Israel has chalked up some remarkable successes in high technology, creating a strong start-up cluster that carries shades of California’s Silicon Valley. The country has spawned hundreds of new companies in information technology and communications as well as biotechnology and, to a lesser extent, clean technology. Between 2002 and 2011, Israeli technology companies raised some $15 billion from investors while the country became a hunting ground for tech multinationals seeking innovations through mergers and acquisitions. During that decade, start-ups gleaned more than $37 billion in foreign capital via initial public offerings or by being bought or merged in cross-border transitions. The value of Israel’s engineering talent is evidenced by the plethora of R&D centers in the country owned and operated by foreign companies. This,development — which has earned Israel the nickname “start-up nation” in some circles — has occurred despite the country being at the center of one of the world’s most politically volatile regions, during an era punctuated by frequent wars and terrorism, and far from the U.S., European and Asian technology markets.

Yet, Israel’s 20-year-old high-tech industry has not performed well against one important measure of success: All of the entrepreneurial and innovative activity has yet to create any large, industry-leading companies. In the Forbes 2000 ranking of the world’s biggest publicly traded companies measured by sales, Israel has a relatively large presence on the list, with 11 companies. Most of these, however, are holding companies geared to the domestic market, which says a lot about how much of the country’s small economy is in the hands of a few business groups. And despite its reputation as a technology center, Israel has only one tech company on the list, the network security company Check Point Software Technologies at number 1,390.

Based on its fiscal 2011 sales, Amdocs, which provides billing and other services to telecom companies, should have made the list, giving Israel a second presence in the ranking, but though the firm was founded in the nation, it is incorporated overseas. Compare that with three other smallish countries with knowledge-based economies, although without the record Israel has of generating start-ups: Switzerland has 45 companies on the Forbes list, three of which are tech companies; Sweden has 25 companies, of which three are tech-oriented; and Singapore was represented by 18 companies, two of which are engaged in technology.

Relative to its small population of 7.8 million people, Israel has an abundance of high-caliber engineering talent, which experts attribute to generally excellent universities and more importantly, an army that invests heavily in developing its own communications and other military technology. That enables large numbers of young Israelis — most of whom are drafted after high school — to receive early grounding in teamwork, leadership and creative problem-solving. These capabilities are then put to use in the civilian sector, both by those who serve in technology units or those in the ordinary service where many are given command responsibilities at an early age. The absence of big, knowledge-oriented industries means start-ups have less competition for the best managers and engineers.

To finance start-ups, Israel has abundant venture capital and a growing cadre of angel investors and companies ready to provide funding. There are incubators and accelerators to provide services, as well experienced attorneys, accountants and bankers familiar with the start-up environment and its special needs. This meeting of entrepreneurialism, engineering talent and venture capital has generated most years between 540 and 670 start-ups annually from 2005 to 2011, according to figures from IVC Research. In all likelihood, many more companies were formed under IVC’s radar.

When Goliath Acquires David

These start-ups follow a similar trajectory. The entrepreneur or entrepreneurs form a small team with the aim of developing a particular product or technology, traditionally in the Internet or business software. Increasingly, though, they are also focusing on fields such as mobile or cloud computing, where costs are low and time-to-market is fast. But the burgeoning firms will take their R&D only so far, perhaps no further than a beta product or some early sales before the start-up is acquired, often by a larger foreign (nearly always American) company. Members of the engineering team become employees of the acquiring company, forming a local R&D unit. The founding entrepreneur may stay on for a while before going on to form another new company. The result is that a promising start-up becomes part of a larger foreign behemoth before it can establish its global identity and grow into an Israeli giant.

Why Israel has failed to leverage its knowledge resources to build sustainable business is a matter of much debate in the country. Some observers have suggested the reason is cultural — an aversion to big organizations, processes and hierarchies that makes it difficult for Israelis to lead, follow and coordinate. In other words, the same factors that make Israel a start-up hothouse prevent it from building large businesses based on its own innovation. Others say it has to do with the risk-reward calculations made by entrepreneurs and investors.

“It’s a young country. When someone gets an order for a significant sum that can significantly improve his and his family’s financial status, the temptation is high,” says Tal Slobodkin, who works in acquisitions, investments and strategy for Cisco in Israel. Since 1998, Cisco has made 10 acquisitions in Israel and invested in 21 companies. “Definitely per capita this is the highest number and even by absolute numbers, this is higher than what we have in India and China, maybe Europe,” he notes.

Cisco is hardly alone in trawling the Israeli technology cluster in search of companies. “It’s easier to be bought,” Slobodkin adds. “Somebody in Barcelona with a great start-up company that could sell to Facebook doesn’t have a Facebook office 20 kilometers away or less. Here in Israel you see that. It’s hard to vet companies when you don’t have any presence.”

In the past, venture capital funds often took a lot of the blame for start-ups selling early, but Slobodkin and others say that is less so the case nowadays. Part of the reason is that foreign VCs are now a much bigger presence in Israel than they were five years ago. With much more capital to manage than local Israeli funds, the prospect of exiting a portfolio company for several tens of millions of dollars is not worth an overseas-based VC firm’s time or trouble. If the start-up doesn’t have the potential to grow and go public, it is hardly worth investing in to begin with, explains the Israeli manager one a major U.S. venture capital firm who asked not be identified.

In fact, the record of Israeli companies establishing and retaining a dominant market position, even in industries they pioneered, is poor. Scitex briefly held the leading position in pre-press design and layoff for the publishing industry before it collapsed during the PC revolution in the 1990s and 2000s. M Systems developed the USB flash drive but was sold to California-based SanDisk, a global leader in flash memory storage products. Metacafe was viewed by some of the world’s savviest venture capitalists as an early rival to YouTube as a video hub, but it ultimately failed. Comverse dominated the voicemail industry and later expanded to billing and other functions but lost traction due to a massive stock options scandal and, now much reduced in size, is feeling pressure from lower-cost Chinese rivals. Better Place, which raised some $800 million to develop a network of electric-vehicle refueling stations in Israel and abroad in partnership with Renault-Nissan, is running out of cash as sales have lagged far behind targets.

Some experts, including Saul Singer, co-author of Start-Up Nation, a 2009 book that lauds Israel’s high-tech industry, have argued that Israel can do perfectly well as a generator of innovation through small companies and has no need to build “an Israeli Nokia.” But the Israel tech industry’s narrow focus on start-ups and R&D companies comes at a cost to the wider economy. While Israel has enjoyed strong growth over the last decade, avoiding the fallout of the global economic crisis, and its unemployment rate is low by current Western standards, by other parameters it is faring poorly.

Weak Performance

Labor productivity has fallen behind leading Western countries and in 2011 was just $33.80 an hour, putting Israel 23rd among the 34 Organisation for Economic Co-operation and Development (OECD) countries, just behind Greece. Israel’s relatively low jobless rate belies the fact that the labor force participation rate is low. There are many reasons to account for this, among them the large and growing population of ultra-orthodox Jews whose men generally shun work for religious study. Much of Israeli business is dominated by domestic monopolies or near monopolies where the absence of competition gives firms little incentive to be either more efficient or more innovative.

Technology is the industry where Israel is supposed to have a comparative advantage. But that advantage is not being shared by much of the economy. The industry’s start-up focus means its employment base is narrowly focused on engineers and others involved in R&D. Although start-ups, like other small enterprises, are often lauded for their job-creating power, the fact is they create few jobs. Figures from the Israel Association of Electronics and Software Industries found that Israeli tech companies with 20 or fewer employees accounted for just 1.5% of total employment in the Israeli high tech industry. Those employing between 20 and 50 people made up 3.1%, those with 50 to 100 employees accounted for 6.7% and companies with 100 to 200 each on their payroll were 14.6%. Nearly three quarters of all employment in the industry was from companies with 300 or more employees.

A study by the recruitment firm Ethosia Human Resources produced for the financial daily Globes last year found that of the 10 biggest employers in Israel’s technology sector, three are defense companies that specialize in military electronics employing 36,000, and three are local units of foreign multinationals, with 14,000 people on their payroll. The four top Israeli non-defense companies together employed just 11,300 people.

The Ethosia study also shows how little employment Israel’s technology sector provides in other kinds of jobs normally found in business. Ethosia counted 198,500 people in technology, of which it had defined job categories for about 169,000. Of the latter, close to a third were employed as software and hardware engineers and designers. Among other categories, the industry employed more physicists (4,433) than it did people in sales (4,158) or finance (3,702).

Israel’s start-up obsession, however, may be changing and not only because of the demands of foreign venture capital funds. Besides industry veterans like Check Point, Amdocs, Nice Systems and Orbotech, new category leaders are emerging in semiconductors (Mellanox, EZchip), web analytics (Conduit, Babylon and Kaltura) and the Internet (Allot Communications and Wix) to name a few. “It’s true that we don’t have hundreds of multi-billion-dollar companies, but it’s a small country and you can’t expect every other company to be huge,” says Slobodkin. “These are companies reaching a billion-dollar valuation and they weren’t around 10 years ago.”

Eyal Gura, a serial entrepreneur with three companies under his belt, notes that as the industry matures and the entrepreneurs themselves move on to their second, third or fourth company, the urgency to cash out quickly diminishes. Gura himself is planning a new start-up in the health care information technology field, and says that this time he is in it for the long run. “The fact that I picked this specific field instead of a mobile app shows that my horizon has changed and that I can afford to think of bigger opportunities and take more risks,” Gura states. “You need regulatory approvals from the [U.S. Food and Drug Administration], and there are privacy issues and technology risks.” Nevertheless, Gura is confident that he can steer his business through those challenges and that he can find the capital and the managers to back him.

In any event, the competition for Israeli start-ups has grown as Europe, China and India have developed start-up clusters of their own. The old days when Israeli start-ups could pioneer a new category without fear of local competition are over, Gura says. “It’s a very big zero sum game. With online properties, there is a winner-take-all market dynamic. So if you look at browsers, e-commerce and payment systems, and email inboxes, usually the first two or three players are the ones who win — the rest close down or are taken over because they don’t create enough returns for investors,” Gura notes. “The so-called advantage we have in Israel is diminishing fast.”

Additional Reading:

The Israeli Innovation Enhancing Your iPhone

Tel Aviv: The Next Medical Device Cluster

Israeli Tech Companies Raise $1.92 Billion in 2012