Dan Singer - Start-up Nation

One need not speculate about what would happen if the positive 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. 2In 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