Israel’s “startup nation” is under threat from the tech giants that nurtured it

Israel’s technology talent has never been in higher demand. More than 300 global technology companies operate in this tiny Mediterranean country—most of them within an hour’s drive of Tel Aviv. A trickle first led by IBM, Intel, Microsoft, Motorola, and Cisco has become a flood of marquee brands: at least 117 companies from 21 countries have opened Israeli R&D centers since 2014, hoping to capture some of the magic in the country’s bubbling ecosystem of more than 6,000 startups.

But as the global giants arrive, they have been driving up salaries, rents, and reputations. Now some fear that the multinationals that once nurtured this fledgling technology powerhouse are unwittingly damaging the potent but fragile mix of entrepreneurship, military training, and chutzpah that drew them to it in the first place. That, they worry, could prevent it from developing into a mature digital economy.

Has Israel’s ecosystem reached an inflection point, or even a crisis? Local entrepreneurs worry that it has—for several reasons.

Reason 1: The talent shortage

“At the beginning we were thinking the more multinationals we bring here, the more jobs we’re going to have,” says Kira Radinsky, who became director of data science for eBay after it acquired her predictive-algorithm startup and is deeply involved in Israel’s digital industry. “What actually happened is that they are taking the jobs from the startups we actually want to grow here and the big companies we want to sustain here.”

The numbers bear this out. In its latest annual report, the Bank of Israel warns that Israel’s demand for qualified technology workers far outstrips supply. With a total high-tech workforce of fewer than 300,000 people, Israel now faces a chronic shortage of some 15,000 skilled engineers.

And things aren’t getting any better. Despite the foreign investment pouring in, the number of tech industry employees increased by just 4% from 2011 to 2015, even as the total population increased by nearly 8%. The proportion of high-tech staff in the business sector as a whole actually fell, from 12.6% to 11.7%.

A report issued in December 16 by Start-Up Nation Central—an NGO that grew out of a bestselling book by Saul Singer and Dan Senor, Start-Up Nation—confirms the trend. “As the demand for tech talent is rapidly increasing, it is not being matched by the supply of programmers, scientists, and engineers, creating a growing shortfall,” the report says.

Israeli companies, the report notes, are opening branches abroad to plug the talent gap: “Every fourth company reports having an overseas development team, Ukraine being the most favored location. Those companies employ about 25% of their entire workforce overseas.”

Reason 2: Overpaid workers

The second big worry for local companies is wage inflation. “The multinationals are raising the salaries,” says Radinsky. “The compensation is really big. A startup cannot afford a software engineer that a multinational can hire.” Tech wages, already more than double the national average, are increasing at twice the pace of pay in other sectors.

These tensions burst into the open a year ago when Amazon, Israel’s latest star arrival, offered to double or triple the salaries of engineers. It even approached people employed by Amazon’s own customers when they came to training seminars for its AWS cloud services. Entrepreneurs were not impressed.

“Just learned that Amazon is actively targeting and trying to poach Lemonade Inc. employees,” fumed Shai Wininger, founder and CEO of the online insurer, in a LinkedIn post. “I wonder if that’s their idea of supporting the start-up ecosystem. Reconsidering Amazon AWS.” Dozens of Israeli entrepreneurs chimed in on Facebook and LinkedIn—most echoing his sentiment.

Amazon rejected accusations that it was unfairly poaching staff with inflated offers. “We offer competitive financial packages, which are in line with other companies operating in the country,” the company told MIT Technology Review; it would not comment further.

Although that particular controversy has subsided, experts remain concerned that Israel’s technology sector could become a victim of its own popularity. “We live in a country of 8.5 million people,” says Michael Eisenberg, a partner at the venture capital firm Aleph, whose investments include Israeli-driven companies like WeWork and Wix. “We don’t have an unlimited talent pool. If you want to keep innovating, you need entrepreneurial upstarts to do that. If we want the entrepreneurial upstarts to scale up, they need access to talent. If they are competing with the deep pockets of the multinationals who have endless cash—it’s getting harder and harder.”

Eisenberg says a number of Israeli companies that have successfully grown big—including Check Point, Nice, and IronSource—give him confidence that Israel can mature into a “scale-up nation.” But he is concerned that the expanding presence of multinationals could slow that growth.

Reason 3: A slowing startup ecosystem

There is certainly evidence to suggest that the influx of multinational interest and investment is taking the fizz out of Israel’s startup ecosystem. The number of startups founded each year is falling, while the number that close each year is rising:

The total amount of capital raised by Israeli high tech continues to climb...

...but the number of deals has fallen by 10% since 2015.

Reason 4: Limited economic rewards

The final concern: foreign firms don’t benefit the Israeli economy nearly as much as home-grown ones do.

A recent trend has been for multinationals to buy Israeli companies and turn them into R&D branches. Apple did exactly that in 2011 when it bought Anobit, a flash memory company based just north of Tel Aviv, and turned it into its first research center outside the US.

Statistics show that for each employee of an Israeli high-tech manufacturer, two more local jobs are created. For each R&D center employee, on the other hand, only one-third of another job is created. When a growing local company turns into a research-based subsidiary of a foreign corporation, then, those potential jobs are lost. So are any intellectual-property revenues and taxes that the independent local business might have generated.

“A growing company needs product managers, accountants, lawyers, business managers,” says Eugene Kandel, a former head of Israel’s National Economic Council who is now CEO of Start-Up Nation Central. “It creates a circle around it. An R&D center doesn’t need anybody. All the functions in that company are outside of Israel.”

There are exceptions. Intel, says Kandel, operates like a “full company.” Its production centers and factories create a multiplier effect that benefits an entire hinterland of suppliers, support staff, and ancillary services. But most new arrivals aren’t developing full operations like Intel’s, restricting themselves to isolated activities.

“They grow, but they’re not businesses in the conventional sense of the word,” says David Rosenberg, economics editor for Haaretz and author of Israel’s Technology Economy: Origins and Impact. “It’s not like manufacturing, where you have outsourcing, subcontracting, and other multiplier effects. Seventy percent of the employees are coders and researchers. They don’t have secretaries and bookkeepers. They’re not actually making anything or selling anything,” he says. “So the spin-off factor is very minimal. It’s a bunch of guys sitting at computers. The most they do is order out a pizza.” 

The dependency trap

But the corporates won’t stop coming. That’s because they need Israel’s innovation, says Zack Weisfeld, who ran startup engagement teams for Microsoft in 110 countries before creating the first Microsoft accelerator in Israel.

“Corporate innovation is dead,” says Weisfeld. “There is more innovation happening outside than inside.” Everyone, he says, needs “skunk works”—offsite, visionary innovation teams of the kind initiated by Lockheed Martin in the 1930s and now practiced by businesses like Alphabet’s X. The Israeli version, nurtured in the army’s now-legendary cyber-intelligence units, is unique enough to keep its engineers in high demand, he says: “The organizations that are smart enough to understand they have that kind of magic are doing wonders.”

The converse is true as well, though: people with a startup mentality need big organizations, says Start-Up Nation author Saul Singer.

“Startups are great at innovation, but it’s very hard for them to scale up,” he says. “Big companies are very good at scaling—but it’s hard for them to innovate. So you combine the strengths of big companies and startups, and that’s a big part of startup nation.”

But this co-dependent relationship between local startups and big foreign firms is what ultimately threatens the “startup nation” model. Liad Agmon, a serial entrepreneur whose company Dynamic Yield provides e-commerce personalization services to major retailers including Under Armour and Urban Outfitters, points out that because of rising salaries, he has already started hiring engineers outside Israel at a fraction of the cost. And if he can do it, so can foreign multinationals: “If Israeli companies just become an R&D center for large international companies and there is a recession, they can cut loose all these engineers really quickly and offshore engineering to Ukraine, India, or Portugal at half the cost.”

The challenge, Agmon says, is for Israel to retain its competitive advantage—innovation—instead of becoming just another foreign engineering center, and a comparatively expensive one at that. “The risk is that the startup ecosystem will not continue flourishing and we will not have growing independent Israeli tech companies like Check Point and Wix,” he says.

Open up, but differently

So what can be done? The government-funded Israel Innovation Authority is taking one route by redirecting its support away from multinationals seeking to purchase local startups, and aiming instead at Israeli companies on the brink of maturity. It wants to help them succeed independently instead of selling out to foreign owners.

The multinationals don’t need government incentives, says Aharon Aharon, the former CEO of Apple in Israel, who now heads the Innovation Authority. “In the last two years about 70 multinationals came to Israel without any government funding,” he says. “I’m not against multinationals, but I’m against government funding for those companies for whom the current ecosystem is such that it will not benefit from them.”

The authority has earmarked more than $200 million in loans and grants to help growing companies avoid the “death valley” period when they have a working prototype but, faced with the challenge of moving to full market deployment, often seek to be acquired or heavily diluted.

“What we are looking for is that there will be ‘complete companies’ in Israel,” Aharon says—in other words, companies that keep the IP onshore and employ a range of staff in functions other than R&D. The contribution of such companies to Israel’s economy is “huge,” he adds.

Another way for Israel to solve the talent problem, says Saul Singer, might be to do what it does best: innovate. Israeli entrepreneurs should build multinational startups with colleagues from other countries, diversifying the talent pool and drawing on that diversity to deepen its innovation, he says.

Some people are already thinking in that direction. Eran Shir has founded Be in Tel Aviv (BETA), an initiative to attract more international entrepreneurs to set up shop in Israel. Michael Eisenberg has started teaching courses in sales and marketing skills to new immigrants at Aleph’s offices in Tel Aviv. The Israel Innovation Authority is pushing for companies to employ foreign workers and offering special five-year visas to foreign entrepreneurs.

“It’s not that startup nation is in danger or threatened,” says Singer. “The question is whether startup nation will realize its potential … to grow substantially, to double and triple the size of our system. That is possible, but we have to change the way we think about opening our doors.”