Israel's Start-up Nation Is Long on Spirit, Short on Cash

Entrepreneurs abound, but where will they will get the money to finance their ambitions?

David Rosenberg
David Rosenberg
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David Rosenberg
David Rosenberg

Make no mistake about it, the spirit of start-up nation is alive and well. The latest figures from the IVC Research Center make that quite clear: Some 575 new companies raised investment capital last year, up from 546 in 2011 and easily the highest number in at least a decade.

The hothouse environment for start-ups that Israel erected in the 1990s has risen a degree or two in temperature over the last couple of years, enabling more potential entrepreneurs than ever to form businesses.

Incubators and accelerators, like the ones operated by such a motley crew of parents like Google and the Tel Aviv municipality, make it incredibly easy to take an unformed idea and turn it into the first stage of a business.

Cheap off-the-shelf software and the low barriers to entry to develop a mobile app are encouraging the phenomenon. If you live between Rehovot and the southern reaches of Haifa, you might think that almost everyone is starting up a company.

Of course, the vast majority of the country is doing nothing of the kind. Indeed, Israel's rate of entrepreneurship is low compared to most other Western countries, unemployment is rising and the middle class is shrinking. But if you have the right skill set and the right connections, the sky's the limit.

But the IVC figures last year, which were released this week, have bad news for start-up nation in them as well, which augur ill for the future of Israeli technology.

More entrepreneurs, less money

The amount of capital raised by all these new enterprises from all types of investors actually fell 10% from 2011 to just $1.92 billion. As for companies that raised at least some of their money from venture capital funds, the decline was an even sharper 22% to $1.37 billion. And finally, Israel-based venture funds have less and less money to hand out: Capital raised was down 19% in 2012.

Israeli VCs long ago ceased to be the biggest source of high-tech finance in their home market and their market share has fallen further in the past two years, from more than a third of the total at the start of 2011 to 26%-28% in 2012.

In short, increasing numbers of entrepreneurs are chasing after increasingly smaller amounts of capital and Israeli investors seem less interested in putting money into local start-ups than venture capital funds in America. These trends do not bode well for Israeli tech or for the economy generally.

An Israeli start-up raised on average $3.3 million last year, down from $3.92 million in 2011. Part of that has to do with growing interest in the earliest-stage companies, which need relatively little capital. It's the more mature companies that need to raise tens of millions of dollars. Last year, tech investors put $146 million into 157 of these so-called seed-stage companies, the most in five years, according to IVC.

That would be good news - after all, if Israel can't build big tech businesses for the long term, at least it should keep the parade of start-ups marching - except that Israeli tech investors have been shunning early-stage companies for years and the outlook looks to be more of the same.

Price Waterhouse Coopers' MoneyTree survey, which also measures VC investing, estimates that about 2.8% of all U.S. VC money went into seed companies in the first nine months of 2012 (the latest for which their figures are available). In Israel, the figure was more than double that, but only because of heavy seed investing in the first quarter; most of the year it was at about 2%. And when Deloitte Touche asked Israeli VC fund managers in December where they thought they would be allocating their capital, most showed no interest in the youngest companies and the risks they entail.

In all likelihood, the decline in the size of investments simply is another sign of the decline of Israeli VC. The sphere is being increasingly left to angel investors (individuals who use their private capital to finance start-ups) and micro funds (small venture capital funds), both of which simply invest less money in their companies than venture funds because that's all they have and because they are looking for a small, quick exit. In other words, the downsizing of the Israeli technology sector to a collection of ever smaller and short-lived businesses primed for sale to a foreign company is proceeding apace.

That may explain why the domestic venture capital investing industry looks like it's in terminal decline. Some funds are growing and thriving, but they are hardly enough to amount to an industry. Israeli VCs invested $516 million last year in tech companies, not much more than they did 10 years ago when the industry was in the midst of a deep post-bubble slump. Israeli funds are not raising serious new capital for themselves either. In 2009, they took in a mere $260 million of new capital and in 2010 not a cent. In 2011, they raised $800 million, a fraction of what they were able to raise in years past.

The VC industry has become dominated by foreign funds investing in Israeli companies. Ordinarily that would be a testament to Israeli technology prowess, but the figures seem to suggest that foreign VCs are also not quite the champions of Israeli high-tech that they once were. They pumped 23% less into Israeli tech companies last year than in 2011, according to the IVC.

If there are so many entrepreneurs and so many good companies out there, why are foreign funds not taking the bait? One reason is that they have different standards than local investors, be they angels, smaller Israeli VCs or micro-funds.
No one managing a whopping billion-dollar-plus fund will devote much capital or management time to a start-up that will end up getting sold for $50 million. And Israel's start-up industry doesn't supply many of the kinds of companies that will grow and develop and reach the stage where they are ready to conduct an initial public offering.

The VC alternatives are a growing part of the tech finance industry, but they are still a small part of it. The big money is still coming from venture capital, but VC investing is falling faster than the alternatives that are increasingly supplementing it. Entrepreneurs there are, but where will they get the money to finance their ambitions?

Israeli shekels are worth more in euro or dollar terms than for many years.Credit: Reuters
Israeli start-up Fiverr offers a variety of services - from digital design to custom birthday cards - starting at only $5.Credit: Bloomberg

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