June 1, 2000

By Avi Machlis
The Financial Times
Copyright © The Financial Times Limited


Entrepreneurs, engineers and investors in Tel Aviv were awe-struck by yesterday's confirmation that Chromatis Networks, which is based in the US but has most of its employees in Israel, was to be bought by Lucent Technologies of the US for Dollars 4.5bn in stock.

Coming just two years after America Online sparked a wave of foreign buy-outs with the Dollars 400m acquisition of Mirabilis, an Israeli creator of an internet chat application, the Lucent-Chromatis deal may have revealed the potential hidden value in many more Israeli start-ups.

The sector is well positioned to ride out current investor concern over technology stocks, since most Israeli start-ups are involved in creating internet and telecommunications infrastructure technologies, rather than simple dotcom applications such as e-commerce websites.

However, the deal also highlights that Israel's high-tech sector is at a critical juncture. Foreign investment is pouring in at an unprecedented pace, but observers are unsure the money will foster the creation of Israel-based global technology companies.

"This deal shows there is great interest in leveraging Israeli technology and entrepreneurship to build strong global companies," says Erel Margalit, managing partner of Jerusalem Venture Partners, the Israeli investment group that led the private financing of Chromatis.

"We have a rare opportunity to put Israel on the map as one of the leading countries breeding international market leaders. But the regulatory elements need to encourage Israelis to complement strong development centres with business leadership centres, and create a series of global companies driven mostly out of Israel."

For a country of just 6m people, capital is not lacking. Israeli venture capital funds are in the process of raising an estimated Dollars 2bn this year, almost exclusively for information technology start-ups.

Foreign institutional investors and leading technology groups, such as AOL, IBM and Lucent, are putting up most of the money. But although Israel's industry is following Silicon Valley investment trends, its distance from world markets, and difficult local business conditions, have sparked an exodus of companies - mostly to the US.

According to a recent report from the Israel Democracy Institute, an independent think-tank, 90 per cent of Israeli-rooted companies like Chromatis registered abroad last year because of a cumbersome regulatory environment and a heavy tax burden.

"There is no economic justification for establishing a company in Israel," it said. "A chief executive who establishes a company in Israel should be immediately fired for irresponsibility."

Israeli venture capital funds encourage such migration. "The first thing a fund manager tells an entrepreneur to do, is to go and establish headquarters in the US," says one entrepreneur who has been soliciting several funds for financing. "I have got into trouble by saying that I want to stay."

A move to the US is often demanded by foreign investors who cannot accept the restrictions of owning an Israeli-registered company. For example, after a merger of an Israeli-registered company, Israeli regulations prohibit shareholders from selling shares for two years.

But most companies are compelled to move abroad simply to be closer to the marketplace. In addition, US management and marketing teams compensate for Israel's weaknesses.

Successful Israeli companies, such as Nasdaq-listed Comverse Technology, a world leader in messaging systems for cellular networks, have used this model. It has also kept most of its 4,000 employees in Israel.

Only a few rising stars such as Check Point Software, a leading internet security company, maintain Israeli headquarters.

For investors, a company's location is irrelevant. Yet for the Israeli economy, which is depending on the high-tech sector as the engine for future growth, the failure to create conditions that encourage companies to create Israel-based global businesses may prove critical.

Ultimately, Israel may forgo massive sums in taxes, jobs and indirect economic benefits.

Unless Israel equalises taxation and corporate regulations to US standards, say venture capitalists, its companies will continue to gravitate towards key markets.

And although recent tax reform proposals promise several improvements, Israeli high-tech players are not holding their breath. "In the past, the start-up industry needed the Israeli government," says Chemi Peres, managing partner of Polaris Venture Capital, Israel's biggest venture capital group.

"Now the government is competing for the entrepreneurs to get them to stay here. If the taxation and corporate laws and regulations are not adjusted to meet the challenges of today, companies simply will not stay."