Advice to Israeli start-ups: Go West

JERUSALEM, June 18 (JTA) — A 27-year-old Israeli software entrepreneur passed the first test toward fulfilling Israel’s new high-tech dream.

Benny Lehmann raised $3 million in the first round of funding for his start-up company.

If all goes well, Lehmann will steer his nascent Jerusalem-based firm, Digital Fuel Technologies, toward success by providing a solution to major problems faced by the emerging application service provider industry.

But amid the excitement of setting up a new business that perhaps, someday, could become the next rising Israeli star on the technology-heavy Nasdaq stock market, Lehmann is not all smiles.

Traveling halfway across the world on 18-hour flights every month for business meetings in California’s Silicon Valley has taught Lehmann what many of his peers have already discovered — he must move to the United States for his company to succeed.

“I’ve got to be close to the customers and potential future investors,” he says, acknowledging that he will probably have to relocate within months. “It’s very difficult. I feel much more comfortable here in Israel. But this is the only way to build a company today.”

As hundreds of new start-ups are established in Israel each year, Lehmann’s dilemma is one faced by a growing number of entrepreneurs. Venture capitalists who helped finance Lehmann’s start-up said registering in the United States is the only way for him to succeed.

“Yored,” the derogatory word once used to characterize Israelis who have decided to live abroad, is nowhere to be heard in the high-tech context. The move abroad has simply become a requisite necessity to build a company in a global business environment and, maybe, to increase the chances of getting rich along the way.

However, the trend shows that Israel’s high-tech sector is at a major crossroads even as it reaches astonishing new heights.

The quandary Israel faces as it tries to keep companies at home was clearly visible last month when Lucent Technologies, the world’s biggest telecommunications equipment manufacturer, bought Israeli-founded Chromatis Networks for $4.5 billion in stock. It was a record deal for a company founded by Israelis.

But like most Israeli start-ups today, Chromatis is not completely Israeli anymore. Chromatis is registered in Virginia, while maintaining a research and development center in Petach Tikva, near Tel Aviv.

Although Chromatis’ original investment team was led by Jerusalem Venture Partners, an Israel-based investment group, most of the investors who profited from the deal were American.

And even though Rafi Gidron and Orni Petruschka, the Israeli founders who have secured a place in the Israeli high-tech hall of fame, pocketed a personal windfall reported at $700 million each, they are unlikely to pay much tax in Israel due to smart tax planning that accompanies most corporate moves abroad.

The question is whether there is a clash between the needs of investors — who are pumping a record $2 billion into the venture capital industry alone this year — and the best interests of the Israeli economy, which is to keep companies based at home.

High-tech players complain that the business environment and tax system in Israel turns off foreign investors, who insist that companies register in the United States to make their lives easier.

Not only is this creating a brain drain of the smartest players in Israeli high-tech — since the founders usually leave with the company — but it could deprive Israel’s economy of tax revenues, thousands of potential jobs and indirect economic benefits of building global companies based in Israel.

For most entrepreneurs, the primary reason to move is because the United States is considered the key marketplace, and young companies need to be on the ground to sell their new technologies.

Even those who want to try to build an Israel-based company are left little choice.

“The first thing a fund manager tells an entrepreneur is to go establish headquarters in the U.S.,” says one entrepreneur, speaking on condition of anonymity because he has been soliciting several funds for financing. “I have gotten in trouble by saying I want to stay.”

A recent report by the Israel Democracy Institute, an independent think tank, warned that although the high-tech sector “saved the Israeli economy” during the 1990s, there is “no guarantee” that it would continue to be the engine for economic growth in the future.

Atop a list of “severe dangers” that threaten the Israeli high-tech boom, the report said that in the last year, 90 percent of “Israeli” high-tech companies were established overseas, mostly in the United States.

“There is no economic justification for establishing a company in Israel,” said the report. “A chief executive who establishes a company in Israel should be immediately fired for his irresponsibility.”

Rami Kalish, managing director at the Polaris Venture Capital group, Israel’s biggest venture fund, says the government is taking the issue more seriously. But it must move faster and quickly learn the rules of the game in a global business environment, or face a continued exodus of the most promising companies.

“If it will be easier and more profitable for entrepreneurs to go and incorporate companies in the U.S., that is what they will do and nothing will stop them,” he says. “Once this is understood, the rest is details.”

For its part, the government has taken some steps to improve some elements of the tax regime, under recent sweeping tax reform proposals. However, those reforms face fierce political objection from the Histadrut, Israel’s powerful trade union federation, and they may never get pushed through the political system.

In any case, says Avi Ben-Bassat, director general of the Finance Ministry and the architect of the reforms, the government cannot advocate policies that favor a particular industry.

Ben-Bassat agrees that high-tech is the “leading industry of the state of Israel” and says the government must “create a comfortable economic environment.

“But we cannot favor one sector or another,” he adds. “We have taken some steps that significantly increase the motivation of companies to continue operating in Israel. If we take away as many barriers as possible, I think more and more companies will stay.”

Chemi Peres, also a managing director at the Polaris fund, disagrees. He says the playing field must be completely leveled if Israel is to benefit from the creation of a sector that will be viable for the long term.

If not, Israel could end up being just a big research and development center for Silicon Valley companies.

“The Israeli economy has two options,” he says. “Either to have the industry set up as Israeli companies, and gain everything associated with it, or to have all Israeli companies go and register as foreign companies and we will lose all the benefits,”

“This is one of the main challenges facing the government,” he adds. “Either way, the industry will grow by itself.”