Investment in Israeli Startups Falls 20% This Year -- Can We Finally Admit There Is a Problem?

By Sarah Lacy , written on July 16, 2012

From The News Desk

Several years ago, on my second reporting trip to Israel I wrote a post for TechCrunch on how the country needed to get its "entrepreneurial mojo" back. It cited hard facts from Dow Jones about the disastrous decline in returns, and warned that investment going into a country was a lagging indicator of the health of an ecosystem.

Put another way: While Israel still had tons of capital at the time -- some 30 times Europe, 350 times India, and 80 times China per capita -- those impressive, enviable numbers would begin to wane if the country didn't dig deep and come up with an area where it could uniquely excel, the way it did with security and semiconductors and more hard core technology in the miracle years of the late 1990s.

Most people I spoke with on the ground in Tel Aviv who were working hard to build companies and invest in the ecosystem agreed with me. Dozens of mis-informed trolls took a fact-based story as a personal attack on their country, called me anti-Semitic, and even made death threats. Never mind, I was arguing for Israeli entrepreneurs in the post, have invested my own money in several reporting trips to Israel and have written more than nearly any other US-based blogger about promising Web companies coming out of the region like MyHeritage. (The comments didn't transfer over in TechCrunch's redesign, which is a shame because they displayed a special kind of insane patriotic venom.)

Well, here we are three years later. And in a quarter where venture capital is globally at one of its highest levels on record, investments in Israel's tech scene are continuing to fall as more capital dries up or pulls out of the region.

According to a new report from the Israeli Venture Capital Research Center, Israeli companies raised $453 million in the second quarter, down 6 percent from the first quarter and down a more substantial 20 percent from the year earlier period.

For the first half of the year, investment declined 11 percent. What's more, the percentage of that coming from Israeli VCs fell from 28 percent to 24 percent from the year's earlier period. Even worse, early stage deals made up just 24 percent of those investments -- the lowest percentage in a decade, according to IVC. That doesn't bode well for the future.

This wasn't a quarter-to-quarter fluke of when deals happened to close. Here's what Koby Simana, CEO of the IVC Research Center had to say:

“The percentage of high-tech investment from Israeli venture capital firms is continuing to decline as capital available for new investments is shrinking. In light of their ongoing difficulties in raising new funds, we expect a further decline in VC high-tech investments throughout this year.”
So this time, we have another researcher -- one inside the country -- saying the exact same thing. Can we face reality now?

In the late 1990s, Israel excelled at building so much valuable technology that its population size and location in the world didn't matter. They made the world come to them, and leveraged a modest $100 million government investment into a multi-billion local VC industry. It was one of the only examples of smart government policy actually creating an entrepreneur ecosystem, and the world tried to follow this model (with most of those programs failing).

But as the venture world has moved from returns being dominated by enterprise and equipment and semiconductors to consumer Web, Israel has struggled year after year. There have been plenty of small exits -- or "tomatoes" as famed Israeli angel investor Yossi Vardi calls them. He encourages entrepreneurs he mentors to be like a gardener growing interesting ideas and features -- a la tomatoes -- and then sell them to a player like Google or AOL who can bring them to market.

That way of company building has done well for Vardi's portfolio and has turned many entrepreneurs into single-digit millionaires. But the lack of home runs has clearly come at the expense of the long-term sustainability of the ecosystem. There's no local multi-billion investment industry just for tomatoes, because just growing tomatoes doesn't need much more than angels and seed funds.

There are exceptions, and I'd list MyHeritage as exhibit A. It is one of the only Israeli Web companies that has beat better-funded, glitzier US rivals. I expect it'll be a $1 billion-plus winner, and after a very long slog, the founder Gilad Japhet deserves it. Kenshoo is another standout. Mick Weinstein has written about many others for us; you can read his excellent work here.

Indeed, Index Ventures has doubled down on the region, with Saul Klein spending more time there. Sequoia Capital says its Israeli portfolio continues to perform well, so clearly not everyone is exiting the market. But what made Israel defy the odds was an overwhelming pattern of companies like those, not just one-offs.

Many books have chronicled how Israeli techies have made the world better, including mine. No one is denying that. But the future of this incredibly important ecosystem depends on how entrepreneurs respond to these facts. If history has proven anything, Israel is fully capable of defying the odds. But facing reality of how the market has changed is the first step.

(Saul Klein is an investor in PandoDaily.)