Observations and Learnings from Israel's Start-up Ecosystem

History

  • The seeds of Israel as a Start-Up Nation were planted in the 1980s with the passing of an innovation authority law.  All resources concerning innovation were to be overseen by a single, non-political authority known as the Office of the Chief Scientist.

  • The law’s text was very forward-looking and mentioned key endogenous growth theory aspects more than 10 years before Paul Romer’s seminal work.

  • Israel provided equity capital to entrepreneurs seeking funding to help catalyze new business formation in the high-tech sector.

  • Overall, Israel’s tech sector grew from low single digits and today accounts for 16% of GDP and employs about 5% of the population.  Israel’s R&D spending as a fraction of GDP is the highest of any country. The start-up nation policies of providing equity capital to start-ups, minimizing frictions, and encouraging entrepreneurship are all fascinating but unlikely to be replicable to other countries for at least 3 reasons:

    • In the early 1990s, after the fall of the Soviet Union, more than 1 million Jews left the USSR and made Aliyah to Israel.  Many of these Russian Jews were highly educated and so were able to move to Israel, bringing world-class technical knowledge, and were poor enough where there was nothing to lose by taking startup risk.  Many of these immigrants were key to founding the first generation of Israeli start-ups between 1990 and 2000.

    • Israel’s government was transitioning from a planned socialist economy to a market socialist economy in the mid-1980s, this was a hard transition, but the country was in such disarray that people were willing to be experimental and try anything to right the ship. There were a large number of engineers in the Israeli SOE sector that were working in inefficient aerospace and defense industries.  Due to the economic liberalization efforts, these engineers were freed to form their own companies.

    • The Office of the Chief Scientist, while wielding a huge amount of power, has been largely insulated from politics. The Chief Scientist tries hard not to pick winners and has invested in many unsuccessful and successful startups.  The expectation is that there will be many failures, and in most countries’ political theater, failure, especially numerous failures, is very hard to tolerate.

The role of the military

  • The Israeli Army (IDF), which conscripts all men and women upon turning 18 for 3-7 years, places its smartest recruits into an intelligence unit known as 8200.  In this unit, soldiers are taught computer engineering and given project-based assignments requiring engineering acumen, resource management, and a sense of entrepreneurship.  The training expenditure on the soldiers’ behalf could range from $500k to $1m, a huge investment given they will only be working in the IDF for a few years.   I spoke with several veterans of Unit 8200 to learn more about their experiences.  Examples of IDF projects might include “using no more than $3 million worth of resources, figure out a way to hack into the enemy’s communication system over the next three months.”

  • The IDF has a culture of practicing post-mortems whenever mistakes are made.  Soldiers must explain to their commander and comrades what happened, how the mistake occurred, and what they plan to do to learn from the experience.  Soldiers are not punished for mistakes, rather, they are process driven to learn from them. 

  • Upon graduation from 8200, these engineers are heavily recruited by existing startups (40% of Israeli startups came out of 8200), found their startups with financing from VCs (many of whom also came out of 8200), or join one of the 400+ MNC research and development offices based in Haifa (proximate to Technion, Israel’s MIT).  Some 8200 veterans do attend university after their military service, but by and large, their training is considered so strong that additional formal education isn’t necessary.   

Current situation

  • Prior to 2016, there were fewer than 100 R&D centers in the country, and the only way to make a lot of money was to launch your own start-up and hope your firm is one of the 10% to 20% that generates a successful exit.  However, now that R&D centers have proliferated from 100 to 400, the war for talent has gotten out of hand.  Engineers can expect to earn >$300k with just a few years of experience from an R&D center. 

  • As MNC R&D centers have grown in the count, the number of start-ups has declined meaningfully from around 1200 in 2016 to about 300 in 2022.  The decline in start-up formation does trouble the government to an extent and the Office of the Chief Scientist is closely studying the issue.

  • After years of cyber warfare and recruitment from units like 8200, some of the largest internet security companies have matured. Mobileye is the most prominent example, resulting in a $10+ billion takeout.  Other examples like Waze and Fiverr have been successful outside of security.

  • One of the disappointing aspects of the high-tech sector in Israel is that its success has not had meaningful spillover effects on other sectors of the economy.   Israel’s non-tech sectors are still meaningfully less productive than OECD averages. Increasing traditional sectors’ productivity through tech enablement remains an elusive goal.

Venture Capital Ecosystem and Migration

  • Israel has a vibrant Angel, Pre-seed, and Seed stage VC market.  There is much less domestic VC capital focused on the later-stage rounds.  This results in Israeli entrepreneurs moving to the US to pursue later-stage capital and scale their businesses in the US. 

  • While moving to the US has long been viewed as positive for the ecosystem as a whole, particularly its valuations, some in Israel are concerned.

  • One of the reasons that tech tends to employ relatively few people concerning its GDP contribution is that when Israeli firms are successful, corporate headquarters are moved to the US.  Following the HQ relocation, Israeli firms tend to fire their local sales, marketing, human resources, and finance, functions and move these jobs to the US.  This means that the biggest beneficiary of Israeli start-ups from a jobs perspective tends to be the US.  The government is now considering further incentives to encourage companies to stay in Israel, but it is likely to be challenging until the Israeli VC market matures enough to provide ample late-stage liquidity.

Areas of opportunity

  • Unlike Jews, Israeli Arabs are not drafted into the IDF.  Instead, they have the option of attending university when they turn 18.  Interestingly, over the last 20 years, Arabs have made great academic strides.  Today, roughly 30% of Technion’s student body are Israeli Arabs.  2/3 of this 30% are women. 

  • Arabs historically have been very underrepresented in the start-up ecosystem.  Arabs founded fewer than 1% of Israeli start-ups. 

  • Some in Israel are trying to change this, Takwin Capital has been operating in Haifa, Nazareth, and is intentionally trying to fund Arab-led startups.  Early results seem very promising.