Start-up Nation

by Dan Senor, Saul Singer

  The Hebrew University’s first board of governors included Weizmann, Israel’s first president, as well as Albert Einstein, Sigmund Freud, and Martin Buber. The Technion was founded in 1925. The Weizmann Institute of Science followed in 1934 and, in 1956, Tel Aviv University—the largest university in Israel today. Thus by the late 1950s, Israel’s population was only around the two million mark and the country already had the seeds of four world-class universities. Other major universities, such as Bar-Ilan University, University of Haifa, and Ben-Gurion University of the Negev, were founded in 1955, 1963, and 1969, respectively.

  Today, Israel has eight universities and twenty-seven colleges. Four of them are in the top 150 worldwide universities and seven are in the top 100 Asia Pacific universities. None of them are satellite campuses from abroad. Israeli research institutions were also the first in the world to commercialize academic discoveries.

  In 1959 the Weizmann Institute established Yeda (which means “knowledge” in Hebrew) to market its research. Yeda has since spawned thousands of successful medical technology products and companies. Between 2001 and 2004, the institute amassed one billion shekels (more than $200 million) in royalty revenues. By 2006, Yeda was ranked first in income royalties among world academic institutes.17

  Several years after the creation of Yeda, the Hebrew University founded its own technology transfer company, called Yissum (a word for “implementation” in Hebrew). Yissum earns over $1 billion annually in sales of Hebrew University–based research and has registered 5,500 patents and 1,600 inventions. Two-thirds of its 2007 inventions were in biotechnology, a tenth were in agricultural technology, and another tenth were in computer science and engineering products. The research has been sold to Johnson & Johnson, IBM, Intel, Nestlé, Lucent Technologies, and many other multinational companies. Overall, Yissum was recently ranked twelfth—after ten American universities and one British university— in global biotech patent rankings (Tel Aviv University is ranked twenty-first).

  Israel, a nation of immigrants, has continually been dependent on successive waves of immigration to grow its economy. It is in large part thanks to these immigrants that Israel currently has more engineers and scientists per capita than any other country and produces more scientific papers per capita than any other nation—109 per 10,000 people.18 Jewish newcomers and their non-Jewish family members are readily granted residency, citizenship, and benefits. Israel is universally regarded as highly entrepreneurial and—like the IDF—dismissive of the strictures of hierarchy.

  In the Persian Gulf, however, governments will allow residency visas for only up to three years, nothing longer—even for fellow Muslims and Arabs. There is no path to citizenship in these countries. So globally sought-after researchers have been unwilling to relocate their families in meaningful numbers and invest their careers in an institution whose host country stifles free speech, academic freedom, and government transparency and puts a time limit on residency. While five- or ten-year residency visas have been considered in several gulf Arab countries, no government has ever ultimately allowed for them.

  These residency restrictions are also symptomatic of a larger obstacle to attracting academics: the few research professionals who have shown up quickly became aware of the government’s desire to keep them on the outskirts. The laws emanate from the pressure on governments to be responsive to Arab nationalism broadly, and sovereign nationalism specifically. For example, an Emirati woman who marries an expat must give up her citizenship, and their children will not be issued a UAE passport or any of the government’s welfare benefits.

  One of the major challenges to a high-growth entrepreneurial culture elsewhere in the Arab world—beyond just the gulf—is that the teaching models in primary and secondary schools and even the universities are focused on rote memorization. According to Hassan Bealaway, an adviser to the Egyptian Ministry of Education, learning is more about systems, standards, and deference rather than experimentation. It is much more the Columbia model than the Apollo.

  This emphasis on standardization has shaped an education policy that defines success by measuring inputs rather than outcomes. For example, according to a study produced by the Persian Gulf offices of McKinsey & Company, Arab governments have been consumed with the number of teachers and investments in infrastructure—buildings and now computers—in hopes of improving their students’ performance. But the results of the recent Trends in International Mathematics and Science Study ranked Saudi students forty-third out of forty-five (Saudi Arabia was even behind Botswana, which was forty-second).19

  While the average student-teacher ratio in the GCC is 12 to 1—one of the world’s lowest, comparing favorably with an average of 17 to 1 in OECD countries—it has had no real positive effect. Unfortunately, international evidence suggests that low student-teacher ratios correlate poorly with strong student performance and are far less important than the quality of the teachers. But the education ministries in most Arab countries do not measure teacher performance. Inputs are easier to measure, through a methodology of standardization.

  Focusing on the number of teachers has particularly harmful implications for boys in the Arab world. Many government schools are segregated by gender: boys are taught by men, girls by women. Since teaching positions have traditionally been less appealing to men, there is a shortage of teachers for boys. As a result of the smaller talent pool, boys’ schools often employ lower-quality teachers. In fact, the GCC gender gap in student performance is among the most extreme in the world.

  Finally, a perhaps even larger factor in the limit on high-growth entrepreneurial economies is the role of women. Harvard University’s David Landes, author of the seminal book The Wealth and Poverty of Nations, argues that the best barometer of an economy’s growth potential lies in the legal rights and status of its women. “To deny women is to deprive a country of labor and talent . . . [and] to undermine the drive to achievement of boys and men,” he writes. Landes believes that nothing is more dilutive to drive and ambition than a sense of entitlement. Every society has elites, and a number of them were born into their upper-echelon status. But there is no more widely dispersed sense of entitlement than ingraining in the minds of half the population that they are superior, which, he argues, reduces their “need to learn and do.” This kind of distortion makes an economy inherently uncompetitive, and it is the result of the subordinated economic status of women in the Arab world.20

  The economy of Israel and many of those in the Arab world are living laboratories for the economic theory of clusters and, more broadly, what it takes for nations to generate—or stifle—innovation. The contrast between the two models demonstrates that a simplistic view of clusters—one that maintains that a collection of institutions can be mechanically assembled and out will pop a Silicon Valley—is flawed. Moreover, it seems that a stake in the country, Tuchman’s “motive,” provides an essential glue that helps encourage entrepreneurs to build and take risks.

  CHAPTER 14

  Threats to the Economic Miracle

  We’re using fewer and fewer of the cylinders to move this machine forward.

  —DAN BEN-DAVID

  THE ISRAELI ECONOMY is still in its infancy. The start-up scene that seems so established today was born at roughly the same time as the Internet economy itself, just over a decade ago. The dawn of Israel’s tech boom coincided not only with a global surge in information technology but with the American tech-stock bubble, the jump-starting of Israel’s venture capital industry through the Yozma program, the massive wave of immigration from the former Soviet Union, and the 1993 Oslo peace accords, bringing what seemed to be the prospect of peace and stability. What if Israel’s economic miracle were simply built on a rare confluence of events and would disappear under less favorable circumstances? Even if Israel’s new economy is not just the product of happenstance, what are the real threats to Israel’s long-term economic success?

  One need not speculate about what would happen if the posit
ive factors that launched Israel’s tech boom in the late 1990s were to disappear. Most of them have.

  In 2000, the tech-stock bubble burst. In 2001, the Oslo peace process crumbled, as a wave of suicide bombings in Israel’s cities temporarily wiped out the tourism industry and contributed to an economic recession. And the massive flow of immigrants from the former Soviet Union, which swelled the Jewish population of the country by one-fifth, exhausted itself by the end of the 1990s.

  These negative developments happened about as rapidly and simultaneously as their positive counterparts had just a few years earlier. And yet the new state of affairs didn’t bring an end to the boom that was only about five years old. From 1996 to 2000, Israeli technology exports more than doubled, from $5.5 billion to $13 billion. When the tech bubble burst, exports dropped slightly, to a low of less than $11 billion in 2002 and 2003, but then surged again to almost $18.1 billion in 2008. In other words, Israel’s technology engine was barely slowed by the multiple hits it took between 2000 and 2004 and managed not just to recover but to exceed the 2000 boom level of exports by almost 40 percent in 2008.

  A similar picture can be seen in venture capital funding. When the VC bubble burst in 2000, investments in Israel dropped dramatically. But Israel’s market share of the global VC flow increased from 15 to 30 percent over the next three years, even as the Israeli economy came under increasing stress.

  Israel may not, however, fare as well in the current global economic slowdown, which, unlike that of 2000, is not limited to international tech stocks and venture capital funding but is being dramatically felt in the global banking system as well.

  That said, the breakdown in international finance has infected almost every nation’s banking system, with two notable exceptions: neither Canada nor Israel has faced a single bank failure. Since Israel’s hyperinflation and banking crisis of the early 1980s—which culminated in 1985 with the trilateral intervention of the Israeli and U.S. governments and the IMF—tight restrictions have been in place. Israel’s financial institutions adhere to conservative lending policies, typically leveraged 5 to 1. U.S. banks, on the other hand—precrisis—were leveraged at 26 to 1, and some European banks at a staggering 61 to 1. There were no subprime mortgages in Israel, and a secondary mortgage market never came into existence. If anything, a shortage of financing—even before the crisis—for small businesses in Israel drove even more people into the technology sector, where taxes and regulations were more friendly and venture capital was available.

  As Israeli financial analyst Eytan Avriel put it, “Israeli banks were horse-drawn carts and U.S. banks were racing cars. But those racing cars crashed badly whereas the carts traveled more slowly and stayed on course.”1

  This is the good news for Israel. Yet while Israel’s economy was not exposed to bad lending practices or complex credit products, it may be overexposed to venture finance, which could soon be in scarce supply. Venture capital firms are funded largely by institutional investors such as pension funds, endowments, and sovereign wealth funds. These investors set aside a specific allocation for what are called alternative investments (venture capital, private equity, hedge funds), typically in the range of 3 to 5 percent of their overall portfolios. But as the dollar value of their public equity (stock market) allocations has shrunk—due in large measure to crashing markets globally—it has shrunk the absolute dollar amount available for alternative investments. The overall pie has been downsized, reducing available funds for venture capital investments.

  A diminished supply of venture capital dollars could mean less “innovation finance” for Israel’s economy. Thousands of workers in Israel’s tech scene have already lost their jobs, and many tech companies have shifted to four-day workweeks to avoid further layoffs.2 In the absence of new financing, many Israeli start-ups have been forced to close.

  In addition to an overdependence on global venture capital, Israeli companies are also overdependent on export markets. Over half of Israel’s GDP comes from exports to Europe, North America, and Asia. When those economies slow down or collapse, Israeli start-ups have fewer customers. Because of the Arab boycott, Israel does not have access to most regional markets. And the domestic market is far too small to serve as a substitute.

  Israeli companies will also find it harder to negotiate exits—like Given Imaging’s IPO on the NASDAQ or Fraud Sciences’ sale to PayPal—which are often the means by which Israeli entrepreneurs and investors ultimately make their money. A global slowdown will coincide with fewer IPOs and acquisitions.

  And a continued deterioration of the regional security situation could also threaten Israel’s economic success. In 2006 and at the turn of 2008 to 2009, Israel fought wars against two groups trained and funded by Iran. While these wars had little effect on the Israeli economy, and Israeli companies have become adept at upholding their commitments to customers and investors regardless of security threats large and small, the next iteration of the Iranian threat could be different from anything Israel has ever experienced.

  Iran, as is widely reported by international regulatory bodies and news organizations, is in pursuit of a nuclear capability. If the Iranian government establishes a nuclear-weaponization program, it could spark a nuclear arms race throughout the Arab world. This could freeze foreign investment in the region.

  While much of the international focus is on the potential threat of an Iranian nuclear missile strike on Israel, the political and security leadership of Israel warns against the effect of an Iranian nuclear capability on the region even if it is never directly used. As Prime Minister Benjamin Netanyahu told us, “The first-stage Iranian goal is to terrify Israel’s most talented citizens into leaving.”3

  Clearly, if the Iranian threat is not somehow addressed, the Israeli economy could be affected. So far, however, the presence or potential of such threats has not deterred foreign companies and venture funds from increasing their investments in Israel.

  Indeed, when it comes to threats to the economy, discussion within Israel centers more on domestic factors. Maybe because Israel has inoculated itself against security threats to its economy in the past, or maybe because the prospect of a nuclear threat is too grave to ponder, Tel Aviv University economist Dan Ben-David is fixated on another threat—the “brain drain” from the faculties of Israeli universities.

  To be sure, Israel is a leader in the international academic community. A global 2008 survey by Scientist magazine named two Israeli institutions—the Weizmann Institute and the Hebrew University of Jerusalem—as the top two “best places to work in academia” outside the United States.4

  Economist Dan Ben-David pointed us to a study by two French academics that ranks nations outside the United States according to publications in top economic journals between 1971 and 2000. The United Kingdom—including the London School of Economics, Oxford, and Cambridge—came in at number two. Germany had fewer than half as many publications per faculty member as the British had. And Israel was number one. “Not five or ten percent more, but seven times more—in a league of our own,” Ben-David crowed to us. “And as good as Israel’s economists are, our computer scientists are apparently even better, relative to their field. We have two Nobel Prizes recently in economics, and one or two in chemistry.”5

  But despite all this success, Ben-David is worried. He told us that Israel’s academic lead has lessened in recent years, and will fall further as older faculty members retire and many of the rising stars leave to teach abroad. In his own field, economics, Ben-David pointed to a study that found that of the top thousand economists in the world, as measured by citations of their work between 1990 and 2000, twenty-five were Israelis, thirteen of whom were actually based in Israel. Since that study was published, only four of these have remained in Israel full-time. And none of the twelve Israelis working abroad in 2000 have returned to Israel. In total, an estimated three thousand tenured Israeli professors have relocated to universities abroad.

  Ben-David is one of those
four top economists who remain in Israel. And he is sounding the alarm on Israel’s continued economic growth. From 2005 through 2008, Israel grew substantially faster than most developed countries. But there was a recession the previous few years so, Ben-David argues, “all we’ve done is return to the long-term path. We’re not in uncharted territory; we are where we should have been had we not had the recession.”

  The problem, according to Ben-David, is that while the tech sector has been surging ahead and becoming more productive, the rest of the economy has not been keeping up. “It’s like an engine,” he says. “You have all the cylinders in the engine. You have all the population in the country. But we’re using fewer and fewer of the cylinders to move this machine forward.” In essence, the tech sector is financing the rest of the country, which is “not getting the tools or the conditions to work in a modern economy.”

  This underutilization brings us to what we believe is the biggest threat to Israel’s continued economic growth: low participation in the economy. A little over half of Israel’s workforce contributes to the economy in a productive way, compared to a 65 percent rate in the United States. The low Israeli workforce participation rate is chiefly attributable to two minority communities: haredim, or ultra-Orthodox Jews, and Israeli Arabs.6

  Among mainstream Israeli Jewish civilians aged twenty-five to sixty-four, to take one metric, 84 percent of men and 75 percent of women are employed. Among Arab women and haredi men, these percentages are almost flipped: 79 percent and 73 percent, respectively, are not employed.7