The Truth About Startup Nation: Pretty but Precarious

It's a lot better living in Startup Nation than in Rest of Nation, even though its figures are misleading, but beware. There's a whiff of bubble in the air.

Tal Shani

Israel may be facing increasing isolation, yet all the world seems to want to buy or invest in an Israel tech company – Microsoft, Dropbox, the Russians, the Chinese, even the "anti-Semitic, Islamophile" Europeans. The average Israeli struggles to get through the month while startups are being showered with hundreds of millions of dollars. Along the northern border, Israel and Hezbollah may trade fire, but in the office towers of Tel Aviv, the world is a peaceful place waiting for the next Israeli advance in cloud computing or cyber security.

The state of chronic war in Israel has clearly done nothing to deter entrepreneurs from starting up companies, investors putting money into them and giant multinationals from buying them.

The disconnect between Israel’s high-tech sector and Israel itself is nothing new. While Israel’s domestic industry features monopolies and hidebound industry, the technology sector is dynamic, highly competitive and global. Whereas in Israel, schools are notoriously bad, in Startup Nation everyone is brilliant and creative.

This past week – indeed the past year –the gap between Startup Nation and the Rest of Nation widened even further.

The year 2014 was a banner one for Israeli tech by almost every yardstick. Startups raised $3.4 billion in investments in 2014, the most ever, including the bubble years of 1999 and 2000. Venture capital funds, which provide most of the investments for startups, drew in $910 million, the most since 2008, and are projected to raise even more this year, perhaps $1.2 billion. Exits – money received by companies acquired or conducting initial public offerings – reached $6.9 billion in 2014, making it one of the best years ever.

And less than a month into 2015, already the year is threatening to shame 2014’s performance. In the third week of January alone, Israeli startups did no less than $910 million of deals of various sorts. The biggest deal was Amazon's purchase of Annapurna Labs for a reported $370 million. Annapurna will now become Amazon's Israeli research and development center, meaning that all four superpowers of the technology world (Google, Facebook and Apple being the others) now have an R&D presence in Israel.

Unfortunate comparisons

All this money flowing into and out of Startup Nation, however, stands in stark contrast to the rest of Israel.

For all its beauties, Israel's technology sector has very limited impact of the rest of Israel. Not that the rest of Israel is suffering too greatly. But economic growth is slowing and incomes are stagnant. Apart from high-tech, the economy is hard-pressed to produce industries that are internationally competitive.

Startups employs small numbers of people in a very limited number of disciplines, mainly of course engineers of one sort or another. Here is just one example of how Startup Nation differs from Rest of Nation.

Dropbox, the U.S. cloud computing company, paid $150 million for the Israeli startup CloudOn last week, which works out to $5 million per employee. This week Hadera Paper, an example per excellence of Rest of Nation, sold its half of the paper products company Hogla-Kimberly to its partner Kimberly Clark for about $320 million, which comes out to $320,000 per employee.

Hogla-Kimberly employs about 1,000 people in three factories while CloudOn employs about 30.

If CloudOn has spurned Dropbox’s offer, maybe it would have grown to a much bigger company employing hundreds. But that route is rarely taken by Israeli startups.

Some people have suggested that Startup Nation’s take-the-money-and-run attitude is changing. Correctly, they point out that 2014 saw a surge in IPOs, with 17 companies selling $2.1 billion of shares, nearly six times the amount in 2013. Companies that opt to go public rather than be bought out are signaling a commitment to remaining independent and growing.

Even companies that have opted to be bought out have tended to be bigger and presumably more mature than in the past, as evinced by the amounts they are raising from venture capitalists. Israelis are no longer just developing a product and quickly cashing out: they’re bringing it onto the market and building a business around it before they sell.

But what do these figures really show? Are get-rich-quick attitudes in Israeli tech really changing? No.

First of all, half the 2014 IPO proceeds were due to a single company, the collision-prevention technology company Mobileye, which is truly a company with a stand-alone technology – not just something that can be patched into someone else’s – with strong long-term growth prospects. But that remains a rarity in Startup Nation.

It's the floor that's straight

If startup companies are raising bigger amounts of money than in the past it has less to do with a new attitude and more to do with the global balance of supply and demand. Israeli companies are winning higher valuations – last week alone five startups completed fundraising rounds of $15 million or more, something that used to be a rarity – because the supply of capital chasing startups is growing.

With interest rates at near zero, where’s a mutual fund or hedge fund supposed to invest? One answer is startup companies. Big corporate investors are looking for action, too, as are Chinese and Russian investors. Breathe in and you begin to detect that acrid smell of irrational exuberance.

Optimists like to say that these giant fundraising rounds and the heady valuations they involve are all about a giant upheaval in the economy. For instance, the ride-sharing service Uber, which has raised an incredible $40 billion, is going to change the way the world gets from place to place. That’s got to be worth billions, no?

Maybe, but no one knows whether Uber will be the next Facebook or the next Pets.com, which was supposed to revolutionize how the world buys dog food but crashed when the dot.com bubble bust in 2000. For investors, and entrepreneurs, the long-forgotten Pets.com is a better case study than Facebook.

In short, what we are witnessing today isn’t the merging of Startup Nation into Rest of Nation by the creation of big companies that acts as big employers and contribute the the wider economy. Rather, we’re seeing a merging of Startup Nation Bubble World.