The hi-tech industry in Israel is maintaining a high level of performance, but is struggling to break through the glass ceiling. Meanwhile, global competition is rapidly growing. If we do not act quickly to handle the fundamental challenges to the industry, its competitive position will erode, and its future performance will diminish.

2015 continued the positive trend seen in the previous year, and was marked by impressive achievements[1]: Israeli companies raised a record USD 4.4 billion and made USD 8 billion worth of exits. However, looking at long-term trends makes it clear that there are still challenges ahead. Browsing through some of the leading global indices reveals that Israel is stagnating as an innovation leader, in comparison to other countries in the international arena. For the first time in many years, Israel has lost the leading position in civilian R&D expenditure (as a percentage of GDP) among developed countries. A variety of reasons contributed to loss of ground, including infrastructure challenges, such as shortage of skilled manpower which substantially limits the competitive ability of hi-tech companies, as well as the continuing decline in government expenditure on R&D. The conclusion is that it is not enough to preserve the current high level of performance, while global competition is increasing. Moreover, the “business as usual” policy will lead to a significant erosion of the competitive position and the performance of the Israeli hi-tech industry. The new Israel Innovation Authority (formerly Office of Chief Scientist) will be facing these and other challenges, which were largely the reason for its establishment.

 

The main events in 2015

In 2015, the cyber sector continued to remain “hot.” The companies in this sector continued to arouse particular interest among foreign enterprises and investors, which was reflected in impressive fundraising and exits amounting to USD 520 million and USD 1.3 billion, respectively[2]. Several acquisitions are noteworthy in this regard: the acquisition of CyActive (already when it was active at the JVP Cyber Labs incubator) by PayPal for USD 65 million, the acquisition of Watchdox by Blackberry for USD 150 million, and the acquisitions of Adallom and Secure Islands by Microsoft for USD 320 million and USD 150 million, respectively. Thus continues the trend of acquisition of Israeli companies, and their re-purposing into global R&D centers of larger corporations. As for acquisitions of Israeli companies by other Israeli enterprises, the most prominent deals included the acquisition of Hypervisor and Lacoon by Check Point for USD 80 million and USD 100 million, respectively, as well as the acquisition of Nice Cyber Division by Elbit for USD 157 million.

Another trend that continues to resonate this year is the interest and involvement of foreign investors, who are not the familiar players from Europe and the United States.  In particular, China's presence and involvement in the local industry have increased both in terms of investment and in terms of strategic partnerships. According to estimates, Chinese investors were involved in a number of equity raisings of Israeli companies, totaling about half a billion dollars[3]. At the same time, the trend has increased in the opposite direction as well – more and more Israeli companies see the Chinese market as an important, and sometimes even necessary market for their operations (for further details see Chapter 6).

Another important development in the global arena took place in late 2015, with the publication of the OECD Action Plan on Base Erosion and Profit Shifting, dealing with the tax planning phenomenon of multinational companies. The Action Plan sets a new and binding standard for member states, whereby multinational companies will not be able to maintain activity that contributes to the income of one country, while paying taxes according to the laws of another country, where the revenues are registered. As a result, these corporations will be forced to choose whether to keep their operations in the current country and pay taxes according to its laws, or to transfer operations to the country with the lower taxes. These recommendations are of great significance for Israel, where many multinational companies maintain extensive R&D activity, but pay most of the taxes for the products developed as part of this activity, in another country. Therefore the Israeli government is currently formulating guidelines on the matter.

Alongside widespread activities in the private sector, the government's innovation policy marked an important event in late 2015, when it approved a major amendment to the Law for Encouragement of Research and Development in Industry of 1984, which resulted in the establishment of the Israel Innovation Authority. Since the beginning of 2016, all the activities of the Office of the Chief Scientist in the Ministry of Economy and Industry were transferred to the Israel Innovation Authority that is taking shape these days. Thus, the first phase was completed in a strategic process that lasted more than two years, and is intended to enhance and empower the abilities of the government to bring economic prosperity through innovation.

 

Hi-tech index: the hi-tech industry maintains a high level of performance

The overall hi-tech index in 2014 was the best in the last decade, mainly due to the improvement in performance of mature companies. In addition, there are preliminary indications of similar level of performance of the hi-tech sector in 2015, as described below.

The hi-tech index is a synthetic index prepared by the Strategy and Economics Division of the Israel Innovation Authority. The index was designed to reflect in real time the different aspects of activity in the hi-tech industry. The index is divided into two sub-indices, based on the understanding of the essential differences between the large, mature companies and startup companies that operate in the domestic market. The aggregated outcome of the index itself is the sum of these two sub-indices.

In the previous report, we asked the readers to comment on the methodology specified, on the various indicators used, as well as on the index in general. After receiving responses, and following a series of internal consultations, we have implemented a number of changes in this year’s index, the most prominent ones being:

  • Switching from the presentation of the index as the sum of the rates of change in the indicators that make up the index, to its presentation as an average of normalized values of these indicators.
  • Additional indicators to better reflect the development of mature companies, including the number and the value of companies acquired by Israeli hi-tech companies; the number and the value of the SPOs carried out; and the refinement of the PE investment indicator to include investments in technology only.

The calculation methodology is fully explained in the publications of the Strategy and Economics division on the Office of Chief Scientist’s website (Hebrew).

The indicators that comprise the startup companies’ sub-index demonstrate a recovery from the global financial crisis, as well as a high level of performance in the last five years. However, keep in mind that the all-time highs in the number and value of hi-tech companies fundraising efforts (693 transactions, in which USD 4.4 billion were raised) largely reflect the enormous rate of foreign investments, that reached record levels of 85% of total investments in the hi-tech industry. This reliance on foreign capital exposes Israel to changes in the global economy, such as downturns in target markets, or interest rate increases in the world, which could lead to a reduction in foreign investments. This situation, along with other challenges, the main of which is the lack of skilled personnel, and the fact that the overall result in this index has remained stable over the recent years, raises the following question: Has the activity of startup companies hit a glass ceiling, which is difficult to break through given existing conditions?

The state of mature companies is more complex, but it may indicate a certain recovery trend in the past two years, following a few years of flailing around. Although, the 2015 results are only partial, because a number of key figures for this year have not been published yet, in particular the export, added value and employment data, the indicators that we do have point to an overall positive year. The increase in the indicators of quantity and value of secondary public offerings (31 which raised USD 9.3 billion) was especially prominent, and may indicate companies’ ambitions to expand and grow[4]. Another noticeable increase occurred in the indicators of the quantity and value of acquisitions made by Israeli hi-tech companies – 76 acquisitions totaling USD 48 billion. The surge in the amount and value of these acquisitions was greatly influenced by Teva’s massive acquisition spree last year[5], which was quite exceptional among Israeli firms, and does not reflect the activity pattern of hi-tech companies in Israel in general. Nevertheless, to preserve the neutrality of the index, we decided to avoid the arbitrary exclusion of any company.

 

The shortage of skilled manpower is a fundamental challenge with long-term consequences

As mentioned above, it is evident that the infrastructural challenge due to a skilled labor shortage is a major obstacle to the growth of both startups and more established companies, which limits the possibility of a significant activity increase in the field. Moreover, the Chief Economist at the Ministry of Finance recently[6] estimated that the stagnation in the hi-tech’s relative share in employment, reflects the constraint on the supply-side, a claim supported by the significant decline, over the past decade, in the percentage of degree recipients majoring in sciences (Figure 2). One of the reasons for this is the sharp drop in the number of graduates in the fields of Computer Science, Mathematics and Statistics, as of 2005 and subsequent years – from a peak of about 3,000 graduates in 2004, to a low of 1,600 graduates in 2008. Despite some recovery in recent years, to date, the number of Computer Science graduates still has not returned to the scope of the early 2000s. This shortage is also reflected in the World Economic Forum index that ranks Israel 17th in the ease of finding skilled employees[7].


Such a shortage of manpower is one of the reasons why the hi-tech industry in Israel is struggling to break through the glass ceiling, despite the generally positive trend in recent years for both startups and more mature companies. This kind of challenge requires ongoing infrastructural treatment, the results of which will be evident only in the medium to long run. Therefore, we must take it on as a national goal, and promote solutions today. The situation is even more alarming when examining industry performance from an international perspective.

 

Global competition is increasing and the Israeli hi-tech industry is stagnating in relation to its competitors

Israel was one of the first countries that recognized the potential of innovation-based growth. This is reflected, among other things, in the continuous government support in industrial R&D for the last forty years. Nevertheless, today, almost all developed countries are waving the innovation banner, and the competition in the international arena is becoming more and more intense. At the same time, while other countries increase their investments in innovation, the Israeli ecosystem is stagnating. If this trend continues, Israeli industry is expected to experience significant difficulties in the face of the increasing competitiveness of other industries. The decline in Israel's global competitiveness poses a significant problem, especially given the reliance of the hi-tech industry on foreign capital markets.

R&D investment as a percentage of GDP is an important macroeconomic indicator that demonstrates Israel’s position in comparison to other countries – a datum acceptable as an estimate of the level of innovation inputs to an economy. Over the years, this figure reflected Israel's relatively large investment in technology and innovation, and Israel indeed has been an unchallenged leader during most of the last decade. In 2014, for the first time after many years of leading this index, Israel was surpassed by South Korea, which invested 4.3% of GDP in R&D, while Israel's R&D expenditure stood at 4.1%. This result is not accidental, and it stems from the realization in many countries that innovation-based industry is a key to sustainable growth, and resources should be invested accordingly[8].

Some argue that the investment in R&D in Israel had reached such a level where the marginal return on investment is not high. Even though it is likely that investments in R&D are being characterized, like most economic activities, by a decreasing marginal return, we absolutely do not agree with this argument. We believe that Israel’s industry and economy can benefit a great deal by directing additional resources towards innovation, both in the hi-tech industry and other sectors with lower productivity levels, where the innovation yield can certainly be higher. In addition, it is important to mention that the same percentage of different GDPs will yield an absolute investment in entirely different magnitudes. Therefore, it certainly can be argued that in order for Israel to compete with other countries, it must invest at a rate much higher than acceptable in other countries with much larger GDPs. Continuation of the “business as usual” policy, in time will result in other countries investing in innovation more than Israel, and increasing their productivity accordingly.

 

A more thorough examination of R&D investment figures shows that in many countries, especially in South Korea, the increase in R&D investment is also due to an increase in government financing (in Korea – about a quarter of the total increase), in addition to an increase in investment by the private sector (Figure 5). On the other hand, Israel has adopted the opposite policy: the percentage of government expenditure on R&D has decreased over the years, and today is well below the OECD average.

 

In this regard, it is important to differentiate between private and government financing of innovation. In our opinion, “smart” government investment in innovation is complementary to private investments in R&D, and despite some substitutability, it has a different rationale and impact. Government expenditure on R&D allows the government to provide incentives for innovative high-risk activities, as well as to ensure the infrastructure necessary for innovation, serve as counter-cyclical investment during recessions, and as an intervention mechanism in specific market failures. These vectors of activity are completely different than private investments aimed at R&D. Therefore, although the total national investment in R&D in Israel did not decrease – since the increase in the volume of private investments offset the reduction in government investment – it is important to understand the future implications of this change in the composition of the investment. We believe that the decline in government investment, defined as government expenditure on R&D as a percentage of GDP, limits the government's ability to tend and cultivate the long-term interests of the hi-tech sector and the economy in general. It also impairs the ability to create an infrastructure appropriate for innovation. Therefore, we are calling for an increase in the government's expenditure on R&D, and the taking of measures to anchor this investment as a fixed percentage of GDP, or alternatively as a fixed percentage of the government budget.

Israel's difficulty to contend with increasing global competition is also reflected in the results it achieves in international rankings. Alongside the comparison of national investments in R&D, it is interesting to examine Israel’s position in other aspects of the innovation field as well. The comparison below is based on a review of leading international indices[9], published during 2015 and dealing with innovation and technology. All the rankings are annual and they evaluate countries, except COMPASS, which is updated less often and ranks ecosystems at the regional level. All the indices measure technological innovation and environmental factors that support it, except for the more comprehensive WEF Global Competitiveness index, out of which we took only the innovation pillar.

The above indices measure different aspects of activity with different methodologies, and therefore do not present a unified picture. However, it is possible to see that in most of them Israel is losing its leading position, and in some it has even dropped precipitously. While part of the decline is explained by the differences in the methodology and parameters, it is difficult to ignore the overall picture indicating erosion in Israel's competitive situation. The WEF Global Competitiveness Index is the only one where Israel retains its relative position, while in all the other rankings Israel’s position has deteriorated in comparison to other nations. The Global Innovation Index shows that Israel has weakened in the ranking of ecosystem business components, infrastructure and human capital. In the Bloomberg Index, Israel has declined due to weakening in the production and patents categories, whereas the Compass index demonstrated the decline of Tel Aviv in the ranking of performance, human capital and funding, compared to the rest of the world's leading innovation environments.

Some of the causes for the decline in ranking in these indices are related to the introduction of new parameters, in which Israel is inherently weak, and these include the size of the domestic market and the distance from major markets. However, delving into the sub-rankings of these indices allows us to identify the various components that constitute the challenges faced by the Israeli innovation industry, which restrict its growth. Human capital availability and the ease of doing business in the country are two such constraints. Improvement in these areas could upgrade Israel's relative position in the world, and contribute to its attractiveness as an ecosystem that encourages and produces innovation.

 

Looking ahead: the hi-tech industry at a crossroads

The hi-tech industry is facing a critical junction – on the one hand it presents a great opportunity: Israeli industry has a track record of business and technological success; it has the expertise, experience and worldwide reputation, and it has reached a high level of maturity. These assets may be utilized to enable the next leap of the Israeli innovation industry.

On the other hand, Israel is facing the risk of a major missed opportunity: the long-term trends are steadily eroding Israel’s competitiveness and constitute a real obstacle to the success of the hi-tech sector in the medium and long term. The main challenges, including the shortage of skilled manpower and stagnation in the volume of government expenditure on R&D, are of an inherently public character, and they relate to the infrastructure necessary for the further development of the Israeli innovation industry. Missing this opportunity will mean that in the foreseeable future there will be a greater risk of decline in the competitiveness of the Israeli hi-tech and a reduction of the economic gain. However, over time, as the world becomes more and more technological, the consequences of this missed opportunity could amount to serious harm to Israeli citizens' quality of life, as well as to the national security and independence of Israel to conduct its foreign relations.

We should not be blinded by the good results of the industry in 2015; the actions we take in the coming years will determine our future path. The Israel Innovation Authority calls to change the national priorities and to set our technological strength as a major national goal. In other words, we need to harness all government ministries and other relevant bodies in order to foster a technological orientation among the general population, to train appropriate personnel, as well as to develop the regulation and tools that will accelerate innovation in general, and technological innovation in particular. The more resources and demographics we can harness in favor of technological innovation, and expand its influence on the entire economy, the better we can prepare the basis for the next leap of the innovation industry of Israel and in Israel.

The establishment of the Israel Innovation Authority signals the importance the Israeli government places on the hi-tech industry and the creation of appropriate tools for its development, as well as the direction it wishes to take as it stands at the crossroads. The Israel Innovation Authority will lead the national effort to achieve economic prosperity through technological innovation, and will create the optimum conditions for a new surge in the Israeli industry and economy. This is not a simple task, but Israel has the necessary conditions for its achievement. The opportunity to do so is certainly within our grasp if we will mobilize as a nation, and will increase the public resources needed for this task, and secure them over time.

 

 

 

[1] All data in this chapter are based on IVC reviews, unless otherwise noted.

[2] Cyber activity data are based on the estimates of the Israel National Cyber Bureau.

[3] IVC estimates.

[4] Further discussion about growth companies is in Chapter 2.

[5] During 2015, Teva has made five acquisitions of foreign companies for a total of USD 46 billion (including the large acquisition of Allergan’s generic division for USD 40.5 billion).

[6] Ministry of Finance Chief Economist, Weekly Review, February 14, 2016.

[7] Ease of Finding Skilled Employees indicator, World Economic Forum Index, Human Capital Report, 2015.

[8] For example, see strategic plans for innovation promotion, recently published in Australia, Canada and the UK.

[9] The selected indices are: the innovation section of the WEF Global Competitiveness Index; Global Innovation Index jointly published by WIPO, Cornell University and INSEAD business school; Bloomberg Innovation Index; world’s top 20 startup ecosystems by COMPASS (formerly Startup Genome).