Start-up Nation (23 page)

“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 strong 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.

“This was a rare government program that had a built-in get in and get out,” said Jon Medved. “This was key to its success.”
And it was also rare for a government program to actually disappear once it had served its initial purpose, rather than continue
indefinitely.

At the time, most business-savvy Diaspora Jews were not investing in Israel. They viewed philanthropy and business as two
distinct activities. While they would make huge donations to not-for-profit organizations that benefited Israel, for the most
part they were reluctant to invest in Israel’s high-tech endeavors.

There were exceptions, of course.

Stanley Chais, a money manager in California, helped raise money for the first round of Yozma funds by setting up parlor meetings
in California with wealthy Jews. He raised millions of dollars for the funds. Erel Margalit, who left the Jerusalem Development
Authority to manage one of the first funds, said that most of the first round of funding was raised from people who had a
“warm place in their heart for Jerusalem or Israel.” Margalit’s first institutional investor was the French insurance giant
GAN
, whose chairman was a French Jew Margalit met by chance on a flight to Paris.

“The government was used as the catalyst,” said Erlich. The first Yozma fund was created in partnership with the Discount
Israel Corporation, an investment bank, and Advent Venture Partners, a premier VC firm from Boston. It was led by Ed Mlavsky,
the longtime director of the
BIRD
Foundation, and Yossi Sela.

Clint Harris, a partner at Advent, said he knew something was different about Israel on his first trip. In the taxicab on
the way from the airport to his Tel Aviv hotel, the driver asked him why he was visiting Israel. Harris replied that he was
there to get a sense of the venture capital industry. The driver then proceeded to give Harris a briefing on the state of
VC in Israel.

The Advent-sponsored fund would be called Gemini Israel Funds. One of its first investments was in November 1993, when it
allocated $1 million to Ornet Data Communications. This investment, as well as the managerial help, was just what Ornet needed
to succeed. Recognizing the company management’s lack of business experience, Mlavsky and Sela helped recruit Meir Burstin
to serve as chairman of the board for the new company. Burstin was an old hand in the high-tech entrepreneurial world, having
founded and led Tekem, one of Israel’s first software companies, and then served as president of Tadiran, one of Israel’s
big defense-technology companies. Burstin brought instant credibility and experience to Ornet.

When the company was teetering on the brink of closing down after wasting the first big financing round, Yossi Sela from Gemini
took over as interim
CEO
of the company and commuted from Ramat Hasharon to Karmiel, a two-hour drive, four days a week. “It took six months of single-minded
determination,” Sela recalled, “from both Gemini and the Ornet founding team, to sell the company and keep the management
team from splintering—not to mention more hours driving from Ramat Hasharon to Karmiel than I’d like to remember—but we did
it.”
¹⁴

The other piece that was critical to the company’s success was Gemini’s ability to bring Walden Venture Capital in as an investor.
Walden, an established firm in Silicon Valley, had experience in the kind of technology Ornet had developed. Returning over
three times its investment in about two years made Ornet Gemini’s first success story.

The ten Yozma funds created between 1992 and 1997 raised just over $200 million with the help of government funding. Those
funds were bought out or privatized within five years, and today they manage nearly $3 billion of capital and support hundreds
of new Israeli companies. The results were clear. As Erel Margalit put it, “Venture capital was the match that sparked the
fire.”
¹⁵

Several of the Yozma funds had high-profile successes early on, with investments in companies such as
ESC
Medical, which designed and built light-based medical solutions like lasers; Galileo, a high-end semiconductor firm; Commontouch,
an enterprise e-mail and messaging provider; and Jacada, which builds online work spaces for customer-service employees at
leading companies.

Along the way, others jumped into the venture capital world—even without the government’s Yozma backing. Jon Medved just missed
the Yozma financing. Years after he sold the company he and his father had built, he heard that there was a $5 million Yozma
allotment available to invest in very-early-stage companies. Known as seed funds, these investments tend to be considered
the riskiest, so Yozma offered a one-to-one match: investors had to bring $2.5 million to the table to get the government’s
$2.5 million.

Medved went to Yigal Erlich with investors ready to write checks and asked for the grant. Unfortunately, it was too late.
But it didn’t matter. The Yozma program was generating the buzz in the U.S. venture community to overcome investors’ reticence
about doing business in Israel. “Israel had excited investors enough that we were able to bring in the $2.5 million and start
Israel Seed Partners in 1994,” even without the government’s matching grant, Medved said. The fund would quickly grow to $6
million, and Israel Seed would go on to raise $40 million in 1999 and $200 million in 2000.

According to the Israel Venture Association, there are now forty-five Israeli venture capital funds. Ed Mlavsky said that
over the period from 1992 to early 2009, there have been as many as 240 VCs in Israel, defined as companies both foreign and
domestic investing in Israeli start-ups.

Soon other governments around the world were taking notice of Yozma’s success. Chief scientist Erlich got calls from foreign
governments, including Japan, South Korea, Canada, Ireland, Australia, New Zealand, Singapore, and Russia, all wanting to
come to Israel and meet the founders of Yozma.

In December 2008, Ireland launched a 500 million “innovation fund” designed to attract cofinancing from foreign venture capitalists.
“The Irish state—ironically for a country that didn’t have diplomatic relations with Israel for the first 40 years of its
existence—has copied the Jewish state,” wrote Irish economist David McWilliams.

Like Yozma, the Irish innovation fund lures foreign VCs to Ireland through a series of state-backed venture capital funds
that partner up with private-sector funds.

McWilliams said, “The big idea is not to attract only U.S. capital and commercial know-how, but to suck in entrepreneurs from
all over Europe. At the moment, Europe has huge reservoirs of scientific talent, but a very poor record at creating start-ups.
The question many investors ask is: where is the European Google? It’s a fair question. In the next ten years, what if that
European Google was set up here using Irish and European brains and U.S. capital? That is the prize.”
¹⁶

Yozma provided the critical missing component that allowed the Israeli tech scene to join in the tech boom of the 1990s. But
in 2000, the Israeli tech sector was hit by multiple blows at once: the global tech bubble burst, the Oslo peace process blew
up into a wave of terrorism, and the economy went into a recession.

Yet Israel’s start-ups quickly adapted and rebounded. During this period, Israel doubled its share of the global venture capital
pie with respect to Europe, growing from 15 to 31 percent. This growth occurred, however, within a tax and regulatory environment
that, while favoring technology start-ups and foreign investors, did not offer the same support to the rest of the economy.

For example, while a technology start-up could attract financing from numerous sources, anyone trying to launch a more conventional
business would have a lot of trouble getting a simple small business loan. Israel’s capital markets were highly concentrated
and constrained. And a particular industry that would seem to be a natural for Israel—financial services—was prevented from
ever getting off the ground.

In 2001, Tal Keinan graduated from Harvard Business School. “Many of my friends who were going off to work on Wall Street
were Jewish, and it struck me that the Jewish state doesn’t have such an industry. When it came to managing investments, Israel
was not even on the map,” Keinan said.

The reason was government regulations. In venture capital, Keinan discovered, “the way the regulatory and tax regime was set
up here, you could essentially operate as though you weren’t in Israel, which was great, and it created a wonderful industry.
The government basically kept its hands off of venture capital.” But, he adds, “you couldn’t do anything outside of venture
capital in any meaningful way. You weren’t allowed to take the performance fees on any money you managed, so you could forget
that entire industry. It was a nonstarter.”
¹⁷

The asset-management business has a simple model: firms receive a flat management fee of about 1 to 2 percent of the money
they manage. But the real upside is in performance fees, which are typically 5 to 20 percent of the return on the investment,
depending on the firm.

Until January 2005, it was illegal for Israeli money-management firms to charge performance fees. So not surprisingly, there
was no industry to speak of.

The change came from then finance minister Benjamin “Bibi” Netanyahu.

With Prime Minister Ariel Sharon’s backing in 2003, Netanyahu cut tax rates, transfer payments, public employee wages, and
four thousand government jobs. He also privatized major symbols of the remaining government influence on the economy—such
as the national airline, El Al, and the national telecommunications company, Bezeq—and instituted financial-sector reforms.

“In the sense that he tackled the stifling role of government in our economy, Bibi was not a reformer but a revolutionary.
A reform happens when you change the policy of the government; a revolution happens when you change the mind-set of a country.
I think that Bibi was able to change the mind-set,” said Ron Dermer, who served as an adviser to four Israeli ministers of
finance, including Netanyahu.
¹⁸

Netanyahu told us, “I explained to people that the private economy was like a thin man carrying a fat man—the government—on
its back. While my reforms sparked massive nationwide strikes by labor unions, my characterization of the economy struck a
chord. Anyone who had tried to start a [nontech] business in Israel could relate.”
¹⁹
Netanyahu’s reforms gained increasing public support as the economy began to pull out of its rut.

At the same time, a package of banking-sector reforms pushed through by Netanyahu began to take effect. These reforms launched
the phaseout of the government’s bonds that had guaranteed about 6 percent annual return. Up until that point, asset managers
for Israeli pensions and life insurance funds simply invested in the Israeli guaranteed bonds. The pension and life insurance
funds “could meet their commitments to beneficiaries just by buying the earmarked bonds. So that’s exactly what they did—they
didn’t invest in anything else,” Keinan told us. “Because of these bonds, there was no incentive for Israeli institutional
investors to invest in any private investment fund.”

But as the government bonds began to mature and could not be renewed, they released some $300 million a month that needed
to be invested elsewhere. “So all of a sudden, boom, you’ve got a local pool of capital to spark an investment industry,”
noted Keinan, as we sat, looking out at the Mediterranean, in his thirtieth-floor office in Tel Aviv, which is where his new
investment fund is headquartered. “As a result, there are very few large international money managers that don’t have some
exposure in Israel now, either in equities or the new corporate bond market, which didn’t exist three years ago, or in the
shekel.”