Start-Up Nation - The Story of Israel's Economic Miracle Part 6

As Eitan Wertheimer told Warren Buffett at the start of the 2006 Lebanon war, "We're going to determine which side has won this war by ramping up factory production to an all-time high, while the missiles are falling on us."10 Israelis, by making their economy and their business reputation both a matter of national pride and a measure of national steadfastness, have created for foreign investors a confidence in Israel's ability to honor, or even surpa.s.s, its commitments. Thanks to Dov Frohman, Eitan Wertheimer, and many others, the question of catastrophic risk, for investors and multinationals looking to do business in Israel, is virtually irrelevant. Israelis, by making their economy and their business reputation both a matter of national pride and a measure of national steadfastness, have created for foreign investors a confidence in Israel's ability to honor, or even surpa.s.s, its commitments. Thanks to Dov Frohman, Eitan Wertheimer, and many others, the question of catastrophic risk, for investors and multinationals looking to do business in Israel, is virtually irrelevant.

CHAPTER 10.

Yozma The Match John Lennon once said about the early years of rock and roll, "Before Elvis, there was nothing."On the success of venture capital and high-tech entrepreneurs.h.i.+p in Israel, to paraphrase Lennon, before Yozma, there was nothing.

-ORNA B BERRY ORNA B BERRY'S SON, Amit, delivered what would be the $32 million message. Amit had retrieved the voice-mail message for his mom. A vice president from Siemens, the German telecommunications conglomerate, had called. Orna Berry, away on yet another trip abroad to pitch her start-up to bigger companies looking to buy, had missed the call. The message from Siemens marked the beginning of a process that culminated in the first acquisition of an Israeli start-up by a European company. The transaction was finalized in 1995.

Though today it's a pretty commonplace event-Europeans have invested hundreds of millions of euros in Israeli companies-in 1995, for an Israeli start-up to be acquired by a European company was unheard-of. Orna Berry believes a new Israeli government program at the time, called Yozma, was what made it possible. She also believes that hundreds of other start-ups have had similar experiences because of the government's initiative.

Berry is hailed as one of Israel's leading business leaders.1 In 1997, she was named Israel's chief scientist in the Ministry of Industry, Trade, and Labor-Israel's innovation czar; in 2007, she became chair of the Israel Venture a.s.sociation. She earned a PhD in computer science from the University of Southern California, worked for the technology consulting company Unisys in the United States, and then returned to Israel to work for IBM and, later, for Intel. In 1997, she was named Israel's chief scientist in the Ministry of Industry, Trade, and Labor-Israel's innovation czar; in 2007, she became chair of the Israel Venture a.s.sociation. She earned a PhD in computer science from the University of Southern California, worked for the technology consulting company Unisys in the United States, and then returned to Israel to work for IBM and, later, for Intel.

But in 1992, she was a first-time entrepreneur. She founded Ornet Data Communications with five colleagues from Fibronics, one of Israel's early tech companies. Ornet Data developed software and equipment for local area networks (LANs), to double the speed of data transmission.

While most users were dialing into the World Wide Web through telephone lines, the Ethernet networking technology was growing as a way to connect LANs-groups of computers that were close together in homes and offices. LANs could move more information, faster, between computers in the network, but bandwidth was still quite limited. Ornet Data's solution created a switch for these networked computers that, Berry estimated, multiplied the bandwidth fifty times.

Ornet Data had just a handful of employees in Karmiel, a city in northern Israel, and an office in Boston that Berry used when she came through town. In the early days of the company, she flew to the United States repeatedly to try to raise money, but she soon realized there was none available.

"There was no mechanism for early-stage high-risk funding in the absence of local venture capital," she told us.2 Venture capital is investment funding that is usually put to work in high-growth technology companies. But for most foreign investors, putting money into Israel seemed absurd. To them, Israel was synonymous with ancient religions, archaeological digs, and deadly conflict. Even those investors who had marveled at Israel's R&D capabilities were spooked by the surge in violence that came with the Palestinian uprising-or intifada-in the late 1980s. This was before Dov Frohman's decision to keep Intel open during the 1991 Gulf War.

According to Jon Medved, founder of Israel Seed Partners, "You could talk to an American fund until you were blue in the face and say, 'Hey, come invest in Israel,' and they would laugh at you."3 Israel's dearth of venture capital through the 1980s was also creating other problems. In the West, the role of the venture capitalist is not simply to provide cash. It's mentoring, plus introductions to a network of other investors, prospective acquirers, and new customers and partners, that makes the venture industry so valuable to a budding start-up. A good VC will help entrepreneurs build their companies.

"It was very clear that something was missing in Israel at the time," said Yigal Erlich, another chief scientist, who was serving in the government in the late 1980s. "While Israel was very good at developing technologies, Israelis didn't know how to manage companies or market products."4 Israeli entrepreneurs had to think globally from the start, creating products for markets thousands of miles and several time zones away. But serious questions loomed: How to customize the product for the market? How to manufacture, market, and ultimately distribute the product to customers so far from the sh.o.r.es of the Mediterranean?

Before the introduction of venture capital in Israel, there were only two sources of funding. First, Israeli start-ups could apply to the Office of the Chief Scientist (OCS) for matching grants. These grants, however, didn't provide anywhere near the amount of money start-ups actually needed, and as a result, most failed. A government report published in the late 1980s claimed that 60 percent of the technology companies deemed worthy of OCS grants were unable to raise follow-on capital to market their products. They may have created great products, but they couldn't sell them.5 Second, Israeli companies could apply for what are called BIRD grants. Created from $110 million put up by the U.S. and Israeli governments, the Binational Industrial Research and Development (BIRD) Foundation created an endowment to support U.S.-Israeli joint business ventures. BIRD gave modest grants of $500,000 to $1 million, infused over two to three years, and would recoup funds through small royalties earned from successful projects.6 Ed Mlavsky became the executive director of BIRD when, in 1978, he made an offhand comment at a meeting of the U.S.-Israel Advisory Council on Industrial R&D. BIRD had been established two years earlier, but the foundation had not funded a single project. The council was meeting to choose a successor to run the foundation, and members were disappointed with the flock of candidates. Mlavsky, born in England but by now an American citizen, said, "Gentlemen, this is horrible; even I can do a better job than any of [the candidates]." The committee thought this was a great idea and tried to convince Mlavsky to quit his job as executive vice president of Tyco International and move his family to Israel. Mlavsky's wife wasn't Jewish and he didn't have a strong emotional connection to Israel, but at the urging of Jordan Baruch, the U.S. a.s.sistant secretary of commerce for science and technology, Mlavsky went to Israel to, as he says, "interview for a job I did not want in a country in which I had no wish to live." His wife was supportive; she had visited Israel in 1979 and fallen in love with the pioneering culture of the still young country. So Mlavsky took a sabbatical from Tyco, put their furniture in storage, and went to Israel. He would end up staying in the position for thirteen years, until he cofounded Gemini, one of Israel's first government-funded venture capital firms. Part of what appealed to Mlavsky was an openness in Israel to experiment with any idea, which he didn't fully appreciate until he was on the ground and immersed in Israeli life.

Mlavsky called BIRD a kind of "dating service," because he and his team played matchmaker between an Israeli company with a technology and an American company that could market and distribute the product in the United States. Not only that, but this matchmaker would subsidize the cost of the date.

Most of the U.S. tech companies BIRD pursued had limited R&D budgets. Because they were midsized to large publicly traded companies, they were skittish about dipping into the quarterly revenues to pay for costly research.

Mlavsky recalls, "We came to [U.S. companies] and said, 'There is this place called Israel, which you may or may not have heard of. We can put you in touch with smart, creative, and well-trained engineers there. You don't have to pay to hire them, relocate them, and you don't have to worry about what happens after the project is over. We will not only introduce you to such a group-we'll give you half the money for your part of the project and half the money the Israelis will need for their part."

To date, BIRD has invested over $250 million in 780 projects, which has resulted in $8 billion in direct and indirect sales.7 The impact of the BIRD program far surpa.s.sed mere revenues: it helped teach burgeoning Israeli tech companies how to do business in the United States. The companies worked closely with their American partners. Many rented office s.p.a.ce in the United States and sent employees overseas, where they could learn about the market and their customers.

In the absence of equity financing, BIRD provided a shortcut to American markets. Even when the venture failed, there was tremendous learning about how to create products designed for markets, as opposed to simply developing technologies.

By 1992, nearly 60 percent of the Israeli companies that went public on the New York Stock Exchange and 75 percent of those listed on the NASDAQ had been supported by BIRD.8 American venture capitalists and investors were beginning to take notice. And yet 74 percent of high-tech exports out of Israel were generated by just 4 percent of high-tech companies. American venture capitalists and investors were beginning to take notice. And yet 74 percent of high-tech exports out of Israel were generated by just 4 percent of high-tech companies.9 The benefits were not being widely dispersed. If new tech companies couldn't get BIRD or government grants, they had to master the art of "bootstrapping": using personal resources, connections, or any other means to cobble together funds. The benefits were not being widely dispersed. If new tech companies couldn't get BIRD or government grants, they had to master the art of "bootstrapping": using personal resources, connections, or any other means to cobble together funds.

Jon Medved tried bootstrapping when he went door-to-door to sell his father's optical transceivers in 1982. At the time, the company consisted of just ten people working out of an actual garage, building optical transmitters and receivers. Medved admitted that he had not taken a single math or physics cla.s.s in college and knew nothing about the nuances of the business that his father had put together. He also didn't know Hebrew.

"I would speak before groups of Israeli engineers who knew nothing about fiber," Medved recalls, "and give them a lecture about fiber optics. If they ever asked a tough technical question, I'd hide behind their Hebrew-'I can't understand you, sorry!' "10 Medved did write a business plan for the company, and he developed revenue projections on the first spreadsheet software available on his suitcase-sized computer; but, like Orna Berry, he found fund-raising to be impossible. Medved did write a business plan for the company, and he developed revenue projections on the first spreadsheet software available on his suitcase-sized computer; but, like Orna Berry, he found fund-raising to be impossible.

Chief scientist Erlich became fixated on ways to overcome the funding challenges facing entrepreneurs. But there was some opposition: "Don't waste your time and money on new, small companies. They're a losing proposition," detractors told him.11 Instead, government economists called for increased funding and partners.h.i.+ps between Israel and the big multinational companies, which at this point were employing thousands of Israelis. Instead, government economists called for increased funding and partners.h.i.+ps between Israel and the big multinational companies, which at this point were employing thousands of Israelis.

There was also another challenge bearing down on Israel at the time: how to deal with the nearly one million Soviet Jewish immigrants beginning to flood the country. The government believed that to absorb these immigrants, the Israeli economy would have to create half a million new jobs. With one out of every three Soviet immigrants a scientist, engineer, or technician, Israel's high-tech sector seemed to be the best solution. But existing R&D centers alone would never be able to handle that many new employees.

In 1991, the government created technology incubators-twenty-four of them. These incubators gave most Russian scientists the resources and financing they needed in the early stage of R&D for their innovations. The goal was not only to develop the technology but to determine whether or not that product could be commercialized and sold. The government funded hundreds of companies through payments of up to $300,000. This got many of the new Russian immigrants working at their craft, but those doling out the money had little, if any, experience with start-up ventures. The government financiers were unable to give these entrepreneurs the support and management they needed to turn these R&D successes into commercially viable products.

"Every year when I tried to review the success of these small companies, it was disappointing," said Erlich. "While they may have succeeded in R&D, we didn't see them succeed in growing companies."12 He became convinced that a private venture capital industry was the only antidote. But he also knew that in order to succeed, an Israeli VC industry would need strong ties with foreign financial markets. The international connections were not just about raising funds; aspiring Israeli VCs needed to be mentored in the art of business mentoring. There were thousands of venture capital firms in the United States that were involved in the nuts and bolts of successful tech start-ups in Silicon Valley. They had experience building companies, understood the technology and the funding process, and could guide first-time entrepreneurs. That's what Erlich wanted to bring to Israel. He became convinced that a private venture capital industry was the only antidote. But he also knew that in order to succeed, an Israeli VC industry would need strong ties with foreign financial markets. The international connections were not just about raising funds; aspiring Israeli VCs needed to be mentored in the art of business mentoring. There were thousands of venture capital firms in the United States that were involved in the nuts and bolts of successful tech start-ups in Silicon Valley. They had experience building companies, understood the technology and the funding process, and could guide first-time entrepreneurs. That's what Erlich wanted to bring to Israel.

That's when a band of young bureaucrats at the Ministry of Finance came up with the idea for a program they called Yozma, which in Hebrew means "initiative."

As Orna Berry told us, "John Lennon once said about the early years of rock and roll, 'Before Elvis, there was nothing.' On the success of venture capital and high-tech entrepreneurs.h.i.+p in Israel, to paraphrase Lennon, before Yozma, there was nothing."13 The idea was for the government to invest $100 million to create ten new venture capital funds. Each fund had to be represented by three parties: Israeli venture capitalists in training, a foreign venture capital firm, and an Israeli investment company or bank. There was also one Yozma fund of $20 million that would invest directly in technology companies.

The Yozma program initially offered an almost one-and-a-half-to-one match. If the Israeli partners could raise $12 million to invest in new Israeli technologies, the government would give the fund $8 million. There was a line around the corner. So the government raised the bar. It required VC firms to raise $16 million in order to get the government's $8 million.

The real allure for foreign VCs, however, was the potential upside built into this program. The government would retain a 40 percent equity stake in the new fund but would offer the partners the option to cheaply buy out that equity stake-plus annual interest-after five years, if the fund was successful. This meant that while the government shared the risk, it offered investors all of the reward. From an investor's perspective, it was an unusually good deal.

"This was a rare government program that had a built-in get in and get out," said Jon Medved. "This was key to its success." And it was also rare for a government program to actually disappear once it had served its initial purpose, rather than continue indefinitely.

At the time, most business-savvy Diaspora Jews were not investing in Israel. They viewed philanthropy and business as two distinct activities. While they would make huge donations to not-for-profit organizations that benefited Israel, for the most part they were reluctant to invest in Israel's high-tech endeavors.

There were exceptions, of course.

Stanley Chais, a money manager in California, helped raise money for the first round of Yozma funds by setting up parlor meetings in California with wealthy Jews. He raised millions of dollars for the funds. Erel Margalit, who left the Jerusalem Development Authority to manage one of the first funds, said that most of the first round of funding was raised from people who had a "warm place in their heart for Jerusalem or Israel." Margalit's first inst.i.tutional investor was the French insurance giant GAN, whose chairman was a French Jew Margalit met by chance on a flight to Paris.

"The government was used as the catalyst," said Erlich. The first Yozma fund was created in partners.h.i.+p with the Discount Israel Corporation, an investment bank, and Advent Venture Partners, a premier VC firm from Boston. It was led by Ed Mlavsky, the longtime director of the BIRD Foundation, and Yossi Sela.

Clint Harris, a partner at Advent, said he knew something was different about Israel on his first trip. In the taxicab on the way from the airport to his Tel Aviv hotel, the driver asked him why he was visiting Israel. Harris replied that he was there to get a sense of the venture capital industry. The driver then proceeded to give Harris a briefing on the state of VC in Israel.

The Advent-sponsored fund would be called Gemini Israel Funds. One of its first investments was in November 1993, when it allocated $1 million to Ornet Data Communications. This investment, as well as the managerial help, was just what Ornet needed to succeed. Recognizing the company management's lack of business experience, Mlavsky and Sela helped recruit Meir Burstin to serve as chairman of the board for the new company. Burstin was an old hand in the high-tech entrepreneurial world, having founded and led Tekem, one of Israel's first software companies, and then served as president of Tadiran, one of Israel's big defense-technology companies. Burstin brought instant credibility and experience to Ornet.

When the company was teetering on the brink of closing down after wasting the first big financing round, Yossi Sela from Gemini took over as interim CEO of the company and commuted from Ramat Hasharon to Karmiel, a two-hour drive, four days a week. "It took six months of single-minded determination," Sela recalled, "from both Gemini and the Ornet founding team, to sell the company and keep the management team from splintering-not to mention more hours driving from Ramat Hasharon to Karmiel than I'd like to remember-but we did it."14 The other piece that was critical to the company's success was Gemini's ability to bring Walden Venture Capital in as an investor. Walden, an established firm in Silicon Valley, had experience in the kind of technology Ornet had developed. Returning over three times its investment in about two years made Ornet Gemini's first success story.

The ten Yozma funds created between 1992 and 1997 raised just over $200 million with the help of government funding. Those funds were bought out or privatized within five years, and today they manage nearly $3 billion of capital and support hundreds of new Israeli companies. The results were clear. As Erel Margalit put it, "Venture capital was the match that sparked the fire."15 Several of the Yozma funds had high-profile successes early on, with investments in companies such as ESC Medical, which designed and built light-based medical solutions like lasers; Galileo, a high-end semiconductor firm; Commontouch, an enterprise e-mail and messaging provider; and Jacada, which builds online work s.p.a.ces for customer-service employees at leading companies.

Along the way, others jumped into the venture capital world-even without the government's Yozma backing. Jon Medved just missed the Yozma financing. Years after he sold the company he and his father had built, he heard that there was a $5 million Yozma allotment available to invest in very-early-stage companies. Known as seed funds, these investments tend to be considered the riskiest, so Yozma offered a one-to-one match: investors had to bring $2.5 million to the table to get the government's $2.5 million.

Medved went to Yigal Erlich with investors ready to write checks and asked for the grant. Unfortunately, it was too late. But it didn't matter. The Yozma program was generating the buzz in the U.S. venture community to overcome investors' reticence about doing business in Israel. "Israel had excited investors enough that we were able to bring in the $2.5 million and start Israel Seed Partners in 1994," even without the government's matching grant, Medved said. The fund would quickly grow to $6 million, and Israel Seed would go on to raise $40 million in 1999 and $200 million in 2000.

According to the Israel Venture a.s.sociation, there are now forty-five Israeli venture capital funds. Ed Mlavsky said that over the period from 1992 to early 2009, there have been as many as 240 VCs in Israel, defined as companies both foreign and domestic investing in Israeli start-ups.

Soon other governments around the world were taking notice of Yozma's success. Chief scientist Erlich got calls from foreign governments, including j.a.pan, South Korea, Canada, Ireland, Australia, New Zealand, Singapore, and Russia, all wanting to come to Israel and meet the founders of Yozma.

In December 2008, Ireland launched a 500 million "innovation fund" designed to attract cofinancing from foreign venture capitalists. "The Irish state-ironically for a country that didn't have diplomatic relations with Israel for the first 40 years of its existence-has copied the Jewish state," wrote Irish economist David McWilliams.

Like Yozma, the Irish innovation fund lures foreign VCs to Ireland through a series of state-backed venture capital funds that partner up with private-sector funds.

McWilliams said, "The big idea is not to attract only U.S. capital and commercial know-how, but to suck in entrepreneurs from all over Europe. At the moment, Europe has huge reservoirs of scientific talent, but a very poor record at creating start-ups. The question many investors ask is: where is the European Google? It's a fair question. In the next ten years, what if that European Google was set up here using Irish and European brains and U.S. capital? That is the prize."16 Yozma provided the critical missing component that allowed the Israeli tech scene to join in the tech boom of the 1990s. But in 2000, the Israeli tech sector was. .h.i.t by multiple blows at once: the global tech bubble burst, the Oslo peace process blew up into a wave of terrorism, and the economy went into a recession.

Yet Israel's start-ups quickly adapted and rebounded. During this period, Israel doubled its share of the global venture capital pie with respect to Europe, growing from 15 to 31 percent. This growth occurred, however, within a tax and regulatory environment that, while favoring technology start-ups and foreign investors, did not offer the same support to the rest of the economy.

For example, while a technology start-up could attract financing from numerous sources, anyone trying to launch a more conventional business would have a lot of trouble getting a simple small business loan. Israel's capital markets were highly concentrated and constrained. And a particular industry that would seem to be a natural for Israel-financial services-was prevented from ever getting off the ground.

In 2001, Tal Keinan graduated from Harvard Business School. "Many of my friends who were going off to work on Wall Street were Jewish, and it struck me that the Jewish state doesn't have such an industry. When it came to managing investments, Israel was not even on the map," Keinan said.

The reason was government regulations. In venture capital, Keinan discovered, "the way the regulatory and tax regime was set up here, you could essentially operate as though you weren't in Israel, which was great, and it created a wonderful industry. The government basically kept its hands off of venture capital." But, he adds, "you couldn't do anything outside of venture capital in any meaningful way. You weren't allowed to take the performance fees on any money you managed, so you could forget that entire industry. It was a nonstarter."17 The a.s.set-management business has a simple model: firms receive a flat management fee of about 1 to 2 percent of the money they manage. But the real upside is in performance fees, which are typically 5 to 20 percent of the return on the investment, depending on the firm.

Until January 2005, it was illegal for Israeli money-management firms to charge performance fees. So not surprisingly, there was no industry to speak of.

The change came from then finance minister Benjamin "Bibi" Netanyahu.

With Prime Minister Ariel Sharon's backing in 2003, Netanyahu cut tax rates, transfer payments, public employee wages, and four thousand government jobs. He also privatized major symbols of the remaining government influence on the economy-such as the national airline, El Al, and the national telecommunications company, Bezeq-and inst.i.tuted financial-sector reforms.

"In the sense that he tackled the stifling role of government in our economy, Bibi was not a reformer but a revolutionary. A reform happens when you change the policy of the government; a revolution happens when you change the mind-set of a country. I think that Bibi was able to change the mind-set," said Ron Dermer, who served as an adviser to four Israeli ministers of finance, including Netanyahu.18 Netanyahu told us, "I explained to people that the private economy was like a thin man carrying a fat man-the government-on its back. While my reforms sparked ma.s.sive nationwide strikes by labor unions, my characterization of the economy struck a chord. Anyone who had tried to start a [nontech] business in Israel could relate."19 Netanyahu's reforms gained increasing public support as the economy began to pull out of its rut. Netanyahu's reforms gained increasing public support as the economy began to pull out of its rut.

At the same time, a package of banking-sector reforms pushed through by Netanyahu began to take effect. These reforms launched the phaseout of the government's bonds that had guaranteed about 6 percent annual return. Up until that point, a.s.set managers for Israeli pensions and life insurance funds simply invested in the Israeli guaranteed bonds. The pension and life insurance funds "could meet their commitments to beneficiaries just by buying the earmarked bonds. So that's exactly what they did-they didn't invest in anything else," Keinan told us. "Because of these bonds, there was no incentive for Israeli inst.i.tutional investors to invest in any private investment fund."

But as the government bonds began to mature and could not be renewed, they released some $300 million a month that needed to be invested elsewhere. "So all of a sudden, boom, you've got a local pool of capital to spark an investment industry," noted Keinan, as we sat, looking out at the Mediterranean, in his thirtieth-floor office in Tel Aviv, which is where his new investment fund is headquartered. "As a result, there are very few large international money managers that don't have some exposure in Israel now, either in equities or the new corporate bond market, which didn't exist three years ago, or in the shekel."

Because of Netanyahu's financial-sector reforms, it also became legal for investment managers to charge performance fees. Keinan didn't waste any time; he founded KCPS, Israel's first full-spectrum financial-a.s.set-management firm, in Tel Aviv and New York. "The moment I read the draft law of Bibi's reforms, my wheels started turning," Keinan said. "It was clear that this truly could liberate our non-high-tech economy."

Keinan argues that a ton of local talent was untapped. "If you think about what young Israelis learn in some of the army intelligence units, for example . . . often highly sophisticated quant.i.tative a.n.a.lytical skills-algorithms, modeling out macroeconomic trends. If they wanted to go into high tech, there were plenty of start-ups that would gobble them up after their army service. But if they wanted to go into finance, they'd have to leave the country. That's now changed. Just think about this," he continued. "There are Israelis working on Fleet Street in London because there was no place for them here. Now, since 2003, there is a place for them in Israel."

PART IV.

Country with a Motive

CHAPTER 11.

Betrayal and Opportunity

The two real fathers of Israeli hi-tech are the Arab boycott and Charles de Gaulle, because they forced on us the need to go and develop an industry.

-YOSSI V VARDI THROUGHOUT THIS BOOK, we've pointed to the ways the IDF's improvisational and antihierarchical culture follows Israelis into their start-ups and has shaped Israel's economy. This culture, when combined with the technological wizardry Israelis acquire in elite military units and from the state-run defense industry, forms a potent mixture. But there was nothing normal about the birth of Israel's defense industry. It was unheard-of for a country so small to have its own indigenous military-industrial complex. Its origins are rooted in a dramatic, overnight betrayal by a close ally. we've pointed to the ways the IDF's improvisational and antihierarchical culture follows Israelis into their start-ups and has shaped Israel's economy. This culture, when combined with the technological wizardry Israelis acquire in elite military units and from the state-run defense industry, forms a potent mixture. But there was nothing normal about the birth of Israel's defense industry. It was unheard-of for a country so small to have its own indigenous military-industrial complex. Its origins are rooted in a dramatic, overnight betrayal by a close ally.

The best way to understand Israel's watershed moment is through a shock to Americans that had a similar effect. During the postwar boom years, America's global status was suddenly punctured when the Soviet Union upstaged the United States by launching the first s.p.a.ce satellite-Sputnik 1. That the Soviets could pull ahead in the s.p.a.ce race stunned most Americans. But in retrospect, it was a boon for the U.S. economy.

Innovation economist John Kao says that Sputnik Sputnik "was a wake-up call, and America answered it. We revised school curricula to emphasize the teaching of science and math. We pa.s.sed the $900 million National Defense Education Act (about $6 billion in today's dollars), providing scholars.h.i.+ps, student loans, and scientific equipment for schools." "was a wake-up call, and America answered it. We revised school curricula to emphasize the teaching of science and math. We pa.s.sed the $900 million National Defense Education Act (about $6 billion in today's dollars), providing scholars.h.i.+ps, student loans, and scientific equipment for schools."1 NASA and the Apollo program were created, as was a powerful new Pentagon agency dedicated to galvanizing the civilian R&D community. NASA and the Apollo program were created, as was a powerful new Pentagon agency dedicated to galvanizing the civilian R&D community.

A little over a decade later, Neil Armstrong stepped onto the moon. The Apollo program and the Pentagon's related defense investments spurred a generation of new discoveries that were ultimately commercialized, with a transformative impact on the economy. This concerted research and development campaign gave birth to entirely new business sectors within avionics and telecommunications, as well as the Internet itself, and became a legacy of America's response to Sputnik Sputnik.

Israel had its own Sputnik Sputnik moment, ten years after America's. On the eve of the 1967 Six-Day War, Charles de Gaulle taught Israel an invaluable lesson about the price of dependence. moment, ten years after America's. On the eve of the 1967 Six-Day War, Charles de Gaulle taught Israel an invaluable lesson about the price of dependence.

De Gaulle, a founder of France's Fifth Republic, had been in and out of senior military and government positions since World War II and served as president from 1959 to 1969. After Israel's independence, de Gaulle had forged an alliance with the Jewish state and nurtured what Israeli leaders believed to be a deep personal friends.h.i.+p. The alliance included a French supply of critical military equipment and fighter aircraft, and even a secret agreement to cooperate in the development of nuclear weapons.2 Like many small states, Israel preferred to buy large weapon systems from other countries, rather than devote the tremendous resources needed to produce them. But in May 1950, the United States, Britain, and France jointly issued the Tripart.i.te Declaration to limit arms sales to the Middle East.

With no ready supply from abroad, Israel had already begun its arms industry with underground bullet and gun factories. One factory was literally hidden underground, beneath a kibbutz laundry; the machines were kept running to mask the banging noise from below. This factory, built with war-surplus tools smuggled from the United States, was producing hundreds of machine guns daily by 1948. Makes.h.i.+ft factories were supplemented by scattershot gunrunning across the globe. David Ben-Gurion had sent emissaries abroad to collect weapons as far back as the 1930s. In 1936, for example, Yehuda Arazi managed to stuff rifles into a steam boiler headed from Poland to the port of Haifa. In 1948, he posed as an amba.s.sador from Nicaragua to negotiate the purchase of five old French mounted guns.

The Israelis got by on these banana republic schemes until 1955, when the Soviet Union, via Czechoslovakia, ignored the leaky Tripart.i.te Declaration and made a ma.s.sive $250 million arms sale to Egypt. In response, de Gaulle took the other side. In April 1956, he began to transfer large quant.i.ties of modern arms to Israel. The tiny state finally had a reliable and first-rate national arms supplier.

After Egypt nationalized the Suez Ca.n.a.l in 1956, the relations.h.i.+p only deepened. France relied on the Suez for sea transport from the region to Europe. The IDF helped guarantee French access to the Suez, and France in return showered Israel with more arms. The supply only grew as the French and the Israelis colluded on more and more operations. De Gaulle's spy agency enlisted Israel's help in undermining anti-French resistance in Algeria, one of France's colonial strongholds. In 1960, France promised to supply Israel with two hundred AMX-13 tanks and seventy-two Mystere fighter jets over the next ten years.3 But on June 2, 1967, three days before Israel was to launch a preemptive attack against Egypt and Syria, de Gaulle cut Israel off cold. "France will not give its approval to-and still less, support-the first nation to use weapons," he told his cabinet.4 But there was more to de Gaulle's decision than trying to defuse a Middle East war. New circ.u.mstances called for new French alliances. By 1967, France had withdrawn from Algeria. With his long and bitter North African war behind him, de Gaulle's priority was now rapprochement with the Arab world. It was no longer in France's interest to side with Israel. "Gaullist France does not have friends, only interests," the French weekly Le Nouvel Observateur Le Nouvel Observateur remarked at the time. remarked at the time.5 De Gaulle's successor, Georges Pompidou, continued the new policy after his own election in 1969. The two hundred AMX tanks France had originally committed to Israel were to be rerouted to Libya, and France even sent fifty Mirage jet fighters Israel had already paid for to Syria, one of Israel's fiercest enemies.

The Israelis quickly pursued stopgap measures. Israeli Air Force founder Al Schwimmer personally recruited a sympathetic Swiss engineer to give him the blueprints to the Mirage engine, so Israel could copy the French fighter. Israel also returned to its pre-state smuggling exploits. In one mission in 1969, five Israeli-manned gunboats battled twenty-foot waves on a three-thousand-mile race from France to Israel; these naval vessels, worth millions of dollars, had been promised to Israel before the new embargo. As Time Time magazine colorfully described it in 1970: "Not since Bismarck has there been such a sea hunt. . . . At various points, [the Israelis] were tracked by French reconnaissance planes, an R.A.F. Canberra from Malta, Soviet tankers, the radar forests of the U.S. Sixth Fleet, television cameramen and even Italian fishermen." magazine colorfully described it in 1970: "Not since Bismarck has there been such a sea hunt. . . . At various points, [the Israelis] were tracked by French reconnaissance planes, an R.A.F. Canberra from Malta, Soviet tankers, the radar forests of the U.S. Sixth Fleet, television cameramen and even Italian fishermen."6 These shenanigans, however, could not compensate for the hard truth: the Middle East arms race was accelerating just at the moment that Israel had lost its most indispensable arms and aircraft supplier. The 1967 French embargo put Israel in an extremely vulnerable position.

Prior to the 1967 war, the United States had already begun to sell weapons systems to Israel, starting with the transfer of Hawk surface-to-air missiles by the Kennedy administration in 1962. Jerusalem's first choice, then, was for the United States to take France's place as Israel's main arms supplier. But the French betrayal had built a consensus in Israel that it could no longer rely so heavily on foreign arms suppliers. Israel decided that it must move quickly to produce major weapons systems, such as tanks and fighter aircraft, even though no other small country had successfully done so.

This drive for independence produced the Merkava tank, first released in 1978 and now in its fourth generation. It also led to the Nesher-Israel's version of the Mirage aircraft-and then to the Kfir, first flown in 1973.7 The most ambitious project of all, however, was to produce the Lavi fighter jet, using American-made engines. The program was jointly funded by Israel and the United States. The Lavi was designed not only to replace the Kfir but to become one of the top-line fighters in the world.

The Lavi went into full-scale development in 1982; on the last day of 1986, the first plane took its inaugural test flight. But in August 1987, after billions of dollars had been spent to build five planes, mounting pressure in both Israel and the United States led to the program's cancellation, first by the U.S. Congress and then by a 1211 vote in the Israeli cabinet.

Many years later, the project and its cancellation still remain controversial: some people believe that it was an impossibly ambitious boondoggle from the beginning, while others claim that it was a great opportunity missed. In a 1991 article in Flight International Flight International magazine, published during Operation Desert Storm, an editor wrote about his experience flying the Lavi back in 1989: "Now when the coalition forces fight in the Gulf they miss the aircraft they really need. It's a real shame that I had to fly the world's best fighter knowing it would never get into service." magazine, published during Operation Desert Storm, an editor wrote about his experience flying the Lavi back in 1989: "Now when the coalition forces fight in the Gulf they miss the aircraft they really need. It's a real shame that I had to fly the world's best fighter knowing it would never get into service."8 Even though the program was canceled, the Lavi's development had significant military reverberations. First, the Israelis had made an important psychological breakthrough: they had demonstrated to themselves, their allies, and their adversaries that they were not dependent on anyone else to provide one of the most basic elements for national survival-an advanced fighter aircraft program. Second, in 1988 Israel joined a club of only about a dozen nations that had launched satellites into s.p.a.ce-an achievement that would have been unlikely without the technological know-how acc.u.mulated during the Lavi's development. And third, although the Lavi was canceled, the billions invested in the program brought Israel to a new level in avionic systems and, in some ways, helped jump-start the high-tech boom to come. When the program shut down, its fifteen hundred engineers were suddenly out of jobs. Some of them left the country, but most did not, resulting in a large infusion of engineering talent from the military industries into the private sector. The tremendous technological talent that had been concentrated on one aircraft was suddenly unleashed into the economy.9 Yossi Gross, one of the Lavi's engineers, was born in Israel. His mother, who'd survived Auschwitz, emigrated from Europe after the Holocaust. As a student in Israel, Gross trained in aeronautical engineering at the Technion and then worked at Israel Aircraft Industries (IAI) for seven years.

Gross, a test-flight engineer at IAI, began in the design department. When he came up with a new idea for the landing gear, he was told by his supervisors to not bother them with innovations but to simply copy the American F-16. "I was working in a large company with twenty-three thousand employees, where you can't be creative," he recalled.10 Shortly before the Lavi's cancellation, Gross decided to leave not only IAI but the whole aeronautics field. "In aeros.p.a.ce, you can't be an entrepreneur," he explained. "The government owns the industry, and the projects are huge. But I learned a lot of technical things there that helped me immensely later on."

This former flight engineer went on to found seventeen start-ups and develop over three hundred patents. So, in a sense, Yossi Gross should thank France. Charles de Gaulle hardly intended to help jump-start the Israeli technology scene. Yet by convincing Israelis that they could not rely on foreign weapons systems, de Gaulle's decision made a pivotal contribution to Israel's economy. The major increase in military R&D that followed France's boycott of Israel gave a generation of Israeli engineers remarkable experience. But it would not have catalyzed Israel's start-up hothouse if it had not been combined with something else: a profound interdisciplinary approach and a willingness to try anything, no matter how destabilizing to societal norms.

CHAPTER 12.

From Nose Cones to Geysers

If most air forces are designed like a Formula One race car, the Israeli Air Force is a beat-up jeep with a lot of tools in it. . . . Here, you're going off-road from day one. The race car is just not going to work in our environment. The race car is just not going to work in our environment.

-YUVAL D DOTAN DOUG W WOOD IS A NEW AND UNLIKELY RECRUIT to Israel. With his calm and reflective demeanor, he stands out among his more brash Israeli colleagues. He was hired from Hollywood to do something that's never before been tried in Jerusalem: Wood is the director of the first feature-length animated movie to be produced by Animation Lab, the start-up founded by Israeli venture capitalist Erel Margalit. to Israel. With his calm and reflective demeanor, he stands out among his more brash Israeli colleagues. He was hired from Hollywood to do something that's never before been tried in Jerusalem: Wood is the director of the first feature-length animated movie to be produced by Animation Lab, the start-up founded by Israeli venture capitalist Erel Margalit.

Wood worked as vice president of feature animation development and production at Turner, Warner Brothers, and Universal. When Margalit asked him to relocate to Jerusalem to create an animated feature, Wood said he would first have to see if Jerusalem had a real creative community. After spending some time in Jerusalem at Bezalel-Israel's leading academy of art and design-he was convinced. "I met with the faculty there. I met with some TV writers and [author] Meir Shalev, and some other big storytellers," he told us. "They were as good if not better than the people you would meet at the world's top arts schools."

But he also identified something different about Israel. "There's a mult.i.task mentality here. We've consulted with a lot of the Israeli technical people and they come up with innovative ways to improve our pipeline and do things more directly. And then there was this time I was working on a creative project with an art graduate from Bezalel. He looked the part-long hair, an earring, in shorts and flip-flops. Suddenly a technological problem erupted. I was ready to call the techies in to fix it. But the Bezalel student dropped his graphic work and began solving the problem like he was a trained engineer. I asked him where he learned to do this. It turns out he was also a fighter pilot in the air force. This art student? A fighter pilot? This art student? A fighter pilot? It's like all these worlds come colliding here-or collaborating-depending how you look at it." It's like all these worlds come colliding here-or collaborating-depending how you look at it."1 It's not surprising that mult.i.tasking, like many other advantages Israeli technologists seem to have, is fostered by the IDF. Fighter pilot Yuval Dotan told us that there is a distinct bias against specialization in the Israeli military. "If most air forces are designed like a Formula One race car, the Israeli Air Force is a beat-up jeep with a lot of tools in it. On a closed track, the Formula One's going to win," Dotan said. But, he noted, in the IAF, "you're going off-road from day one. . . . The race car is just not going to work in our environment."2 The difference between the Formula One and the jeep strategies is not just about numbers; each produces divergent tactics and modes of thinking. This can be seen in the different "strike packages" that each air force constructs for its missions. For most Western air forces, a strike package is built from a series of waves of aircraft whose end goal is to deliver bombs on targets.

The United States typically uses four waves of specialized aircraft to accomplish a specific component of the mission: for example, a combat air patrol, designed to clear a corridor of enemy aircraft; a second wave that knocks out any enemy antiaircraft systems that are firing missiles; a third wave of electronic warfare aircraft, tankers for refueling, and radar aircraft to provide a complete battle picture; and, finally, the strikers themselves-planes with bombs. These are guarded by close air-support fighters "to make sure nothing happens," Dotan explained.

"It's overwhelming and it's very well coordinated," Dotan said of the U.S. system. "It's very challenging logistically. You've got to meet the tanker at the right place. You've got to rendezvous with the electronic warfare-if one guy's off by a few seconds, it all falls apart. The IAF could not pull off a system like this even if it had the resources; it would just be a big mess. We're not disciplined enough."

In the Israeli system, almost every aircraft is a jack-of-all-trades. "You don't go into combat without air-to-air missiles, no matter what the mission is," said Dotan. "You could be going to hit a target in southern Lebanon, with zero chance of meeting another aircraft, and if you do, the home base is two minutes' flying time away and someone else can come and help you. Still, there's no such thing as going into hostile territory without air-to-air missiles."

Similarly, nearly every aircraft in the IAF has its own onboard electronic warfare system. Unlike the U.S. Air Force, the IAF does not send up a special formation to defeat enemy radars. "You do it yourself," Dotan noted. "It's not as effective, but it's a h.e.l.l of a lot more flexible." Finally, in a typical Israeli strike package, about 90 percent of the aircraft are carrying bombs and are a.s.signed targets. In a U.S. strike package, only the strikers in the final wave are carrying bombs.