Start-up Nation

by Dan Senor, Saul Singer

  Frohman had spent enough time abroad to be familiar with the rap against investing in Israel. Almost every day a bad headline about Israel ricocheted around the world: another terrorist attack . . . another provocation on its border . . . more bloodshed. Intifada. Violence, terror, war. It was the only narrative people knew.

  He believed that both Israel and its economy needed a counternarrative. As the January 15 deadline approached, he became fixated on an imaginary boardroom debate—taking place somewhere in the United States—between an executive who was enthusiastic about investing in Israel and a cautious board that thought he was reckless. What would the enthusiast need in his back pocket? I understand your skepticism. I saw the news, too. But let’s not forget that Intel was producing the 386 chip—one of Intel’s most important microchips—in Israel during the Gulf War, and the Israelis never missed a beat. They stayed on schedule. They were not late . . . not even once . . . not even when missiles were falling on them.

  On January 17, Frohman informed his employees of his unilateral decision to keep Intel Israel open during the war, in defiance of government orders, but on a voluntary basis: no worker would be punished for not showing up.

  At 2:00 a.m. on January 18, Frohman, like most Israelis, was awoken by air-raid sirens. He and his family quickly put on their gas masks and sealed themselves into their home’s safe room. When the all clear sounded, they learned that eight missiles had struck Tel Aviv and Haifa—near Intel’s main R&D facility—but they had not been armed with chemical warheads. More missiles were expected in the days ahead. Whether Saddam would arm future Scuds with chemical capabilities was still unclear.

  At 3:30 a.m., when Frohman arrived at the plant with his gas mask, he went straight to the clean room—the heart of the chip factory, where, to maintain a dust-free environment, technicians worked in sealed suits that made them look like astronauts. Work there had already resumed. He was told that when the sirens had sounded earlier, the employees had gone to a sealed room in the plant, but after quick calls home, they had returned to their work stations. When the first postattack morning shift began, Frohman expected to see—best-case scenario—half of the shift; 75 percent showed up. Following a second Iraqi missile attack the next night, turnout at Intel’s Haifa design center increased to 80 percent. The more brazen the attacks, the larger the turnout. Welcome to Israel’s “new normal.”

  The executives in Intel’s Santa Clara headquarters could not get their heads around this. During a conference call with Santa Clara two days later, air-raid sirens went off again. The Israeli team members asked for a moment to relocate, put on their gas masks, and continued the call from their sealed room. A group of Intel workers even set up a wartime kindergarten on the premises, since schools were still closed and if employees wanted to be part of Frohman’s defiant mission, they had no choice but to bring their children to work. On top of their regular jobs, the workers volunteered to serve shifts on kindergarten duty.

  The legacy of Frohman’s commitment is still seen in the decisions of new multinational companies to set up critical operations in Israel. And some of these facilities, such as Google’s, were being built around the time of the 2006 Lebanon war.

  The explanation for this concerns more than just engineering talent. It is also a matter of less tangible factors, such as a drive to succeed that is both personal and national. Israelis have a term for this: davka, an untranslatable Hebrew word that means “despite” with a “rub their nose in it” twist. As if to say, “The more they attack us, the more we will succeed.”

  As Eitan Wertheimer told Warren Buffett at the start of the 2006 Lebanon war, “We’re going to determine which side has won this war by ramping up factory production to an all-time high, while the missiles are falling on us.”10 Israelis, by making their economy and their business reputation both a matter of national pride and a measure of national steadfastness, have created for foreign investors a confidence in Israel’s ability to honor, or even surpass, its commitments. Thanks to Dov Frohman, Eitan Wertheimer, and many others, the question of catastrophic risk, for investors and multinationals looking to do business in Israel, is virtually irrelevant.

  CHAPTER 10

  Yozma

  The Match

  John Lennon once said about the early years of rock and roll, “Before Elvis, there was nothing.”

  On the success of venture capital and high-tech entrepreneurship in Israel, to paraphrase Lennon, before Yozma, there was nothing.

  —ORNA BERRY

  ORNA BERRY’S SON, Amit, delivered what would be the $32 million message. Amit had retrieved the voice-mail message for his mom. A vice president from Siemens, the German telecommunications conglomerate, had called. Orna Berry, away on yet another trip abroad to pitch her start-up to bigger companies looking to buy, had missed the call. The message from Siemens marked the beginning of a process that culminated in the first acquisition of an Israeli start-up by a European company. The transaction was finalized in 1995.

  Though today it’s a pretty commonplace event—Europeans have invested hundreds of millions of euros in Israeli companies—in 1995, for an Israeli start-up to be acquired by a European company was unheard-of. Orna Berry believes a new Israeli government program at the time, called Yozma, was what made it possible. She also believes that hundreds of other start-ups have had similar experiences because of the government’s initiative.

  Berry is hailed as one of Israel’s leading business leaders.1 In 1997, she was named Israel’s chief scientist in the Ministry of Industry, Trade, and Labor—Israel’s innovation czar; in 2007, she became chair of the Israel Venture Association. She earned a PhD in computer science from the University of Southern California, worked for the technology consulting company Unisys in the United States, and then returned to Israel to work for IBM and, later, for Intel.

  But in 1992, she was a first-time entrepreneur. She founded Ornet Data Communications with five colleagues from Fibronics, one of Israel’s early tech companies. Ornet Data developed software and equipment for local area networks (LANs), to double the speed of data transmission.

  While most users were dialing into the World Wide Web through telephone lines, the Ethernet networking technology was growing as a way to connect LANs—groups of computers that were close together in homes and offices. LANs could move more information, faster, between computers in the network, but bandwidth was still quite limited. Ornet Data’s solution created a switch for these networked computers that, Berry estimated, multiplied the bandwidth fifty times.

  Ornet Data had just a handful of employees in Karmiel, a city in northern Israel, and an office in Boston that Berry used when she came through town. In the early days of the company, she flew to the United States repeatedly to try to raise money, but she soon realized there was none available.

  “There was no mechanism for early-stage high-risk funding in the absence of local venture capital,” she told us.2

  Venture capital is investment funding that is usually put to work in high-growth technology companies. But for most foreign investors, putting money into Israel seemed absurd. To them, Israel was synonymous with ancient religions, archaeological digs, and deadly conflict. Even those investors who had marveled at Israel’s R&D capabilities were spooked by the surge in violence that came with the Palestinian uprising—or intifada—in the late 1980s. This was before Dov Frohman’s decision to keep Intel open during the 1991 Gulf War.

  According to Jon Medved, founder of Israel Seed Partners, “You could talk to an American fund until you were blue in the face and say, ‘Hey, come invest in Israel,’ and they would laugh at you.”3

  Israel’s dearth of venture capital through the 1980s was also creating other problems. In the West, the role of the venture capitalist is not simply to provide cash. It’s mentoring, plus introductions to a network of other investors, prospective acquirers, and new customers and partners, that makes the venture industry so valuable to a budding start-up. A good VC will help entrep
reneurs build their companies.

  “It was very clear that something was missing in Israel at the time,” said Yigal Erlich, another chief scientist, who was serving in the government in the late 1980s. “While Israel was very good at developing technologies, Israelis didn’t know how to manage companies or market products.”4

  Israeli entrepreneurs had to think globally from the start, creating products for markets thousands of miles and several time zones away. But serious questions loomed: How to customize the product for the market? How to manufacture, market, and ultimately distribute the product to customers so far from the shores of the Mediterranean?

  Before the introduction of venture capital in Israel, there were only two sources of funding. First, Israeli start-ups could apply to the Office of the Chief Scientist (OCS) for matching grants. These grants, however, didn’t provide anywhere near the amount of money start-ups actually needed, and as a result, most failed. A government report published in the late 1980s claimed that 60 percent of the technology companies deemed worthy of OCS grants were unable to raise follow-on capital to market their products. They may have created great products, but they couldn’t sell them.5

  Second, Israeli companies could apply for what are called BIRD grants. Created from $110 million put up by the U.S. and Israeli governments, the Binational Industrial Research and Development (BIRD) Foundation created an endowment to support U.S.-Israeli joint business ventures. BIRD gave modest grants of $500,000 to $1 million, infused over two to three years, and would recoup funds through small royalties earned from successful projects.6

  Ed Mlavsky became the executive director of BIRD when, in 1978, he made an offhand comment at a meeting of the U.S.-Israel Advisory Council on Industrial R&D. BIRD had been established two years earlier, but the foundation had not funded a single project. The council was meeting to choose a successor to run the foundation, and members were disappointed with the flock of candidates. Mlavsky, born in England but by now an American citizen, said, “Gentlemen, this is horrible; even I can do a better job than any of [the candidates].” The committee thought this was a great idea and tried to convince Mlavsky to quit his job as executive vice president of Tyco International and move his family to Israel. Mlavsky’s wife wasn’t Jewish and he didn’t have a strong emotional connection to Israel, but at the urging of Jordan Baruch, the U.S. assistant secretary of commerce for science and technology, Mlavsky went to Israel to, as he says, “interview for a job I did not want in a country in which I had no wish to live.” His wife was supportive; she had visited Israel in 1979 and fallen in love with the pioneering culture of the still young country. So Mlavsky took a sabbatical from Tyco, put their furniture in storage, and went to Israel. He would end up staying in the position for thirteen years, until he cofounded Gemini, one of Israel’s first government-funded venture capital firms. Part of what appealed to Mlavsky was an openness in Israel to experiment with any idea, which he didn’t fully appreciate until he was on the ground and immersed in Israeli life.

  Mlavsky called BIRD a kind of “dating service,” because he and his team played matchmaker between an Israeli company with a technology and an American company that could market and distribute the product in the United States. Not only that, but this matchmaker would subsidize the cost of the date.

  Most of the U.S. tech companies BIRD pursued had limited R&D budgets. Because they were midsized to large publicly traded companies, they were skittish about dipping into the quarterly revenues to pay for costly research.

  Mlavsky recalls, “We came to [U.S. companies] and said, ‘There is this place called Israel, which you may or may not have heard of. We can put you in touch with smart, creative, and well-trained engineers there. You don’t have to pay to hire them, relocate them, and you don’t have to worry about what happens after the project is over. We will not only introduce you to such a group—we’ll give you half the money for your part of the project and half the money the Israelis will need for their part.”

  To date, BIRD has invested over $250 million in 780 projects, which has resulted in $8 billion in direct and indirect sales.7

  The impact of the BIRD program far surpassed mere revenues: it helped teach burgeoning Israeli tech companies how to do business in the United States. The companies worked closely with their American partners. Many rented office space in the United States and sent employees overseas, where they could learn about the market and their customers.

  In the absence of equity financing, BIRD provided a shortcut to American markets. Even when the venture failed, there was tremendous learning about how to create products designed for markets, as opposed to simply developing technologies.

  By 1992, nearly 60 percent of the Israeli companies that went public on the New York Stock Exchange and 75 percent of those listed on the NASDAQ had been supported by BIRD.8 American venture capitalists and investors were beginning to take notice. And yet 74 percent of high-tech exports out of Israel were generated by just 4 percent of high-tech companies.9 The benefits were not being widely dispersed. If new tech companies couldn’t get BIRD or government grants, they had to master the art of “bootstrapping”: using personal resources, connections, or any other means to cobble together funds.

  Jon Medved tried bootstrapping when he went door-to-door to sell his father’s optical transceivers in 1982. At the time, the company consisted of just ten people working out of an actual garage, building optical transmitters and receivers. Medved admitted that he had not taken a single math or physics class in college and knew nothing about the nuances of the business that his father had put together. He also didn’t know Hebrew.

  “I would speak before groups of Israeli engineers who knew nothing about fiber,” Medved recalls, “and give them a lecture about fiber optics. If they ever asked a tough technical question, I’d hide behind their Hebrew—‘I can’t understand you, sorry!’ ”10 Medved did write a business plan for the company, and he developed revenue projections on the first spreadsheet software available on his suitcase-sized computer; but, like Orna Berry, he found fund-raising to be impossible.

  Chief scientist Erlich became fixated on ways to overcome the funding challenges facing entrepreneurs. But there was some opposition: “Don’t waste your time and money on new, small companies. They’re a losing proposition,” detractors told him.11 Instead, government economists called for increased funding and partnerships between Israel and the big multinational companies, which at this point were employing thousands of Israelis.

  There was also another challenge bearing down on Israel at the time: how to deal with the nearly one million Soviet Jewish immigrants beginning to flood the country. The government believed that to absorb these immigrants, the Israeli economy would have to create half a million new jobs. With one out of every three Soviet immigrants a scientist, engineer, or technician, Israel’s high-tech sector seemed to be the best solution. But existing R&D centers alone would never be able to handle that many new employees.

  In 1991, the government created technology incubators—twenty-four of them. These incubators gave most Russian scientists the resources and financing they needed in the early stage of R&D for their innovations. The goal was not only to develop the technology but to determine whether or not that product could be commercialized and sold. The government funded hundreds of companies through payments of up to $300,000. This got many of the new Russian immigrants working at their craft, but those doling out the money had little, if any, experience with start-up ventures. The government financiers were unable to give these entrepreneurs the support and management they needed to turn these R&D successes into commercially viable products.

  “Every year when I tried to review the success of these small companies, it was disappointing,” said Erlich. “While they may have succeeded in R&D, we didn’t see them succeed in growing companies.”12 He became convinced that a private venture capital industry was the only antidote. But he also knew that in order to succeed, an Israeli VC industry would need st
rong ties with foreign financial markets. The international connections were not just about raising funds; aspiring Israeli VCs needed to be mentored in the art of business mentoring. There were thousands of venture capital firms in the United States that were involved in the nuts and bolts of successful tech start-ups in Silicon Valley. They had experience building companies, understood the technology and the funding process, and could guide first-time entrepreneurs. That’s what Erlich wanted to bring to Israel.

  That’s when a band of young bureaucrats at the Ministry of Finance came up with the idea for a program they called Yozma, which in Hebrew means “initiative.”

  As Orna Berry told us, “John Lennon once said about the early years of rock and roll, ‘Before Elvis, there was nothing.’ On the success of venture capital and high-tech entrepreneurship in Israel, to paraphrase Lennon, before Yozma, there was nothing.”13

  The idea was for the government to invest $100 million to create ten new venture capital funds. Each fund had to be represented by three parties: Israeli venture capitalists in training, a foreign venture capital firm, and an Israeli investment company or bank. There was also one Yozma fund of $20 million that would invest directly in technology companies.

  The Yozma program initially offered an almost one-and-a-half-to-one match. If the Israeli partners could raise $12 million to invest in new Israeli technologies, the government would give the fund $8 million. There was a line around the corner. So the government raised the bar. It required VC firms to raise $16 million in order to get the government’s $8 million.

  The real allure for foreign VCs, however, was the potential upside built into this program. The government would retain a 40 percent equity stake in the new fund but would offer the partners the option to cheaply buy out that equity stake—plus annual interest—after five years, if the fund was successful. This meant that while the government shared the risk, it offered investors all of the reward. From an investor’s perspective, it was an unusually good deal.