Bubbles and Exits – Who Will Enjoy the Billions From Israeli High-tech?

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Israel is now home to Paypal's second biggest development center. PayPal also just bought Israeli startup CyActive.Credit: Dreamstime

The Israeli high-tech industry has never been in better shape. The pace of investment is unprecedented, while first rank global technology firms are buying more companies here and increasing their dependence on local engineering talent.

In two days in early January, over $100 million was raised by startups here, while that same week Amazon and Dropbox bought Israeli startups. Only last week, electronic payments leader PayPal announced it had chosen to establish its global center for information security in Israel and bought Be’er Sheva startup CyActive, for a reported $60 million.

The year 2014 was a record one according to almost every parameter, and so far it seems the trend is continuing in 2015.

Cheap money

So, for how long will we continue to see these signs of growth – and are these signs of a bubble? Will the foundations of Israeli high-tech allow the continued founding of firms and their growth over the next few years so we can continue to see big deals? In order to get some answers to these and other questions, we invited three senior high-tech industry executives who invest in and buy such companies. They are in constant contact with Israeli entrepreneurs and their clients overseas, and have all already experienced one crisis in the sector.

It is hard to ignore the “boom” in investments and acquisitions of Israeli startups since the beginning of the year, which have totaled over $1.2 billion. Another noticeable trend is the increased investment activity by Chinese Internet giants such as Alibaba and Baidu.

Yair Snir, the director of M&A and business development for Microsoft Europe, Middle East and Africa, explains that cheap money is behind the timing. Investors do not have a wide range of alternatives, he says.

Izhar Shay, a partner at Canaan Partners, a venture capital fund established last year, says Israel is a mirror image of what is happening in the United States – for good and bad. For a long time, there has been a lot of money on the East Coast that is looking for technology investments. Funds have been investing $10 million to $15 million without blinking an eye, he says. Some of this money has reached Israel, and the Israeli companies currently raising money and being sold were not founded yesterday; many started during the global crisis of 2008-2009. This is not a coincidence, says Shay – it is always good to invest during a crisis.

Veteran investor and entrepreneur Yossi Vardi says there is no doubt the market is very hot. The market has being flying since 2009 and has been recovering aggressively, he says. There are a number of other reasons for the timing, he adds. Over the past two years, large companies and brands have reached the conclusion that they need to join the global “Open Innovation” community. They understood that internal innovation within the company is not enough for its needs.

This change has led even companies not thought of as being technological to make such acquisitions, including consumer products companies. An example is the high-tech accelerator run in Israel by Coca-Cola. “Two years ago, the buyers were the Amazons and Googles,” says Vardi. “Today we see all the consumer products companies, and in health and fashion, trying to gamble and buy as many firms as possible.” This is an enormous change, which will bring lots of resources to the industry. Local startups are very attractive because Israelis sell their firms at the beginning; if they buy after the companies mature, it is more expensive, explains Vardi.

Another factor changing the high-tech industry here is the accumulation of free capital from Chinese and Indian investors. The inflow of funds from places that never invested in Israel before – Chinese and Russian investors, for example – is significant, confirms Shay. The Chinese make strategic investments, and since the money is available, they want to finance the entire food chain, he says. They are buying Israeli insurance companies and Tnuva, and are willing to invest in venture capital funds. Al the new funds from the last two years have Chinese investors, and they also make direct investments in firms, notes Shay.

It is also easier for Chinese and Russian companies to enter the Israeli market than Silicon Valley, explains Snir. The quality here is no less, and this gives Israel an advantage, he adds.

The nursery model

Are exits good for the Israeli economy, or just for those who sell the company? And what chance does a startup have to fulfill its dream of an exit – the local equivalent of the 19th-century gold rushes? These questions have been part of the dialogue for the past two decades, but have returned in this period of major exits.

At the times when companies were sold and their local operations closed after the sale, exits were heavily criticized and turned traumatic. During the periods when they grew into large development centers for multinational corporations, they turned out to be not so bad after all. For example, since 2011, Apple’s development center in Israel has expanded to over 700 employees, compared to the 200 employees Anobit Technologies had when Apple bought it out. From this acquisition of the flash memory designer for a reported $390 million, Israel became one of the leading hardware R&D centers for the world’s most valuable company. What would have been the fate of Anobit if Apple had not bought it out and it remained an independent startup? How many new jobs would have been created? How large would its sales have been, and would it ever have put Israel on the global technology map?

How can we define the success of a startup or an exit? IVC Research, which specializes in high-tech, recently examined that very question. It looked into what happened to more than 10,000 startups established in Israel from 1999 through 2014, and found that only 2.5% were a success. It should be noted that IVC chose a stiff measure of “success”: annual sales in excess of $100 million and at least 100 employees. This means that companies with “only” tens of millions of dollars in sales annually, or those with only dozens of employees – who may have provided economic value for their investors – were not rated a success.

Vardi, one of the founding fathers of local high-tech, describes the Israeli startup scene as adhering to the nursery model. “Large companies come here to buy ideas, not sales,” he observes. “They package the ideas in companies and sell them. That is the reason for the success of the Israeli model.” The parameters for success set by IVC are irrelevant for the model of Israeli companies, says Vardi.

Is there a bubble?

One of the burning questions over the past year, mostly in Silicon Valley, is whether the industry is experiencing a bubble. The answer is not clear-cut. “The beauty of a bubble is that you only identify it after it bursts,” says Snir. “The Americans say if it walks like a duck and quacks like a duck, it’s a duck,” adds Vardi.

“Even if we are not in a bubble that will burst, we are in a period where all the parameters are on the rise,” says Shay. “For the last 20 years, high-tech has proved itself as a cyclical industry. We all are working under the assumption that it will not continue forever – there will be a correction, there will be a crisis. The question is whether there will drops or corrections,” he says.

The current situation reminds many of early 2000, just before the dot-com bubble burst. Companies reached astronomic valuations then, too, and in many cases the valuations did not stem from real revenues or business models, but from models based on the number of users (or eyeballs). This is also exactly the time when many investors entered the sector – and were burned when the bubble burst. Is today any different?

Snir says we must take into account that just because money is cheap, it does not necessarily go to the wrong places. Serial entrepreneurs who have proved themselves can now work their charm on larger scales and at faster paces. “Money is a form of fuel,” says Snir. “When there is more fuel, you travel faster. This money allows faster maturity, too. In fashionable areas, such as cyber, we see faster maturity in a shorter period of time.”

But only 9% of the Israeli public is enjoying the fruits of the high-tech party, says Vardi. This has helped make Israel the Western country with the highest level of economic inequality, he warns. The problem is that over the past two decades, the high-tech sector has kept to its same relative size in the Israeli economy, but not expanded to other sectors of society.