Start-up Nation (4 page)

Another commonly cited factor in Israel’s success is the country’s military and defense industry, which has produced successful
spin-off companies. This is part of the answer, but it does not explain why other countries that have conscription and large
militaries do not see a similar impact on their private sectors. Pointing to the military just shifts the question: What is
it about the Israeli military that seems to foster entrepreneurship? And even with the influence of the military, why is it
that defense, counterterrorism, and homeland security companies today represent less than 5 percent of Israel’s gross domestic
product?

The answer, we contend, must be broader and deeper. It must lie in the stories of individual entrepreneurs like Shai Agassi,
which are emblematic of the state itself. As we will show, it is a story not just of talent but of tenacity, of insatiable
questioning of authority, of determined informality, combined with a unique attitude toward failure, teamwork, mission, risk,
and cross-disciplinary creativity. Israel is replete with such stories. But Israelis themselves have been too busy building
their start-ups to step back and try to stitch together how it happened and what others—governments, large companies, and
start-up entrepreneurs—can learn from their experience.

It would be hard to imagine a time when understanding the story of Israel’s economic miracle could be more relevant. While
the United States continues to be rated the world’s most competitive economy, there is a widespread sense that something fundamental
has gone wrong.

Even before the global financial crisis that began in 2008, observers of the innovation race were sounding alarms. “India
and China are a tsunami about to overwhelm us,” predicted Stanford Research Institute’s Curtis Carlson. He forecasts that
America’s information technology, service, and medical-devices industries are about to be lost, costing “millions of jobs
. . . like in the 1980s when the Japanese surged ahead.” The only way out, says Carlson, is “to learn the tools of innovation”
and forge entirely new, knowledge-based industries in energy, biotechnology, and other science-based sectors.
²⁰

“We are rapidly becoming the fat, complacent Detroit of nations,” says former Harvard Business School professor John Kao.
“We are . . . milking aging cows on the verge of going dry . . . [and] losing our collective sense of purpose along with our
fire, ambition, and determination to achieve.”
²¹

The economic downturn has only sharpened the focus on innovation. The financial crisis, after all, was triggered by the collapse
of real estate prices, which had been inflated by reckless bank lending and cheap credit. In other words, global prosperity
had rested on a speculative bubble, not on the productivity increases that economists agree are the foundation of sustainable
economic growth.

According to the pioneering work of Nobel Prize winner Robert Solow, technological innovation is the ultimate source of productivity
and growth.
²²
It’s the only proven way for economies to consistently get ahead—especially innovation born by start-up companies. Recent
Census Bureau data show that most of the net employment gains in the United States between 1980 and 2005 came from firms younger
than five years old. Without start-ups, the average annual net employment growth rate would actually have been negative. Economist
Carl Schramm, president of the Kauffman Foundation, which analyzes entrepreneurial economics, told us that “for the United
States to survive and continue its economic leadership in the world, we must see entrepreneurship as our central comparative
advantage. Nothing else can give us the necessary leverage.”
²³

It is true that there are many models of entrepreneurship, including microentrepreneurship (the launching of household businesses)
and the establishment of small companies that fill a niche and never grow beyond it. But Israel specializes in high-growth
entrepreneurship—start-ups that wind up transforming entire global industries. High-growth entrepreneurship is distinct in
that it uses specialized talent—from engineers and scientists to business managers and marketers—to commercialize a radically
innovative idea.

This is not to suggest that Israelis are immune from the universally high failure rate of start-ups. But Israeli culture and
regulations reflect a unique attitude to failure, one that has managed to repeatedly bring failed entrepreneurs back into
the system to constructively use their experience to try again, rather than leave them permanently stigmatized and marginalized.

As a recent report by the Monitor Group, a global management consulting firm, described it, “When [entrepreneurs] succeed,
they revolutionize markets. When they fail, they still [keep] incumbents under constant competitive pressure and thus stimulate
progress.” And the Monitor study shows that entrepreneurship is the main engine for economies to “evolve and regenerate.”
²⁴

The question has become, as a
BusinessWeek
cover put it, “Can America Invent Its Way Back?”
²⁵
The magazine observed that “beneath the gloom, economists and business leaders across the political spectrum are slowly coming
to an agreement: Innovation is the best—and maybe the only—way the U.S. can get out of its economic hole.”

In a world seeking the key to innovation, Israel is a natural place to look. The West needs innovation; Israel’s got it. Understanding
where this entrepreneurial energy comes from, where it’s going, how to sustain it, and how other countries can learn from
the quintessential start-up nation is a critical task for our times.

Four guys are standing on a street corner . . .

an American, a Russian, a Chinese man, and an Israeli. . . .

A reporter comes up to the group and says to them:

“Excuse me. . . . What’s your opinion on the meat shortage?”

The American says: What’s a shortage?

The Russian says: What’s meat?

The Chinese man says: What’s an opinion?

The Israeli says: What’s “Excuse me”?

—M
IKE
L
EIGH
,
Two Thousand Years

S
COTT
T
HOMPSON LOOKED AT HIS WATCH.
¹
He was running behind. He had a long list of to-dos to complete by the end of the week, and it was already Thursday. Thompson
is a busy guy. As president and former chief technology officer of PayPal, the largest Internet payment system in the world,
he runs the Web’s alternative to checks and credit cards. But he’d promised to give twenty minutes to a kid who claimed to
have a solution to the problem of online payment scams, credit card fraud, and electronic identity theft.

Shvat Shaked did not have the brashness of an entrepreneur, which was just as well, since most start-ups, Thompson knew, didn’t
go anywhere. He did not look like he had the moxie of even a typical PayPal junior engineer. But Thompson wasn’t going to
say no to this meeting, not when Benchmark Capital had requested it.

Benchmark had made a seed investment in eBay, back when it was being run out of the founders’ apartment as a quirky exchange
site for collectible Pez dispensers. Today, eBay is an $18 billion public company with sixteen thousand employees around the
world. It’s also PayPal’s parent company. Benchmark was considering an investment in Shaked’s company, Israel-based Fraud
Sciences. To help with due diligence, the Benchmark partners asked Thompson, who knew a thing or two about e-fraud, to check
Shaked out.

“So what’s your model, Shvat?” Thompson asked, eager to get the meeting over with. Shifting around a bit like someone who
hadn’t quite perfected his one-minute “elevator pitch,” Shaked began quietly: “Our idea is simple. We believe that the world
is divided between good people and bad people, and the trick to beating fraud is to distinguish between them on the Web.”

Thompson suppressed his frustration. This was too much, even as a favor to Benchmark. Before PayPal, Thompson had been a top
executive at credit card giant Visa, an even bigger company that was no less obsessed with combating fraud. A large part of
the team at most credit card companies and online vendors is devoted to vetting new customers and fighting fraud and identity
theft, because that’s where profit margins can be largely determined and where customer trust is built or lost.

Visa and the banks it partnered with together had tens of thousands of people working to beat fraud. PayPal had two thousand,
including some fifty of their best PhD engineers, trying to stay ahead of the crooks. And this kid was talking about “good
guys and bad guys,” as if he were the first to discover the problem.

“Sounds good,” Thompson said, not without restraint. “How do you do that?”

“Good people leave traces of themselves on the Internet—digital footprints—because they have nothing to hide,” Shvat continued
in his accented English. “Bad people don’t, because they try to hide themselves. All we do is look for footprints. If you
can find them, you can minimize risk to an acceptable level and underwrite it. It really is that simple.”

Thompson was beginning to think that this guy with the strange name had flown in not from a different country but rather a
different planet. Didn’t he know that fighting fraud is a painstaking process of checking backgrounds, wading through credit
histories, building sophisticated algorithms to determine trustworthiness? You wouldn’t walk into
NASA
and say, “Why build all those fancy spaceships when all you need is a slingshot?”

Still, out of respect for Benchmark, Thompson thought he’d indulge Shaked for a few more minutes. “So where did you learn
how to do this?” he asked.

“Hunting down terrorists,” Shaked said matter-of-factly. His unit in the army had been tasked with helping to catch terrorists
by tracking their online activities. Terrorists move money through the Web with fictitious identities. Shvat’s job was to
find them online.

Thompson had heard enough from this “terrorist hunter,” too much even, but he had a simple way out. “Have you tried this at
all?” he asked.

“Yes,” Shaked said with quiet self-assurance. “We’ve tried it on thousands of transactions, and we were right about all of
them but four.”

Yeah, right
, Thompson thought to himself. But he couldn’t help becoming a bit more curious. How long did that take? he asked.

Shaked said his company had analyzed forty thousand transactions over five years, since its founding.

“Okay, so here’s what we’re going to do,” Thompson said, and he proposed that he give Fraud Sciences one hundred thousand
PayPal transactions to analyze. These were consumer transactions PayPal had already processed. PayPal would have to scrub
some of the personal data for legal privacy reasons, which would make Shvat’s job more difficult. “But see what you can do,”
Thompson offered, “and get back to us. We’ll compare your results with ours.”

Since it had taken Shvat’s start-up five years to go through their first forty thousand transactions, Thompson figured he
wouldn’t be seeing the kid again anytime soon. But he wasn’t asking anything unfair. This was the sort of scaling necessary
to determine whether his bizarre-sounding system was worth anything in the real world.

The forty thousand transactions Fraud Sciences had previously processed had been done manually. Shaked knew that to meet PayPal’s
challenge he would have to automate his system in order to handle the volume, do so without compromising reliability, and
crunch the transactions in record time. This would mean taking the system he’d tested over five years and turning it upside
down, quickly.

Thompson gave the transaction data to Shvat on a Thursday. “I figured I was off the hook with Benchmark,” he recalled. “We’d
never hear from Shvat again. Or at least not for months.” So he was surprised when he received an e-mail from Israel on Sunday.
It said, “We’re done.”

Thompson didn’t believe it. First thing Monday morning, he handed Fraud Sciences’ work over to his team of PhDs for analysis;
it took them a week to match the results up against PayPal’s. But by Wednesday, Thompson’s engineers were amazed at what they
had seen so far. Shaked and his small team produced more accurate results than PayPal had, in a shorter amount of time, and
with incomplete data. The difference was particularly pronounced on the transactions that had given PayPal the most trouble—on
these, Fraud Sciences had performed 17 percent better. This was the category of customer applicants, Thompson told us, that
PayPal initially rejected. But in light of what PayPal now knows from monitoring the rejected customers’ more recent credit
reports, Thompson said, those rejections were a mistake: “They are good customers. We should never have rejected them. They
slipped through our system. But how did they
not
slip through Shaked’s system?”

Thompson realized that he was looking at a truly original tool against fraud. With even less data than PayPal had, Fraud Sciences
was able to more accurately predict who would turn out to be a good customer and who would not. “I was sitting here, dumbfounded,”
Thompson recalled. “I didn’t get it. We’re the best in the business at risk management. How is it that this fifty-five-person
company from Israel, with a crackpot theory about ‘good guys’ and ‘bad guys,’ managed to beat us?” Thompson estimated that
Fraud Sciences was five years ahead of PayPal in the effectiveness of its system. His previous company, Visa, would never
have been able to come up with such thinking, even if given ten or fifteen years to work on it.

Thompson knew what he had to tell Benchmark: PayPal could not afford to risk letting its competitors get hold of Fraud Sci-ences’
breakthrough technology. This was not a company Benchmark should invest in; PayPal needed to acquire the company. Immediately.