Israel Seed Partners in 1994,” even without the government’s matching grant, Medved said. The fund would quickly grow to $6 million, and Israel Seed would go on to raise $40 million in 1999 and $200 million in 2000.

  According to the Israel Venture Association, there are now forty-five Israeli venture capital funds. Ed Mlavsky said that over the period from 1992 to early 2009, there have been as many as 240 VCs in Israel, defined as companies both foreign and domestic investing in Israeli start-ups.

  Soon other governments around the world were taking notice of Yozma’s success. Chief scientist Erlich got calls from foreign governments, including Japan, South Korea, Canada, Ireland, Australia, New Zealand, Singapore, and Russia, all wanting to come to Israel and meet the founders of Yozma.

  In December 2008, Ireland launched a 500 million “innovation fund” designed to attract cofinancing from foreign venture capitalists. “The Irish state—ironically for a country that didn’t have diplomatic relations with Israel for the first 40 years of its existence—has copied the Jewish state,” wrote Irish economist David McWilliams.

  Like Yozma, the Irish innovation fund lures foreign VCs to Ireland through a series of state-backed venture capital funds that partner up with private-sector funds.

  McWilliams said, “The big idea is not to attract only U.S. capital and commercial know-how, but to suck in entrepreneurs from all over Europe. At the moment, Europe has huge reservoirs of scientific talent, but a very poor record at creating start-ups. The question many investors ask is: where is the European Google? It’s a fair question. In the next ten years, what if that European Google was set up here using Irish and European brains and U.S. capital? That is the prize.”16

  Yozma provided the critical missing component that allowed the Israeli tech scene to join in the tech boom of the 1990s. But in 2000, the Israeli tech sector was hit by multiple blows at once: the global tech bubble burst, the Oslo peace process blew up into a wave of terrorism, and the economy went into a recession.

  Yet Israel’s start-ups quickly adapted and rebounded. During this period, Israel doubled its share of the global venture capital pie with respect to Europe, growing from 15 to 31 percent. This growth occurred, however, within a tax and regulatory environment that, while favoring technology start-ups and foreign investors, did not offer the same support to the rest of the economy.

  For example, while a technology start-up could attract financing from numerous sources, anyone trying to launch a more conventional business would have a lot of trouble getting a simple small business loan. Israel’s capital markets were highly concentrated and constrained. And a particular industry that would seem to be a natural for Israel—financial services—was prevented from ever getting off the ground.

  In 2001, Tal Keinan graduated from Harvard Business School. “Many of my friends who were going off to work on Wall Street were Jewish, and it struck me that the Jewish state doesn’t have such an industry. When it came to managing investments, Israel was not even on the map,” Keinan said.

  The reason was government regulations. In venture capital, Keinan discovered, “the way the regulatory and tax regime was set up here, you
could essentially operate as though you weren’t in Israel, which was great, and it created a wonderful industry. The government basically kept its hands off of venture capital.” But, he adds, “you couldn’t do anything outside of venture capital in any meaningful way. You weren’t allowed to take the performance fees on any money you managed, so you could forget that entire industry. It was a nonstarter.”17

  The asset-management business has a simple model: firms receive a flat management fee of about 1 to 2 percent of the money they manage. But the real upside is in performance fees, which are typically 5 to 20 percent of the return on the investment, depending on the firm.

  Until January 2005, it was illegal for Israeli money-management firms to charge performance fees. So not surprisingly, there was no industry to speak of.

  The change came from then finance minister Benjamin “Bibi” Netanyahu.

  With Prime Minister Ariel Sharon’s backing in 2003, Netanyahu cut tax rates, transfer payments, public employee wages, and four thousand government jobs. He also privatized major symbols of the remaining government influence on the economy—such as the national airline, El Al, and the national telecommunications company, Bezeq—and instituted financial-sector reforms.

  “In the sense that he tackled the stifling role of government in our economy, Bibi was not a reformer but a revolutionary. A reform happens when you change the policy of the government; a revolution happens when you change the mind-set of a country. I think that Bibi was able to change the mind-set,” said Ron Dermer, who served as an adviser to four Israeli ministers of finance, including Netanyahu.18

  Netanyahu told us, “I explained to people that the private economy was like a thin man carrying a fat man—the government—on its back. While my reforms sparked massive nationwide strikes by labor unions, my characterization of the economy struck a chord. Anyone who had tried to start a [nontech] business in Israel could relate.”19 Netanyahu’s reforms gained increasing public support as the economy began to pull out of its rut.

  At the same time, a package of banking-sector reforms pushed through by Netanyahu began to take effect. These reforms launched the phaseout of the government’s bonds that had guaranteed about 6 percent annual return. Up until that point, asset managers for Israeli pensions and life insurance funds simply invested in the Israeli guaranteed bonds. The pension and life insurance funds “could meet their commitments to beneficiaries just by buying the earmarked bonds. So that’s exactly what they did—they didn’t invest in anything else,” Keinan told us. “Because of these bonds, there was no incentive for Israeli institutional investors to invest in any private investment fund.”

  But as the government bonds began to mature and could not be renewed, they released some $300 million a month that needed to be invested elsewhere. “So all of a sudden, boom, you’ve got a local pool of capital to spark an investment industry,” noted Keinan, as we sat, looking out at the Mediterranean, in his thirtieth-floor office in Tel Aviv, which is where his new investment fund is headquartered. “As a result, there are very few large international money managers that don’t have some exposure in Israel now, either in equities or the new corporate bond market, which didn’t exist three years ago, or in the shekel.”

  Because of Netanyahu’s financial-sector reforms, it also became legal for investment managers to charge performance fees. Keinan didn’t waste any time; he founded KCPS, Israel’s first full-spectrum financial-asset-management firm, in Tel Aviv and New York. “The moment I read the draft law of Bibi’s reforms, my wheels started turning,” Keinan said. “It was clear that this truly could liberate our non-high-tech economy.”

  Keinan argues that a ton of local talent was untapped. “If you think about what young Israelis learn in some of the army intelligence units, for example . . . often highly sophisticated quantitative analytical skills—algorithms, modeling out macroeconomic trends. If they wanted to go into high tech, there were plenty of start-ups that would gobble them up after their army service. But if they wanted to go into finance, they’d have to leave the country. That’s now changed. Just think about this,” he continued. “There are Israelis working on Fleet Street in London because there was no place for them here. Now, since 2003, there is a place for them in Israel.”

  PART IV

  Country with a Motive

  CHAPTER 11

  Betrayal and Opportunity

  The two real fathers of Israeli hi-tech are the Arab boycott and Charles de Gaulle, because they forced on us the need to go and develop an industry.

  —YOSSI VARDI

  THROUGHOUT THIS BOOK, we’ve pointed to the ways the IDF’s improvisational and antihierarchical culture follows Israelis into their start-ups and has shaped Israel’s economy. This culture, when combined with the technological wizardry Israelis acquire in elite military units and from the state-run defense industry, forms a potent mixture. But there was nothing normal about the birth of Israel’s defense industry. It was unheard-of for a country so small to have its own indigenous military-industrial complex. Its origins are rooted in a dramatic, overnight betrayal by a close ally.

  The best way to understand Israel’s watershed moment is through a shock to Americans that had a similar effect. During the postwar boom years, America’s global status was suddenly punctured when the Soviet Union upstaged the United States by launching the first space satellite—Sputnik 1. That the Soviets could pull ahead in the space race stunned most Americans. But in retrospect, it was a boon for the U.S. economy.

  Innovation economist John Kao says that Sputnik “was a wake-up call, and America answered it. We revised school curricula to emphasize the teaching of science and math. We passed the $900 million National Defense Education Act (about $6 billion in today’s dollars), providing scholarships, student loans, and scientific equipment for schools.”1 NASA and the Apollo program were created, as was a powerful new Pentagon agency dedicated to galvanizing the civilian R&D community.

  A little over a decade later, Neil Armstrong stepped onto the moon. The Apollo program and the Pentagon’s related defense investments spurred a generation of new discoveries that were ultimately commercialized, with a transformative impact on the economy. This concerted research and development campaign gave birth to entirely new business sectors within avionics and telecommunications, as well as the Internet itself, and became a legacy of America’s response to Sputnik.

  Israel had its own Sputnik moment, ten years after America’s. On the eve of the 1967 Six-Day War, Charles de Gaulle taught Israel an invaluable lesson about the price of dependence.

  De Gaulle, a founder of France’s Fifth Republic, had been in and out of senior military and government positions since World War II and served as president from 1959 to 1969. After Israel’s independence, de Gaulle had forged an alliance with the Jewish state and nurtured what Israeli leaders believed to be a deep personal friendship. The alliance included a French supply of critical military equipment and fighter aircraft, and even a secret agreement to cooperate in the development of nuclear weapons.2

  Like many small states, Israel preferred to buy large weapon systems from other countries, rather than devote the tremendous resources needed to produce them. But in May 1950, the United States, Britain, and France jointly issued the Tripartite Declaration to limit arms sales to the Middle East.

  With no ready supply from abroad, Israel had already begun its arms industry with underground bullet and gun factories. One factory was literally hidden underground, beneath a kibbutz laundry; the machines were kept running to mask the banging noise from below. This factory, built with war-surplus tools smuggled from the United States, was producing hundreds of machine guns daily by 1948. Makeshift factories were supplemented by scattershot gunrunning across the globe. David Ben-Gurion had sent emissaries abroad to collect weapons as far back as the 1930s. In 1936, for example, Yehuda Arazi managed to stuff rifles into a steam boiler headed from Poland to the port of Haifa. In 1948, he posed as an ambassador from Nicaragua to ne
gotiate the purchase of five old French mounted guns.

  The Israelis got by on these banana republic schemes until 1955, when the Soviet Union, via Czechoslovakia, ignored the leaky Tripartite Declaration and made a massive $250 million arms sale to Egypt. In response, de Gaulle took the other side. In April 1956, he began to transfer large quantities of modern arms to Israel. The tiny state finally had a reliable and first-rate national arms supplier.

  After Egypt nationalized the Suez Canal in 1956, the relationship only deepened. France relied on the Suez for sea transport from the region to Europe. The IDF helped guarantee French access to the Suez, and France in return showered Israel with more arms. The supply only grew as the French and the Israelis colluded on more and more operations. De Gaulle’s spy agency enlisted Israel’s help in undermining anti-French resistance in Algeria, one of France’s colonial strongholds. In 1960, France promised to supply Israel with two hundred AMX-13 tanks and seventy-two Mystère fighter jets over the next ten years.3

  But on June 2, 1967, three days before Israel was to launch a preemptive attack against Egypt and Syria, de Gaulle cut Israel off cold. “France will not give its approval to—and still less, support—the first nation to use weapons,” he told his cabinet.4

  But there was more to de Gaulle’s decision than trying to defuse a Middle East war. New circumstances called for new French alliances. By 1967, France had withdrawn from Algeria. With his long and bitter North African war behind him, de Gaulle’s priority was now rapprochement with the Arab world. It was no longer in France’s interest to side with Israel. “Gaullist France does not have friends, only interests,” the French weekly Le Nouvel Observateur remarked at the time.5