It’s time to secure the foundations of Israel’s high-tech pyramid

As the peak of our high-tech pyramid expands, its base is crumbling. The total number of early-stage startups has slumped. Without fresh startups today, there will be not be enough late-stage companies in 10 years’ time.

More than 3,000 years ago, our ancestors were enslaved to build the Pharoahs’ pyramids. Today, the Children of Israel are free, but we must urgently rebuild the high-tech pyramid we have created.

Like those ancient monoliths, Israel’s high-tech ecosystem is becoming one of the wonders of the world. And the new heights scaled by Israel’s startup nation are only made possible by the wide, stable foundation of startups on which its ecosystem can stand and scale. Early-stage companies provide the testing-ground for new technologies and entrepreneurs. Startups allow first-time founders to take risks, try ideas, fail, learn and try again. They also provide the seed-stage companies from which tomorrow’s champions can grow.

From the summit, it is easy to be dazzled by the achievements of Israel’s venture capital colossus. With a record $10.5 billion of investment in 2020 and on track to double to a staggering $20 billion this year, the tech ecosystem is the pride of Israel, the engine of its fast-growing high-tech economy and the envy of the world.

But even as the peak of our high-tech pyramid expands, its base is crumbling. The surging growth is driven by late-stage startups. That is wonderful, but the total number of early-stage startups has slumped.

“The number of new startups founded each year is sharply declining, the number of seed-level investment rounds is diminishing, and governmental research and development budgets are being cut on an annual basis – dramatically, relative to other countries,” says Ami Applebaum , Chairman of the Israel Innovation Authority (IIA).

A decade or two ago, the companies driving today’s wave of investment were early-stage startups. Without fresh startups today, there will be not be enough late-stage companies in 10 years’ time.

The latest annual report from the IIA makes somber reading. While celebrating the huge successes of Israel’s tech ecosystem, there are worrying signs that its foundations are in need of urgent attention.

“In just five years, the number of new start-ups established on an annual basis in Israel has plummeted, from 1,400 startups established in 2014, to 850 new startups in 2019 and an estimated 520 new startups in 2020. This figure represents a sharp drop of almost 70 percent in the number of new startups established each year compared to 2014,” the IIA reports.

“The number of new startups that are currently being established has a direct impact on the future of Israeli high-tech in the future,” the report warns, asking whether enough young companies are being created “to preserve Israel as a startup nation.”

The report also found that the number of investors participating in seed investments – aimed at fledgling startups – has also declined in the last two years.

The record venture sums raised in the past 18 months have been fueled mainly by large investments into late-stage startups. In the past five years, the number of investments of $100 million and more has grown almost seven-fold from three such investments in 2015, to 20 in 2020. Meanwhile, 30 investments exceeding $100 million were finalized just in the first half of 2021.

The IIA wonders whether this is “the end of the Israeli ‘Startup Nation’ era.” The concern is fully justified.

In response, the authority has launched a $25 million Hybrid Seed program . It aims to increase the number of potential investors involved in the seed stages, to increasingly focus the authority’s resources on early-stage funding of accelerator companies, and to encourage quality investors to participate in earlier stages via the Angels Law.

Here in Israel, complaining about the government is a national sport. There is plenty to complain about – not least the four elections we’ve had in the last two years.

But occasionally we need to stop and tell the government when it does something right. The Israeli government’s assistance to key areas of the tech ecosystem has been a triumph – and one that should continue. From the early days of the Israel Innovation Authority (then called the Office of the Chief Scientist) Israel’s tech ecosystem has been a finely-harmonized duet between the public purse and private enterprise.

More than 1,000 projects have been carried out under the Israel-U.S. Binational Industrial Research and Development (BIRD). The BIRD Foundation’s mission is to stimulate, promote and support industrial R&D of mutual benefit to the U.S. and Israel. It supports about 20 projects each year and cumulative sales of products developed through BIRD exceed $8 billion.

Under the Approved Enterprise program, corporations can receive grants for fixed assets and low tax rates for establishing eligible businesses in specific areas. One of the participants in this program is Intel, which over the years has invested more than $35 billion in Israel.

Starting with a Research Fund in 1984 that provided matching grants of 20-50% for civilian R&D projects, the Office of the Chief Scientist helped seed Israel’s tech ecosystem. From 1990, it established a network of high-tech incubators with grants of up to 85 percent for each company participating.

The Yozma program provided bait money to convince people to come and set up venture funds in Israel and was the catalyst for the creation of Israel’s venture capital community. The program offered a subsidy of up to $8 million if you brought $16 million of private investment and then you returned the subsidy. Between 1993 and 1998, the Israeli government invested $100 million in the scheme, whose value had increased to $250 million by 1996. The investment was repaid in full and seeded the establishment of 40 venture capital funds that within a few years had transformed this public-private initiative into a fully-privatized industry that is now set to bring $20 billion of investment to the country.

That’s a heck of a return on those $8 million notes from 20 to 30 years ago that were paid back in full almost immediately.

The IIA continues to step in to encourage specific sectors. In 2011, a tender was launched to create a bio-med fund backed by $40 million and financial guarantees from the Israeli government. OrbiMed won and created its first Israel-focused medtech fund with $222 million in capital commitments. In 2016, OrbiMed closed a second Israeli fund with $307 million and no government assistance.

In 2020, the IIA successfully prodded Israel’s banks, insurance companies, pension funds and other institutional investors to start backing Israeli venture funds by creating a safety net with 40 percent downside protection. The program has been wildly successful.

The question is not how to celebrate these impressive achievements, but to ask what the government is doing now and what should it be doing in the future to build on its past wins and make sure this story continues adding new chapters of success.

Israel must do three things to guarantee the startup nation continues to flourish.

1. Return to good governance

Israel’s government has been effectively frozen for more than two years. The country needs to pass a budget, appoint officials to thousands of vacant positions, restructure its education and health systems, modernize its transportation infrastructure, expand its airports and overhaul its housing policy to accommodate a population that has doubled since 1988 and is growing three times faster than the OECD average.

2. Encourage early-stage investment

Israel needs to refocus attention on investing in companies at seed and early stages. The Israeli government historically has stepped in at different moments to help the ecosystem. We need more incentives for early-stage investments.

In January, the IIA once again led the way by establishing a $25 million Hybrid Seed incentive program to encourage investments in seed-stage startups, with grants to startups joining veteran seed-stage investors interested in those companies. The authority also introduced significant changes to its technological incubators incentive program with grants of more than $1.5 million per project to encourage startups in complex high-tech fields such as the life sciences, bio-convergence, agriculture, food, industry 4.0, sustainability, artificial intelligence and quantum computing. This initiative is crucial and should be expanded.

If Israel’s ecosystem is to continue to grow, we need to encourage more investment in the early-stage companies that will become the unicorns of tomorrow. The government must go further. It should expand and simplify the potentially effective Angels Law that encourages angel investors by providing downside protection for bets on early-stage companies, and consider other regulatory incentives.

I am optimistic because Israel’s new Prime Minister is Naftali Bennett, a former tech entrepreneur who understands the situation better than most. (Full disclosure: I was the seed investor in Bennett’s first company more than 20 years ago).

3. Increase support for the Israel Innovation Authority

Israel’s tech ecosystem has grown nearly tenfold in a decade and is set to double again this year. However, the budget for the Israel Innovation Authority, the government unit charged with guiding and fostering this economic powerhouse has remained flat. The IIA has been struggling to maintain its headcount and funding. Adjusted for inflation, the IIA budget has actually been eroded. That’s just dumb. How does Israel expect to maintain its competitive advantage if it hobbles the department most responsible for its runaway success? The IIA has repeatedly demonstrated its effectiveness and expertise in kick-starting Israel’s tech economy and deserves a big piece of the credit for the country’s global leadership. The IIA returns more bang for its buck than any other part of the Israeli government. Its funding should be immediately and dramatically increased.

The Pharoahs’ pyramids have endured for centuries. Let’s make sure our high-tech pyramid is built to last.