What do website gadget developer LabPixies and insulin pump maker Medingo have in common? It’s not only that both companies are based in Israel. They also are among the country’s start-ups that have attracted the attention of international investors, with U.S. Internet giant Google recently snapping up LabPixies and Swiss pharmaceutical multinational Roche buying Medingo, a subsidiary of local medical device conglomerate Elron Electronic Industries. Israel is indeed becoming fertile ground for the likes of Google, Roche and other companies looking to acquire innovative businesses to add to their portfolios.

That’s why when U.S. software firm Microsoft was scanning the globe for new sites to expand its international research and development presence a few years ago, Israel was on its itinerary, according to Zach Weisfeld, the firm’s country director of business development and strategy.

“Innovation, together with the engineering excellence and the very quick-to-market production of … high-quality products, really makes Israel shine,” Weisfeld noted at a recent conference in Washington, D.C., sponsored by the U.S. Chamber of Commerce titled, “The United States and Israel: Building Business Through Innovation.” Based in Haifa and high-tech hub Herzliya, the Israel site has become one of Microsoft’s three strategic global development centers since opening in 2006, responsible for much of the new technology which the firm is now known for, such as its free anti-virus software.

In becoming a hotbed of global high-tech innovation, Israel has made a virtue out of necessity, turning its small size — and the fact that it is based in one of the most politically charged regions in the world — to its advantage, according to other conference participants. “We live in a small country of 7.5 million people and we don’t have neighbors to trade with and don’t have many resources of our own,” said Nechemia “Chemi” Peres, chairman of the America-Israel Chamber of Commerce and managing general partner and co-founder of Pitango Venture Capital in Herzliya. “The only way to face the world market is through innovation and technology.”

But even with noted innovative efforts in sectors ranging from solar energy to electric vehicles, Israel has paid a high price for its economic dependence on the world market. For one thing, foreign direct investment in the country dropped dramatically during the global economic downturn, from $10.9 billion in 2008 to $3.9 billion in 2009, according to the World Bank.

Meanwhile, according to a November report from The Economist Intelligence Unit (EIU) in London, weak global demand for Israel’s exports has also hit the country hard. But recovery — although slow — is on the way. With growth in exports having dropped 11.4% in 2009, an increase of 6.3% is forecast for 2010 and 6.9% in 2011. Overall, GDP will grow 3.7% in 2010 and a “respectable” 3.4% next year, according to the EIU report. That’s good news for the country’s entrepreneurs, the EIU’s report noted: “After pausing last year, consumption per head — measured in U.S. dollar terms — is set to resume its upward trajectory in 2010, helped by a recovery in household incomes and a strengthening shekel.”

Calling on Support

Israel now has the second largest number of start-ups in the world, after the U.S., and the largest number of Nasdaq-listed companies outside North America. One of those is Given Imaging, a Nasdaq-listed medical technology company, based in Yoqneam, a city southeast of Haifa. The company got much of its initial funding in 1998 from Elron Electronic Industries. With markets now in 60 countries and offices around the world, revenue for the first nine months of 2010 increased to $112.9 million, up 11% from the same period the previous year. Asked about the key to the company’s survival, panelist Nachum Shamir, its president and CEO, was unequivocal: Israel’s small, tight-knit business community. “All you have to do is make a few phone calls to get the funding you need,” Shamir said. For that reason, about 90% of Israel’s start-ups raise at least some of their seed money locally, according to Pitango’s Peres.

Entrepreneurs have had another source of support: the government. The country is ranked number three in Southwest Asia and number 29 overall in the World Bank’s recent Ease of Doing Business Index, which considers, among other things, the simplicity and transparency of local business regulations. “I think the Israeli government has put tremendous resources into innovation,” Peres said.

One way that has been happening is by offering conditional grants to cover 50% of a company’s R&D costs, to be repaid if a project is successful. About 500 companies receive such grants each year. Other costs of getting a business up and running are covered as well. For example, through a partnership with Microsoft, the government offers start-up companies free Microsoft software for three years. According to Weisfeld, 700 start-ups have taken the government up on that offer.

But Peres, for one, wants the government to do more, particularly when it comes to encouraging companies from outside Israel to increase the flow of foreign direct investment. A step in that direction was taken over the summer, when the government launched a program to pay as much as half the salaries of bankers employed in Israel by international banks if they establish R&D centers in the country.

An additional step involves Pitango. Earlier this year, the VC company was part of a winning bid for an innovative joint government-private sector fund called Al-Bawadir (or “buds” in Arabic), beating out 11 other firms. The first fund of its kind, Al-Bawadir will soon invest in a range of start-up and mature companies belonging to minorities, a much-neglected part of Israel’s workforce. According to a report about the fund on news website Haaretz.com, Israel has 1.5 million Arab, Druze and other minority citizens, or 20% of the population, but their contribution to output is just 8%.

Peres, the son of Israeli President Shimon Peres, expects the fund to invest about $50 million in 20 to 30 manufacturing, service and high-tech companies over five years and mature in 10 years. “We’re already planning the sequel funds,” Peres told Haaretz newspaper in March.

Battlefield to Boardroom

Panelists at the conference also explored a different — and arguably unique — factor influencing innovation in Israel: how future business leaders and entrepreneurs, while conscripts in the country’s military service, pick up a raft of skills that are as useful in the boardroom as they are on the battlefield. With all young Israelis required to serve in the Israel Defense Forces (IDF) — 36 months for men, 21 months for women — “military service is so important here for getting young people to think outside the box and lead others,” Microsoft’s Weisfeld noted.

Gideon Argov, president and CEO of Entegris, a Massachusetts-based technology manufacturing company, listed six values he learned while serving in Israel’s army as a tank commander and operations officer that have been crucial to his success in business: clear thinking, resourcefulness, stamina, an ability to improvise, teamwork and leading by doing. “These are not values you learn at [business school] and they do not happen through an academic environment. But they do relate to entrepreneurial success and should be implanted in business,” said Argov, who, following his military service, went on to earn a bachelor’s degree at Harvard and an MBA at Stanford.

According to Argov, the first lesson he learned upon entering the IDF in 1974 was that “you have to question everything.” He described the environment then, when the surprise attack of the 1973 Yom Kippur War was still fresh in everyone’s memory. After the fighting ended, a government commission found serious flaws in the army’s intelligence branch, which had ignored various warnings of an attack. That failure, Argov said, encouraged a culture of questioning.

But there is one critical entrepreneurial value that isn’t — and shouldn’t — be taught on the battlefield: A culture of risk-taking, added Guy Filippelli, a former U.S. military intelligence officer who is CEO of Berico Technologies, a Virginia-based company providing analytic and technology services to U.S. intelligence and defense agencies. He conceded that even if risk-taking in boardrooms might not lead to success, it’s one of the necessary hazards of being at the cutting edge. “I always try to encourage failure,” he said. “You cannot be innovative without doing that.”