Does Israel Have What It Takes to Create the Next Instagram or Facebook?

Entrepreneurs and venture capitalists who once dreamed of easy money in the start-up nation are now contending with an industry where funding models are being upended and Cinderella stories are increasingly hard to come by.

What was the most significant event in the digital world in 2012? Facebook's purchase of Instagram, by a knock-out.

When the social media behemoth snapped up Instagram for about $1 billion, it sent shockwaves through both the local and global technology industries.

Instagram is a photo-sharing service that allows users to apply a variety of artsy filters to their snaps. It was started by two kids with only $60,000. Within 18 months, they were rich beyond their fondest fantasies, maybe.

Before the Instagram deal, plenty of cash was of course being invested in mobile apps and software. But this particular transaction, and the sheer size of the sum, showcase the trends in tech investment.

The Instagram deal has two major elements: time (not much) and money (much).

It took a mere 18 months from the first line of code to be written to the device being downloaded on 30 million smartphones. This is how the Instagram proved the scale of demand – in traditional high-tech stories it takes much longer, and much more money, to become so widespread.

But these days, Internet products and services are put to the test, and vetted, in the blink of an eye. It takes only a few weeks to know if you've created a killer app, or produced a dud.

The cost component is also crucial. In the world of open-source code, open-source operating systems and cloud computing, it is cheaper than ever to turn a good idea into a good product. The distance between the young, creative entrepreneur and the broad market has never been shorter.

From the funders’ point of view, this kind of environment is a paradise – not only because it's so easy to see whether the product is successful, but also because one can avoid endless fundraising rounds and massive, million-dollar investments to prove its feasibility. The combo also reduces risk.

Meanwhile, new funding models have risen. Once, entrepreneurs would need to scrabble for seed money, then knock on the doors of venture-capital firms. Now they have a range of choices: angels and super-angels, incentive programs and incubators, even crowdsourcing.

The old venture-capital firms must now compete for the entrepreneurs, a trend that is aggravating the crisis that has already been nagging at venture-capital firms for a few years.

The exception that doesn't prove the rule

While the local startup scene is riding at a height not seen since the days of the dot-com bubble, the local venture-capital industry is at a low ebb.

From 2009 to 2012, Israeli funds raised only about $1.8 billion, compared with $4.6 billion in the four years before that period. In 2012, they scraped up only $607 million – a 30-percent decline from 2011. Israeli funds’ portion of the total investment in local startups decreased from 49 percent in 2005 to 24 percent in 2012. According to estimates by Zeev Holtzman, chairman and founder of Giza Venture Capital, that number is expected to go even lower, and dip to less than 20 percent in 2013.

“What’s happening these days is absurd. There’s a feeling of abundance, but the situation is actually hopeless,” Holtzman says. “Ninety percent of all the small Internet companies that are now drawing all the interest are going to shut down within two years. It’s a passing fad. While it’s very easy to found a startup and raise seed money, you really need quite a large fortune to actually succeed and reach tens of millions of users all over the world. In the American market, about 470 companies are considering IPOs or selling the company at more than $100 million. On average, each of those companies raised $90 million so far. What does that mean? It means that to reach such high valuations, you have to invest time and money. Instagram’s story is an exception that doesn’t prove the rule.”

Waze wasn't built in a day

Aharon Mankovsky, managing general partner of the Pitango venture-capital fund, says, “The number of Instagrams that succeed is close to zero. There’s an illusion in the market that you need less money to succeed in the Internet field. It’s true that on the Internet, you can see at the earliest stages whether your idea is a good one or not, but you still need tens of millions of dollars to build a company. Take Waze, for example. It’s an excellent mobile application, but so far they’ve already raised about $70 million, and I estimate that they’ll need to raise at least another $30 million until they reach maturity or a situation where they can be sold.”

It’s important to mention that Holtzman and Mankovsky belong to venture-capital funds, which are the main casualties of the Instagram phenomenon. But other folks in the industry also draw a parallel between the drying up of venture-capital funds and the prevailing trends in the world of technology.

“The whole venture-capital industry is undergoing substantial change, not just in Israel,” says one high-ranking industry figure. “In the past, Israeli technology firms concentrated on selling products intended for large companies – in other words, the customers were not end-users. But when the industry started turning toward the consumer, marketing became a very important element in every young company’s survival.

“To market a mobile application successfully, for example, you have to understand the target market better. In that field, we’re at a disadvantage. Entrepreneurs prefer to contact the global funds, which can put them directly in touch with people who live and breathe the consumer market. The good startups contact funds abroad very early on to get close to the target market and also to raise money from the leading global funds. The institutional investors’ money keeps flowing in, but mainly to the large companies, such as big-name global funds like Sequoia, Axle Ventures and Kleiner Perkins. The niche funds – that is, dedicated funds like the Israeli funds – have a tough time raising money. There’s a wide gap between what a global fund can offer an entrepreneur and what a local niche fund can offer.”

But hope springs eternal

For years, the processor field has been on the downswing. It hit its low point in 2012, when Freescale Semiconductor’s development center closed down and Texas Instruments’ development center downsized substantially. This was also the year when Micron Semiconductor announced it would be closing its manufacturing plant in Israel.

Whether it's development or manufacturing, plant closures stem from the same cause.

“The biggest change to happen in recent years was the transition from PC to laptop computing,” says Shlomo Markel, VP of Broadcom Corporation. “The sophistication is going over to end devices, which are controlled by a few giant corporations. Companies like TI, which linked their future to Nokia’s, suffered. On the other hand, processor companies such as Qualcomm and Broadcom, whose processors are used in Apple and Samsung products, have thrived.

Today, the development and manufacture of a complex, 22-nanometer advanced-geometry processor requires an investment of tens of millions of dollars and a lot of time. Venture-capital funds and also the entrepreneurs themselves are unwilling to take a risk. It’s easier and nicer to build applications.”

Despite this assessment, Merkel feels confident that the vast wealth of knowledge accumulated in Israel won't be going to waste. "It's not that the demand for local processor engineers has dipped," he says. "What's changed are the companies that employ the engineers."

Some of the engineers let loose by Texas Instruments, he says, were recruited by Apple. And others, laid off from Freescale, were hired by Advanced Micro Devices. The demand for processors, he says, isn't going anywhere, and the future will hold plenty of opportunities for them.

“The Internet of physical things – in other words, connecting products such as cars and items for home use to the Internet – will be the big engine of demand for the new processors,” he says.

The next Facebook won't be from Israel

For quite a few years, the foreign development centers have been playing an increasingly important role in Israel’s high-tech industry. In 2012, this trend got a boost when Apple began hiring workers for its new development center in Haifa, which was at the time still being built. The shift of Israeli talent from local companies to multi-national firms reflects a large-scale trend in which the world of technology is draining into a small number of large corporations.

Markel believes the trend is a positive one. “We think Israel is attractive for the multi-nationals,” he says. “We have high-quality human resources here, and our developers’ daring and creativity make Israel unique among other places in the world. I understand there’s some risk that a multi-national might close its doors in Israel and move to a cheaper place, but most companies that operate here are very positive about it.”

In the end, the critical question for Israel’s high-tech industry in early 2013 is whether it expects to grow and expand the circle of the employees who enjoy its fruits. While the long-term trends that affect it create opportunities, for now they have not led to a significant increase in the number of workers in high-tech.

“The number of employees in high-tech is not growing, and maybe it’s even declining,” says Mankovsky. “While the number of companies may have increased because things are picking up in the Internet field, these entrepreneurs have relatively small influence on their environment. Internet companies do not need many suppliers or manufacturing workers. Over the past year, they’ve begun to understand here that the next Facebook will not be coming from Israel.”

He adds, “Our advantage is in technology, not in marketing. Even successful Internet companies such as Conduit and Outbrain are based on strong technology, not just on a marketing idea.”
 

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Tomer Applebaum