The Office of the Chief Scientist (OCS) at the Israeli Ministry of Economy has introduced its first annual Innovation Report. This report presents an overview of the Israeli hi-tech industry while describing the trends, challenges and opportunities in different sectors of the industry. The report was written in cooperation with several authorities, including the ministry's Employment Department, Digital Israel, the Program for Returning to Industry and Academia in Israel and others. It illuminates, in one place for the first time, different aspects of the country’s innovation ecosystem - from the state of human resources to the European framework program (Horizon 2020), from the life sciences program to a review of the growth and potential in the phenomenon of crowdfunding. 

According to the Chief Scientist in the Israeli Ministry of Economy, Avi Hasson: "This first innovation report summarizes current trends in Israel's hi-tech industry. With it, we begin an annual tradition of presenting an overall picture of the state of the industry in this country. I believe such a picture is necessary to analyze the trends developing before our eyes and to identify the main challenges we must face and the new opportunities at hand. It is incorrect to look at the hi-tech industry as monolithic - the “startup sector” and the more mature industry operate differently and require different tools if we are to move the market forward. Though 2014 was a hallmark year for Israeli startups, we are far from reaching the industry's full potential." 

Chief Scientist Avi Hasson added that: "The innovation report allows us, for the first time, to examine characteristics and trends which were until now isolated, to connect the dots and create an overall picture, with desired horizons of activity, clear goals and ways to meet new challenges. The ecosystem in which the hi-tech industry operates is multifaceted and complex. We identified five core components in this ecosystem: innovation policy, human capital, funding, industrial innovation and international activity. The report raises issues affecting anyone concerned with advancing the hi-tech industry and implementing innovation in the private and public sectors. Reviewing these issues is meant to serve as a basis for ongoing dialogue between the industry, investors, entrepreneurs and the government, and to direct our joint efforts towards attaining economic prosperity through technological innovation." 

The Need for New Funding Sources for the Industry 

2014 was a record year for raising capital for the hi-tech industry, but a look at the long-term trends reveals that sources of funding for the industry are not sufficiently robust: the venture capital model was shaken in recent years due to economic crises and relatively low yields, and this led to a selective reduction of the number of funds and to mergers by many players in the market. Moreover, the local stock market's position has been eroded and many companies choose to go public and raise money on foreign stock exchanges. 

In light of these changes, the industry must increase funding and diversify such sources as institutional bodies or the greater public through crowdfunding platforms. This would ensure that there are sufficient sources of funding for companies with different needs and that there won't be dependency on one dominant source. The OCS, whose budget has also diminished over the years, is partnering with the industry to pinpoint new sources of funding and remove obstacles limiting the use of alternative channels. 

Apart from increasing funding, there is great importance in diversifying sources which can be utilized as “Smart Money” - i.e. investments that will help companies grow and enter new markets. Even if capital-rich sources are found, “Smart Money” would still be lacking in some areas, i.e. investment which is not purely financial but which comes from investors with experience and ties in new markets, who can help companies grow and develop wisely.

Growing More Hi-tech Startups into Major Companies 

Israel has been blessed with a plethora of startups but many of them are quickly sold to larger companies and never grow to become major companies within Israel. Some claim that these "speed boats" - startups with quick exits - are where our market's competitive edge lies, but the OCS believes that growth of local "large ships" - i.e. mature companies - is crucial. Large companies employ a higher number and wider variety of employees and develop know-how within Israel. It is also more difficult to move their activities abroad. The challenge of company growth is not purely technological but also requires identifying market trends, grasping foreign cultures and understanding different markets - with the business development this entails. 

Therefore, the OCS shouldn't oppose entrepreneurs heading for exits, but rather create incentives and conditions that will make it worthwhile for Israeli companies to continue their growth in Israel. The OCS has seen many web-related companies that have demonstrated significant growth in recent years such as Outbrain or IronSource, but this is not enough - more companies like these are needed to become market leaders. 

Implementation and Development of Technologies in Traditional Branches and the Public Sector

Traditional industry in Israel is characterized by low-level technological proficiency and low productivity. Increasing access to innovative technologies and R&D and providing the means to implement them are the basis of increasing productivity in these branches. The Office of the Chief Scientist is leading a program supporting R&D in traditional industries and has invested NIS 1.5 billion in these industries in the past few years. Government services to citizens can also be greatly improved through technological innovation. To this end, the OCS is cooperating with Digital Israel, the bureau in charge of modernizing public services. 

Efficient and Smart Government Assistance 

Today, the structure and defined purview of the OCS is not in sufficient sync with its clients' needs and makes it difficult to provide timely, focused solutions. Therefore the OCS has recently led a wide-ranging strategic process examining how the OCS must adapt itself to the dynamic reality, while updating its instruments of support in light of the above challenges. With the establishment of the new government, the OCS intends to begin promoting the organizational changes this entails. The OCS is getting ready for a significant strategic-organizational shift, intended to increase accessibility for industry, focus the missions it undertakes and adapt its capabilities according to these goals. This will be accomplished by moving from an agency with a single funding structure to five centers of innovation, each with its own mission and target audience. 

According to Chief Scientist Hasson: "As an organization serving the innovation industry, we will strive to innovate the tools we utilize and increase experimentation with the diverse, creative means at our disposal. This, while maintaining our existing core of support for industrial R&D always with an eye towards what’s good for the market and advancing industry as a whole." 

The Hi-tech Index 

The Hi-tech Index is designed to differentiate between fledgling startups and more mature companies, and therefore help create a more focused work plan adapted to these different characteristics. The Hi-tech Index will help analyze the innovation ecosystem in Israel and outline a policy and the means to implement it, while keeping in mind a company's characteristics - first and foremost through clearly differentiating startups from mature companies. The startup industry is highly influenced by shifts in the financial world and behaves dynamically. The index allows us to follow flows and ebbs in startup activity and their connection to global developments. On the other hand, mature companies characteristically enter crises in a more controlled manner and usually recover relatively quickly.

A major part of the report deals with new funding alternatives: 

Strategic Investments and Corporate Venture Capital Funds 

Two main alternatives for Israeli tech firms other than raising funds or going public have become available in recent years. The first option is strategic acquisition by a major corporation with large cash reserves and the desire and ability to buy a startup or promising technology. This is much more than a purely financial deal since these major companies often serve as platforms for wide-scale distribution and an interface with a global crowd of consumers. This phenomenon has transformed the goals of many startups, which see it as a value-added proposition due to major corporations' willingness to pay sums exceeding the startup’s market value, following considerations like “synergy” or eliminating competition. This is backed up by recent examples in the global arena such as the acquisition of WhatsApp by Facebook for $22 billion in October 2014 and in the local arena with the acquisition of Waze by Google for $1.1 billion in June 2013. 

Another option is raising money through corporate venture capital funds, which are gradually becoming key players in the local industry, despite the fact that their scope of activity in Israel is still far from that in the US. Several foreign corporate venture capital funds are currently active in Israel, while Israeli corporate VCs investing in local ventures are all but nonexistent. Despite popular misconceptions, corporate VCs seeking innovative value for their activities are willing to invest in all stages of a company, particularly in their early stages. This is evident by the high number of corporate accelerators in Israel, from companies like Deutsche Telecom, Citi and others. 

The obvious advantages are the strong ties corporations have with the industry and access to infrastructure and know-how unique to the corporation. The main disadvantage can be an occasional conflict of interest between a corporation and the invested company. However, companies in the seed and pre-seed stages still do not sufficiently enjoy this channel of investment, many times because of the difficulties in identifying the appropriate contact who will open doors at the major corporation. 

More Alternatives: Micro-funds and Crowdfunding 

A wider look at the funding needs of Israeli technology companies shows that in the current business environment that enables sufficient funding for companies in early stages, many new startups are cropping up. As a result, there is "inflation" of seed companies reaching the first significant capital-raising stage (Round A). This typically involves a significant increase in companies' capital needs and the supply of concentrated capital by VC funds. On the other hand, funds have moved more and more in recent years to a "bigger bets" strategy, i.e. investing larger sums of money in a smaller number of companies which are predicted to make successful exits. Thus, the available capital is relatively limited considering the number of companies vying for it, especially in light of the extra demand for funding described above. The lack of Round A funding makes it difficult for many companies to finance their continued activity and sometimes they must either cut back or even close down (series A crunch). In the US, this phenomenon acted as a catalyst for the creation of funds specializing in investment in early-stages (micro-VC), and this trend is now coming to Israel. The Round A funding gap in Israel is estimated at $100-200 million. 

The blossoming of micro-VCs also comes from a change in companies' funding needs and the character of exits, especially in web, mobile and new media companies. Companies in these fields need relatively low amounts of money and strong competition leads to quick exits for relatively low sums. In answer to this need, micro-VCs have arisen, managing sums in the low tens of millions and investing small sums in companies at their early stages. They thus fill the gap left by large funds, interested in investing larger sums of money with an eye towards greater gains from large-scale exits. In the years 2011-2014, Israeli micro-VCs raised $440 million, 14% of the total capital raised by Israeli VCs. 

Another platform providing solutions for early-stage companies and gaining traction in recent years is crowdfunding. A more selective type of crowdfunding is the model of "smart investor clubs." This model is based on raising larger sums from a select crowd of wealthy and experienced investors. The Israeli OurCrowd equity-based crowdfunding platform is a trendsetter in this field. In less than two years, the company raised more than $90 million, invested in 55 companies and recruited more than 6,000 investors. 

Increased Interest by the Financial Sector in Hi-tech 

Another trend in early-stage funding is the increased interest shown by the financial sector in hi-tech. Recent steps taken by major banks show that the banking system understands the added value of hi-tech and is investing resources and efforts in harnessing it, both to facilitate intra-organizational innovation and to leverage credit for hi-tech (especially in an economic environment with a 0% interest rate). The lion’s share of funding in hi-tech today is supported by private equity. With an eye towards developing the field of debt financing in hi-tech, Bank Leumi and Bank Hapoalim have established tech branches giving this industry targeted solutions. A bank's tech branch will offer deep financial expertise in the world of hi-tech and increase the package of services given and the credit allotted to this field. Through services and funding options not currently available, and by giving added value to the companies themselves, banks intend to become major players in funding hi-tech companies. 

Another main channel of activity for advancing organizational innovation and improving banking services and user experience is investment in companies specializing in financial technology (fintech). Thus, Bank Leumi teamed up with The Elevator accelerator to launch a unique program for advancing innovative initiatives in the fields of finance and banking. Bank Hapoalim established a unique fund that will invest NIS 80 million in technology companies specializing in developing products for the financial markets. The Israeli financial sector’s openness to adopting and promoting technological innovation, as both investors and advisors, is expected to greatly assist the hi-tech sector. The OCS has begun examining additional ways to support this activity and increase the presence of the Israeli finance sector in Israeli hi-tech, especially where growing companies is the goal. 

It should be noted that the OCS runs 45 support programs in five main areas of activity: startups, technological infrastructure, growing companies, international activity and R&D programs. These programs enjoy a budget of NIS 1.5 billion annually and offer assistance in many fields, including: cyber-security biotechnology, life sciences, communications, software, cleantech and others. Chief Scientist programs reach all parts of the country and every branch of industry. 

The presence of foreign funds in Israel has been growing and as a consequence, so has Israeli hi-tech's dependence on foreign capital. So, for example, in 2013, foreign investors funded 75% of investments in Israeli companies and 85% of all capital raised by Israeli VCs. In effect, foreign funding is responsible for up to about half the R&D funding in Israel. Most foreign funding invested in Israeli VCs comes from the US, but in the last three years, there has been increasing interest from investors in Asia, mainly from China.