Zoom in on industry: the blooming of growth companies
The hi-tech industry in Israel is not monolithic and is made up of several groups of companies, each with unique characteristics and needs. In-depth analysis of the industry allows us to identify the formation of a new group – a group of growth companies – as part of the overall maturation of the innovation ecosystem in Israel.
We wish to thank Yifat Oron, CEO of Leumitech, Yossi Vinitzky, Head of Poalim Hi-Tech, and David Cohen, CEO of SVB Israel Advisors, for their contributions to the financial part of this chapter.
The hi-tech industry in Israel is not monolithic, but is made up of groups of companies, sharing common characteristics and challenges. The distinction between the various groups is important for understanding the patterns of activity within each group, and in particular for identifying the difficulties they face, as well as formulating the solutions most appropriate for them. In this chapter, we would like to offer a conceptual segmentation of the companies in the industry into five groups with common characteristics, and to provide a general description of the nature of their activities. Alongside the three generic groups – startups, SMEs and large companies – that can be found in any hi-tech industry, two unique groups can be distinguished in Israel – the group of R&D centers of multinational corporations, and the group of growth companies.
- R&D centers: Multinational corporations have more than 300 R&D centers in Israel. Although, these are backed by the corporations behind them, their activities are not similar at all to the activities of large companies, and therefore we created a separate group for them. Activity in the R&D centers is characterized by an almost absolute focus on research and development, minimal manufacturing activity and lack of sales. In this context, it is important to note that Intel, for example, was classified in the group of large companies, and not in the group of R&D centers of multinational corporations, despite the fact that there is a foreign multinational corporation behind it.
- Growth companies: This group differs from the others due to its dynamism. The companies in this group are characterized by a rapid transition from SME (or startup), with the ultimate goal of becoming large companies. The 30 companies in this group also exhibit impressive sales growth (ranging from tens to hundreds of millions of dollars), and are in the eye of the storm. Beyond the dry statistics, their most striking feature is the strategic decision to become global leaders in their fields, without merging or being acquired by a larger company. The distinction between growth companies and other SMEs becomes more relevant as the industry matures and more companies go this route, a phenomenon that will be reviewed in detail later in this chapter.
The figure below provides a schematic description of the general characteristics of the companies in each group, which may also include “non-stereotypical” companies. At the same time, the segmentation contributes to the understanding of each group's share of the industry and allows us to delve into the phenomena that characterize just some of the groups. Therefore, later in this chapter we will focus on the industry maturation trend and the formation of growth companies.
The industry is ready for the growth companies boom
In recent years, the change and maturation of the Israeli hi-tech industry has become noticeable. In the past, the Israeli industry has been largely known for its ability to make projects “out of nothing” and create commercial value out of an idea. Over the years, the impression has grown that Israelis know how to set up startups, but do not know how to manage and lead them to the next level. Several economists and public officials have made comments on this subject, arguing that in this manner Israel is realizing its comparative advantage vis-à-vis other countries, and that we should not push for change or be troubled by the culture of quick realization customary among Israeli entrepreneurs – they should be left to do what they do best, and the “professionals” (mainly executives from the US) should carry on from there. However, the price of this conduct was reflected in the loss of knowledge, management experience and great value for the Israeli economy, due to the lack of ability to grow companies locally.
Today, this impression is changing, mainly due to the increase of the number of startup companies that, instead of making a quick exit by selling themselves to a larger multinational, are taking the longer route to become full-fledged international players in their own right. Much of the data from past few years indicate the maturity of the industry, both on the entrepreneurs’ and the investors’ sides, to plan, finance and execute growth-oriented long-term approaches, as opposed to the rapid exit strategy, which was more common in the past. The main component that drives this change is time: the Israeli hi-tech industry is now entering the third decade since its breakthrough into the international community’s consciousness, and the cumulative experience gained is having its effect.
Maturing entrepreneurs – ready for a marathon
In recent years there has been an increase in the number of experienced entrepreneurs (those who have established at least 2 startups) out of the total number of entrepreneurs. These entrepreneurs have already gone through several major realization events, such as acquisition, merger or IPO, as well as a few resounding failures. They were involved in business activity at the global level, and were exposed to managing methods of their companies during the stages of growth after the realization event, following a commitment to remain with the company for a period of a few years. Thus, they were able to recognize the fuller potential of the technological solutions they themselves have created and promoted. This experience, together with huge IPOs of companies such as Mobileye, have helped increase the motivation and appetite of local entrepreneurs to take their next venture one step further, and not give in to the temptation to take an early exit.
Moreover, there is a noticeable increase in the time it takes for startup realization, which is indicative of a longer process of value enhancement prior to the realization date. As a result, the average exit value also went up more than 100% in the last five years. The merger trend among Israeli companies also testifies of the maturity on the part of the entrepreneurs. Several of these mergers, which amounted to record sums in terms of the nature of this activity in the Israeli industry (such as the purchase of EZchip by Mellanox for approximately USD 800 million, or the purchase of Supersonic by IronSource for approximately USD 200 million), are clarifying the understanding that emerges among local entrepreneurs, that they should join forces to reach the potential of a much higher value.
Maturing investors – increase in perseverance and long-term investment
The maturity of local entrepreneurs, large as it may be, is not enough by itself, as the entrepreneurs are frequently subject to the desires and realization strategies of their investors. Indeed, it is evident that the business environment and active investors in the field also support the trend of further developing companies. Nowadays investors are showing greater patience and longer-term thinking in the early stages of companies' development, which is expressed in the time granted for realization, as mentioned earlier. Some investors, who were entrepreneurs themselves, rely on their own experience and relevant connections in the local and global business sphere, to assist entrepreneurs in thinking big about the venture’s potential.
Later stages demonstrate increased involvement of the investors in the local arena, as well as a surge in investments in technology companies by PE funds. These investments are a fruitful ground for entrepreneurs interested in developing their company into a global leadership position. The amounts of capital being raised later in the growth stage reflect a similar trend.
The above data makes it clear that the present day conditions are right and more suitable for the local growth of more companies that in the future will become the economic anchor of the advanced hi-tech industry in Israel. This trend offers many advantages, especially in employment, the added value companies will produce and the export market. However, this trend is also expected to pose a number of challenges at the local level, such as: increasing demand for skilled employees (and the resulting rise in wage costs), the consolidation process that will lead to the closure of smaller competitors, and an increase in demand for financing sources that specialize in enterprise growth.
New players – new financing tools
The expansion of the industry, as well as the increased striving for independent growth, has resulted in a need to change the paradigm regarding the ways of funding hi-tech activity in Israel. To date, the most common forms of financing were based on equity. Currently, with the diversification of companies in the industry, and the emergence of new needs, like the need for capital growth, new financing tools are being created in order to cater to these requirements. In recent years, a new financing model has developed in Israel, and it involves debt financing by banks.
Until recently, various bodies, such as angel investors or venture capital funds, provided the financing of hi-tech, while the banks in Israel were not involved in this field. This was due to the fact that hi-tech companies are not like the usual borrowers from the bank: hi-tech companies are globally-oriented, and their activities are characterized by uncertainty, losses in the initial phase, long development periods followed by high growth rates, as well as frequent changes in ownership and operating models. Whereas, the banks are used to providing loans to entities with a certain monetary flow, securities and predictable income stream. Therefore, the involvement of the banks in the field was cautious and gradual, and it required them to make a series of adjustments, both technical and perceptional.
Accordingly, the possibility of hi-tech companies obtaining debt financing through banks and financial institutions – a common option in various Western countries, especially the United States – began to gain momentum in Israel in recent years. Israel's two leading banks see the hi-tech field as a strategic direction for the development of their business. Leumi Bank operates Leumitech – an independent company that specializes in providing unique products and services for hi-tech companies. Similarly, Bank Hapoalim had established Poalim Hi-Tech – a dedicated unit that specializes in financing of hi-tech companies. The third player operating in this field is the Silicon Valley Bank. SVB is an experienced entity in technology investing in the United States and around the world that has been operating in Israel since the late 1990s. These organizations offer hi-tech companies in all stages a variety of dedicated banking products, services and tools.
Today, the relative share of debt investments in hi-tech, as of 2015, is still small and is only about a quarter of a percent of the total credit granted by the banking system this year (which stands at about 900 billion shekels). However, it seems that this financing model has developed because it benefits the banks that share in the profits of Israel's most dynamic economic sector, as well as hi-tech companies that enjoy more financing channels. Another advantage of this model is that it leaves the companies’ control in Israeli hands, thus reducing their exposure to foreign investors and global financial system fluctuations. In light of this, the Israel Innovation Authority is currently examining the need to provide government guarantees for bank loans for startups that currently do not meet the bank's risk criteria. The purpose of this examination is to increase the supply of finance for hi-tech industry by expanding the range of companies that can benefit from debt financing.
What is debt financing?
The absolute majority of financing transactions in the Israeli hi-tech industry are based on equity. The equation is simple – whenever the company requires additional funding for development purposes, it begins to search for a potential investor. The eventual investor funds the company in order for it to be able to take the next step in its development, and in return he gets a partial ownership in the company and some of its profits. This operation is repeated at every development stage of the company, and involves a reappraisal of the value of the company, as well as ownership dilution of the original entrepreneurs and other costs associated with the transaction. However, when dealing with debt financing, the company applies to the bank for a loan and must return it under the conditions stipulated in advance, without giving up control of the company. Among other advantages of this financing model is avoiding redundancy of the above-mentioned procedural processes involved in raising equity, as well as saving time and effort of looking for investors and negotiations, which often require several months for completion.
The disadvantage of raising capital via debt financing stems from the fact that the money loaned must be returned, which is not an easy task for most hi-tech companies that have not yet reached profitability or predictable levels of sales. In addition, with debt financing no one expects the bank to promote the company or to work for its success, as an angel investor or a venture capital fund are able to do for the companies in their portfolios. Hence, debt financing is not suitable for all companies, and it is ideal mainly for companies in the sales stage, with competent leadership and a clear direction.
Hi-tech industry is ready for the next step
The maturing of the hi-tech industry in Israel is reflected in the accumulation of experience and expertise in the Israeli ecosystem – among both entrepreneurs and investors – in a variety of industry building aspects, from the development of know-how, to implementing a winning business strategy. Currently, the industry is mature enough for its next phase of development, which involves new challenges – business, technological, and national. The diligent attention of the Israel Innovation Authority will enable the realization of the hi-tech industry’s potential. As a result, the division-based structure of the Israel Innovation Authority was created, enabling a platform for a proper diagnosis of the needs and challenges faced by each of the above-mentioned groups, offering them suitable solutions. Appropriate policies and cooperation between the industry and the government at this stage are necessary conditions to realize the assets accumulated by the industry to-date, to accelerate the maturation and growth trends, as well as to leverage the benefits they embody in favor of the Israeli economy as a whole.
 The analysis is based on data from the database of the Startup Nation Finder, IVC, and Deloitte’s Fast 50 index. In order to classify the currently operating hi-tech companies into various industry groups, we divided all the companies listed in the SNC Finder database in accordance with criteria we set in advance. To identify the growth companies, we used Deloitte Technology Fast 50 index of 2015, which ranks 50 of the country's fastest-growing technology companies based on their growth percentage over the last four years (cumulative figure). Only companies that have grown by 30% per year (using geometric mean) and currently employ more than 100 employees, were defined as growth companies. We combined these companies with companies belonging to or candidates to join the Growth Companies Forum established in Israel in 2015, and received a final list of 30 companies.
 Sources of presented data are: Doing Business in Israel in 2015 report and the IVC database.