Israel’s High Tech Shifts Into High Gear

TEL AVIV —  This is not a country known for conspicuous consumption, which is why people are still talking about the party Chemi Peres, Rami Kalish and their partners at Polaris Venture Capital recently threw for 800 of their closest friends.

Held beneath a vast pavilion at a bucolic retreat a few miles out of town, it featured a seemingly endless supply of food. There was a free bar and, for any teetotalers present, plenty of espresso and cappuccino. Topping off the festivities was a performance by Israel’s hottest pop star.

If the bash didn’t quite measure up to the extravagant standards of, say, the average Silicon Valley dot-com, all agreed that the country had never seen anything like it. But that was not to criticize. After all, the party was staged to celebrate what one might call, after the founding of the Jewish state itself, Israel’s second miracle: a high-tech boom that has helped transform an economy that until fairly recently ranked as a global basket case.

Indeed, it was not only the lavishness of Polaris’ party but also the sheer size of it that left everyone awe-struck.

“If you had that party five years ago and invited everybody in the business,” said A. I. Mlavsky, a 20-year veteran of Israeli investing, “you could have had it in a cafe.”

The phenomenon that is Israeli high technology has emerged so suddenly that it has surprised even people in Israel, a country never particularly known for its humility.

Not a factor in global high tech 10 years ago, Israel today ranks third in the world in the number of Nasdaq-listed tech companies. The number of Israeli start-up firms per capita is the highest anywhere except for Silicon Valley.

Investors from around the world, who shunned Israel as recently as the early 1990s, today clamor for a piece of the action. Before 1992, there were no Israeli venture capital funds. Now there are 130, and last year alone they raised $1.6 billion in new capital (most of it from the U.S.). When Polaris, the country’s most successful venture firm, started its first fund in 1993, it struggled to raise $20 million. For its latest fund, it set a goal of $300 million and had to stop accepting money when the total reached $500 million.

Scarcely a month passes without the appearance of a new milestone: Polaris’ record-breaking financing feat came only days after Lucent Corp. paid a record $4.5 billion for Tel Aviv-based Chromatis Networks, a maker of fiber-optic systems.

Entire new industries have been erected upon Israeli innovations. Among these is Internet telephony, which took off after Tel Aviv-based VocalTec invented devices known as IP, or Internet protocol, “gateways,” which allow voice calls to travel between conventional telephone networks and computer networks.

The rise of digital networks such as the Internet has proved a particular boon for Israel. Not only has the Internet’s capacity to render geography irrelevant erased one of Israel’s great business disadvantages--its distance from its prime export market, the U.S.--but it has also provided Israeli inventors with a huge blank canvas, which they have taken to like a swarm of fledgling Rembrandts.

“The architecture of the Internet resembles that of the Jewish Diaspora,” says Yossi Vardi, the avuncular sage of Israeli high tech, striving to explain why Israeli technicians took so readily to the worldwide network’s decentralized structure. Vardi became a national folk hero in 1998 when America Online paid $407 million for his company, Mirabilis Ltd., the marketer of ICQ, an instant-messaging technology developed by a group of young software mavens that included his son.

Even the most cursory tour of the smoked-glass towers of the burgeoning high-tech suburb of Herzliya outside Tel Aviv, or the dusty industrial parks bordering Jerusalem and Haifa, suggests that many of the innovations that will make the Internet a truly indispensable utility in the decades ahead will come from Israel.

There’s Haifa-based SpeedBit, whose Download Accelerator cuts the time needed to download applications from the Web by as much as half. The firm has acquired 5 million users in a matter of months with its free program, without spending a dime on advertising. And Browzwear, which developed a program that allows online shoppers to dress 3-D images of themselves in virtual garments to see how they look before buying. And GuruNet, which allows Web users to pull word definitions, synonyms, translations and other handy material off the Internet by clicking on any relevant word anywhere on their screen.

And those are just start-ups. Among the country’s established technology concerns is Check Point Software, a world leader in Internet security programs for large corporations, which at about $18 billion boasts the highest valuation of any Israeli company on the Nasdaq Stock Market.

A Reexamination of National Character

Yet, inclined as they are to Talmudic self-examination in all things, Israelis don’t shrink from the profound issues raised by their growing prominence in global high tech.

Some problems are typical of hot high-tech economies everywhere, including a desperate shortage of manpower that recently led the industry to offer the Israeli government a bounty of up to $125 million in exchange for admitting up to 10,000 foreign engineers on temporary visas. (The government has not yet taken up the offer.)

But other issues are uniquely Israeli. The country’s sudden success in the global electronics market has led it to reexamine its national character, and it doesn’t always like what it sees: a culture that is superb at innovation but poor at strategic management, independent-minded enough to produce 1,500 start-ups but too independent to turn them into great multinational enterprises.

“There’s a sense that what we don’t have in the Israeli business environment is the ability to organize ideas or initiatives in a structured fashion,” says Ron Lubasch, managing director of Lehman Bros. Israel. “We Israelis like to deal with crises, not to sit down and strategize.”

Others are concerned that Israel’s success at marketing its technology around the world will undermine the very qualities that make the country special. Some profess to detect signs that the threads binding the country’s best and brightest to the homeland are already under strain. “If not for Zionist sentiment,” remarks one high-tech businessman, “this entire industry would be in California.”

In fact, much of it already is in California or elsewhere in the U.S. More than 90% of Israel’s high-tech start-ups are incorporated not in Jerusalem but in Delaware, because Israeli entrepreneurs consider the country’s tax policy and merger-and-acquisition rules antiquated for the high-tech era. If Israel’s capital gains taxes and business regulations were comparable to America’s, they argue, many of those companies would come home.

Many people also wonder whether the wealth being created in the high-tech sector, which still employs only about 200,000 Israelis, will exacerbate the stresses and strains, both secular and religious, that already crisscross Israeli society like the cracks in a sheet of thin ice.

“The gap between rich and poor here is the fastest-growing in the Western world,” remarks Avraham Burg, speaker of the Knesset, Israel’s parliament. “Plus we have all our other schisms: religious-nonreligious, Jews and Arabs, right and left, immigrants and native Israelis. And all the gaps overlap each other.”

The accumulation of high-tech wealth is also likely to widen the troublesome 15-1 gap in per-capita income between Israel and its Arab neighbors.

All this represents a remarkable transformation in an economy that was once written off as a floundering socialist experiment. In the early 1980s, inflation in Israel surpassed 500% a year, the country’s foreign debt of $21 billion was the largest per capita in the world, and government expenses--mostly military and welfare--consumed a massive 72% of the gross national product.

The economy was propped up almost entirely by American aid, of which Israel was the largest recipient. The products Israel was best known for were oranges, which once represented 60% of its annual exports, and armaments.

Today oranges make up 5% of all exports, and defense exports are stagnant at about 10%. By contrast, electronics and software exports account for 39%, or $6.6 billion, in 1999, according to Economic Models Ltd., a Tel Aviv economic consulting firm. Although much of the Israeli economy is still performing poorly, the high-tech sector is expected to drive overall annual growth to more than 5% over the next few years.

Several factors helped Israel establish itself as perhaps the world’s most successful Silicon Valley clone. One is its claustrophobic geography: Just as Silicon Valley is shoehorned onto a swath of real estate with bodies of water on either side and with two cities (San Francisco and San Jose) at either end, Israel is backed up against the Mediterranean by a ring of traditionally hostile neighbors. A history of international boycotts and embargoes, moreover, has infused the populace with the habits of self-reliance.

Then there is the presence of a powerful intellectual incubator. In Silicon Valley, it is Stanford University. In Israel, it is the army, which requires up to three years of service from every Jewish 18-year-old and provides the best of them with incomparable management training, a high-tech education and the kind of personal network that young Americans get from four years of college.

Just as the growth of many traditional industries has been driven by the availability of cheap muscle--think railroads, auto makers and steel companies--high tech needs brainpower. In patents per capita, Israel ranks third in the world, after the U.S. and Japan. In engineers as a percentage of the national work force it ranks first, with 135 per 10,000 employees--roughly double the figures for the U.S. and Japan.

But added to that is a wave of imported help: the arrival over the 10 years starting in 1989 of a million Soviet and Russian refugees, many with advanced training in such fields as chemistry, materials science and engineering. They became--in the words of Jonathan Medved, an American-born venture capitalist here--the “foot soldiers” of Israel’s economic upturn.

“The people who came over were very educated,” recalls Yigal Erlich, then the chief scientist in the Ministry of Trade and Industry, who was responsible for finding a way to absorb the new immigrants. “These we got free of charge, and the advantage was huge to the state of Israel.”

A Nation Both Insular, Cosmopolitan

The last necessary element is cultural. Just as Silicon Valley loves to celebrate its ethos of risk-taking and informality, in which failure is not only an option but almost a necessary experience that prepares you for the next try, Israeli businesspeople brandish their own idiosyncratic ideology: “Israeli culture is based on rebellion, ignoring borderlines and conventional wisdom, and improvising,” says Gideon Tolkowsky, a leading venture capitalist.

The result is a nation that, like Silicon Valley, is at once insular and cosmopolitan.

Israelis never tire of reminding visitors that their country is so small it often seems that everyone knows everyone else. The 800 guests socializing under Polaris Venture Capital’s pavilion at that party in June included many who should by rights be arch-competitors in business and politics, yet they invest in one another’s firms.

No one is at all surprised that Polaris, one of whose partners is the son of former Labor Party Prime Minister Shimon Peres, is a principal backer of VCON, a communications company run by Yair Shamir, the son of former Likud Prime Minister Yitzhak Shamir, Peres’ political polar opposite.

“In this country, you can’t afford to have any enemies, because it’s so small,” says Ami Erel, the amiable chief executive of Elron Electronic Industries Ltd., a leading electronics maker, and head of the Assn. of Electronics Industries.

Most of these factors were in place for years before they jelled. One missing factor was money.

It is a rare veteran Israeli entrepreneur who cannot describe the painful process of trying to scare up foreign financing in the 1980s. Israel was viewed then as a country either perpetually at war or on the verge of war, led by a government tarnished by leftism.

“Nobody in his right mind wanted to invest in Israel,” recalls Tolkowsky, whose father, Dan, started one of the first domestic investment banks during that period. “Israel was perceived as high-risk, politically and economically.”

“Americans wouldn’t invest in Israel, and Israeli investors didn’t understand high tech,” says Zohar Zisapel, a former Israeli intelligence officer who helped his older brother Yehuda build RAD Data Communications Inc. into one of the largest high-tech holding companies in the country. “No one even accepted the idea of Israel as a place of high technology,” he recalls of those arid years.

Overseas capital in Israel traditionally had come from well-heeled Jewish families who regarded their stakes more as expressions of Zionist philanthropy than as working investments. Among them was the Bronfman family of Canada, the owners of Seagram Co. (which controls Universal Studios and recently agreed to a takeover by France’s Vivendi).

“We had some sleepy Israeli investments that the family had made as early as the ‘60s,” says Jonathan Kolber, a former Salomon Bros. banker who was then the Bronfman family’s financial advisor and is now CEO of Koor Industries, a major Tel Aviv conglomerate controlled by the family. When Kolber unloaded one holding, a supermarket chain, to an Israeli entrepreneur for a gain of about 400%, the Bronfmans were flabbergasted.

“The management committee said to me, ‘You don’t make money in Israel, you give it away,’ ” he says.

As the ‘80s drew to a close, the situation was about to get grimmer. The looming wave of Soviet immigration seemed almost certain to overwhelm the tiny country’s economic resources.

Israel was saved by that rarest of global phenomena: the creation of a pair of sensible and effective government programs.

The first was a so-called incubator program, which provided selected Russian immigrants with $150,000 a year for two years, along with Israeli management help, to develop scientific and technical projects for commercial use.

“The idea wasn’t to create employment but to exploit their ideas so they wouldn’t be wasted sweeping the streets,” says Erlich, who supervised the program in its first years.

The second program was dubbed “Yozma,” or “Initiative.” The brainchild of Vardi, then a government minister, the program aimed to jump-start Israel’s venture sector by luring foreign venture firms with subsidies of government capital. If a foreign firm committed $12 million in partnership with an Israeli investment group, the government would put up another $8 million. After a few years, the private investors could buy out the government stake at a bargain price.

Yozma’s success outstripped even its creators’ wildest dreams. Ten funds were created, including several whose offspring, such as Polaris, are today among Israel’s leading investment groups. Many companies they financed became leaders of the country’s high-tech surge. And the success of the first wave helped awaken other Western investors to Israel’s newfound potential.

“We did not expect the speed or the snowball effect,” says Erlich. “I thought half the funds would fail.” In fact, all succeeded, and all but one exercised the option to buy out the government.

Yozma happened to coincide with several other positive changes in the investment climate. The 1993 Oslo accords with the Palestinians encouraged people to believe that the peace process was irreversible, and the relaxation of the Arab embargo at about the same time encouraged more foreign companies to do business with Israel.

“Israel became a more acceptable place to invest,” recalls Zeev Holtzman, CEO of the investment firm Giza Group. High-tech companies such as Intel, Motorola, Microsoft, and Cisco felt more comfortable expanding existing plants or building new ones, which meant importing more technological know-how. And the worldwide tech frenzy gained steam, raising demand for new products and services.

But just as Israelis began to participate more in this huge global marketplace, they began to perceive that the same qualities that made them superb innovators could handicap them as multinational managers. It’s one thing to produce a world-beating technology; it’s an entirely different matter to sell it across the world, which requires sophisticated marketing and planning that are alien to the traditional Israeli world view.

One measure of how the Israelis think about their position and potential in the world is that the company most often idealized by its entrepreneurs is not American but Finnish: Nokia, the cell phone manufacturer that has reached global eminence despite its origin in a country with only four-fifths of Israel’s population. It’s a rare conversation with an Israeli businessman that doesn’t drift into a discussion of why Israel has not yet hatched a company on Nokia’s scale.

“Lacking a Nokia means we really lack good business practices,” says Shabtai Adlersberg, chief executive of AudioCodes, a communications systems company.

“What Israel has is amazing skills of improvisation, but they don’t make organized marketers,” says Medved, the U.S.-born venture capitalist. Unless they learn, he warns, the country risks being relegated to “a high-tech sweatshop for the rest of the world.”

One way in which Israelis have tried to overcome what they see as their cultural shortcomings is by grafting their technological skills to American management know-how, most often by hiring Americans for CEO and other top executive positions.

This has become a highly controversial practice, and not only because it looks like Israel is capitulating to American economic imperialism. It also tends to supplant one set of cultural problems with another--the differences between the way Israelis and Americans do things.

“The fact that everyone here speaks English misleads people into thinking they all speak the same language,” says veteran investor Mlavsky, a British-born scientist and venture financier.

The potential clashes start with the Israeli definition of debate, which is vehement argumentation expressed in Hebrew, a language every bit as blunt and direct as Anglo-Saxon. Anyone not attuned to the peculiar rhythms of Israeli discourse might be inclined to misinterpret routine discussion as irreconcilable disagreement.

Then there’s the Israeli opinion about vested authority, which can be summarized as a conviction that there is no such thing--exemplified by the oft-quoted title of a popular film, “Kol Mamzer Melech”--”Every Bastard a King.”

“In the U.S., you don’t argue with the CEO,” says Nir Birkat, managing director of BRM Group, a backer of start-up companies. “In Israel, if you don’t argue it means you don’t care.”

Many businesspeople here believe that Israel is already moving beyond this colonial phase. Some companies have finessed the cultural gap by hiring Israeli managers who have spent many years in the U.S., a generation that is growing in size. Polaris Venture Capital’s partners, for instance, attribute their success to their backgrounds as managers of overseas branches of foreign corporations.

“You have to have substantial time working and living outside Israel to learn the right way of doing business,” says Rami Kalish, a Polaris partner.

Others believe that it won’t be long before the country’s management skills catch up to its talent for invention.

“We will have a Nokia here,” says entrepreneur Yair Shamir, who is a sponsor of a novel management-training program at Haifa’s Technion, the country’s leading technical institute. “We will have many more than one.”

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Israel’s High-Tech Economy

Numerous factors have combined to make Israel one of the most vibrant high-technology economies in the world.

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Venture capital

Venture investments in Israeli companies are soaring, with much of the capital coming from the U.S. Israel’s Internet-related companies garnered 71% of those investments:

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Tame inflation

After the hyperinflation of the mid-1980s, the country is a more attractive place to invest.

1985: 308.77

1990: 17.13

1995: 10.00

2000: 2,88

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Israel’s GDP

Israel’s per-capita gross domestic product is the highest in the region by a wide margin.

1999 GDP per capita in U.S. dollars:

Israel: 16,100

Lebanon: 3,500

Egypt: 1,400

Palestinian Authority: 1,400

Jordan: 1,200

Syria: 1,100

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Engineering talent

Among the keys to the country’s high-tech boom is the talent of its work force; Israel leads the world in number of engineers as a percentage of total employment.

Engineers per 10,000 employees:

Israel: 135

U.S.: 70

Japan: 65

The Netherlands: 53

Canada: 38

Switzerland: 35

Taiwan: 34

Britain: 38

South Korea: 25

Iceland: 22

Singapore: 19

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Sources: International Monetary Fund; Economic Models Ltd.; PricewaterhouseCoopers Money Tree survey; Israeli Assn. of Electronics Industries; Israeli Ministry of Trade and Industry

Researched by NONA YATES/Los Angeles Times

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MEN OF VISION

The twin folk heroes of Israel’s high-tech boom could hardly be more different. C1