Israel’s Silicon Wadi Is Bringing In Billions from Investors

From Drones to CyberSecurity, Israel’s high-tech mecca is a hotbed of technology start-ups that’s drawing billions in investment from foreign companies and venture capital firms.

Unmanned Systems and Robotics Conference

An Israeli soldier takes a photograph of the Super Heron HF Medium Altitude Long Endurance Unmanned Aircraft System (UAS) manufactured by Israel Aerospace Industries (IAI), on display at the Unmanned Systems and Robotics Conference (AUS&R 2016) in Rishon LeZion, Israel, on September 19, 2016. (Photo by David Vaaknin for Institutional Investor Magazine )

David Vaaknin/For Institutional Investor Magaz

A white drone with a 12-foot wingspan banks sharply over an artificial lake on the outskirts of Tel Aviv. The unmanned aerial vehicle, or UAV, is so quiet that herons on the water’s edge don’t budge until the hawklike aircraft is barely a hundred feet away. As the drone swoops in, its cameras beam high-resolution images of the terrain and the birds onto a large outdoor screen for a rapt audience of military analysts and arms buyers while a presenter extols the aircraft’s virtues. “It allows a military unit to peer down on enemies hidden behind hills or buildings and then call in artillery or air strikes,” he says.

Inside an adjacent, hangar-size convention hall at Israel’s annual Autonomous, Unmanned Systems & Robotics (AUS&R ) convention, some 500 attendees hailing from Israel, the U.S., Europe, Asia, and Latin America inspect a score of other drone models. They include a tiny, kamikazelike craft bearing an explosive charge that hovers and surveys its surroundings until its controller directs it to crash into and blow up a target; a drone as large as a tank that can ferry soldiers and cargo in and out of urban combat zones; and a UAV with the wingspan of a business jet that can stay aloft for more than a day on espionage missions.

In less than 30 years, Israel, once better known for its agricultural kibbutzim, has transformed itself into a high-tech industrial nation with a per capita income of some $35,300, just behind France’s and nearly 9 percent greater than Japan’s. Silicon Wadi, a 125-mile corridor stretching from the plains around the northern port of Haifa to the Negev Desert in the south, has spawned more high-tech start-ups than all of Europe. Only the U.S. claims more high-tech start-ups, and it has a population nearly 40 times larger than tiny Israel’s 8.2 million.

The boom has attracted a rising tide of foreign investment from global tech giants looking to bolster their research and development operations and tap into promising new technologies, and from foreign venture capital firms eager to finance hot new start-ups. Israeli companies are especially strong in products and services related to military activities and protection against Internet attacks. The nation is the world’s second-leading exporter, after the U.S., of both military drones and cybersecurity services — two of the hottest digital-era industries.

The ramifications of this two-decade-old surge have spilled into diplomacy and geopolitics. The technological prowess of the Israel Defense Forces (IDF) and the Israeli military and cybersecurity industries is gaining the country informal alliances even with longtime Middle East antagonists like Saudi Arabia and the Gulf emirates. Israeli media have reported that the country has exchanged intelligence on Iran and Yemen with Saudi military officials in the past year. In July a Saudi delegation led by retired general Anwar Eshki visited Israel and met with intelligence officials to discuss cybersecurity and antimissile defense systems, according to local press reports. In September the New York Times reported that Israel’s NSO Group was selling smartphone surveillance spyware to the United Arab Emirates. “More and more nations see Israel as a potent partner,” Prime Minister Benjamin Netanyahu told the United Nations General Assembly in September. “Because of our unmatched experience and proven capabilities in fighting terrorism, many of your governments seek our help in keeping your countries safe.”

Billions of dollars in venture capital and high-tech export earnings pour into Israel each year despite continued global criticism of the country’s half-century occupation of the West Bank, which has inspired the Boycott, Divestment, and Sanctions movement. Google, Facebook, Microsoft Corp., Oracle Corp., and hundreds of European and Asian businesses are investing heavily in their Israeli R&D operations, which account for about half of the nation’s 290,000 high-tech jobs, and snapping up promising young ventures. “The boycott campaign is annoying, but it has had no material effect on our business,” says Joseph Gaspar, chief financial officer of Elbit Systems, the country’s largest exporter of military drones.

Underpinning this high-tech boom is a uniquely Israeli ecosystem that links elite military units, hundreds of start-up companies, and a multilayered investment community.

Typically, high-tech entrepreneurs are young veterans of IDF intelligence groups who learned to operate in tightly knit teams while working on technological solutions to military needs. The most celebrated of these intelligence outfits, Unit 8200, is Israel’s equivalent of the National Security Agency. It has spawned thousands of fledgling entrepreneurs and other start-up executives who network at the annual gathering of alumni in June. “It’s an opportunity to meet a partner at a venture capital firm or the CEO of an established company, and believe me, a lot of business cards get exchanged,” says Nir Lempert, chairman of the Unit 8200 alumni association and CEO of C. MER Industries. Lempert regularly recruits Unit 8200 alumni for MER, a supplier of mobile communications infrastructure for antiterrorist security networks.

Over the past two decades, Israel has built a sophisticated, deep-pocketed investment community for start-ups. The venture capital market has slowed in many parts of the world, but it continues to swell in Israel. Last year $4.4 billion in venture capital poured into Israeli companies, a figure that is on course to hit $6 billion in 2016, according to the IVC Research Center in Tel Aviv, which tracks the high-tech sector.

Increasingly, the money is coming from abroad. Last year non-Israeli firms supplied 85 percent of new venture capital, up from about 50 percent a decade ago. “You can find more modest deals than in the U.S.,” says Paz Eshel, an applications software and information technology specialist at the Israeli office of Boston-based Battery Ventures, which has invested in more than 30 Israeli start-ups in the past two decades. There aren’t as many unicorns in Israel, he adds, but there are plenty of start-ups with $200 million outcomes to attract foreign investors.

At the top of this food chain are multistage venture capital firms that take a start-up from seed stage to an initial public offering. Other venture firms are early-stage investors, exiting before a start-up goes public. Crowdfunding — drawing upon numerous small investors — accounts for the remainder of start-up capital. “Forget about writing a $50,000 check to a venture capital fund, because they want millions,” says Jon Medved, founder and CEO of Jerusalem-based OurCrowd, one of the largest crowdfunding platforms, with almost 15,000 investors and $250 million in assets.

To be sure, Israeli start-ups face plenty of challenges. Entrepreneurs dream of growing large enough to move their headquarters to the U.S. while keeping their R&D in Israel, but most founders are technology wizards who lack the patience or managerial skills to build their companies up to the IPO stage. Instead, they are serial entrepreneurs who sell out to larger Israeli or foreign, usually American, companies and then go on to a new start-up. According to IVC Research, the number of exits — both IPOs and acquisitions — has averaged about 100 annually over the past decade; the average exit was worth $86.5 million last year, compared with an average of $62 million over the past ten years.

“A lot of Israeli entrepreneurs are young and inexperienced,” says Yoav Tzruya, a partner in Jerusalem Venture Partners (JVP), one of the largest local venture firms, with $1.1 billion under management. “When they are faced with an exit that yields tens of millions of dollars, they go for liquidity.” The same can be said about Israeli venture firms, most of which are early-stage investors with only a ten-year horizon. “That’s not enough time to create a billion-dollar company,” concedes Tzruya.

Competing against foreign multinationals in their own backyard can be daunting for Israeli start-ups. Some 350 global companies from the U.S., Europe, and Asia have R&D operations in Israel. Many of these outposts were created by acquiring Israeli start-ups whose founders doubted they could achieve the scale to compete with Silicon Valley behemoths. In 2015 a record $9 billion was spent, mainly by foreign companies, to acquire 104 Israeli outfits. Microsoft alone bought five businesses, most notably paying $320 million to purchase Adallom, a cloud security company. Oracle acquired three companies in the first half of this year, including Ravello Systems, a provider of cloud-based software services, for $500 million.

But none of these constraints is slowing down entrepreneurs who see opportunities in a world under mounting unconventional military and Internet-era threats. This is particularly true in the cybersecurity field. Few countries have been quicker and more effective than Israel at creating companies to cope with hacker attacks on governments and businesses — and to cash in on an increasingly lucrative market.

Israeli companies don’t confine themselves to cyberdefense. According to media reports, an Israeli start-up, Cellebrite, was hired by the U.S. Federal Bureau of Investigation to successfully crack the iPhone security code of the San Bernardino, California, terrorists after Apple refused to cooperate. (Neither the FBI nor Cellebrite will confirm these reports.) Another Israeli security company, NSO Group, has gained notoriety for selling spyware to Middle Eastern, African, and Latin American governments tracking critics and dissidents.

According to research firm Gartner, global cybersecurity revenue grew 4.7 percent in 2015, to $75 billion, and will soar to $170 billion by 2020. Hardly a week goes by without news of a massive breach. The hacking, presumably by Russian intelligence agencies, of the e-mail accounts of Democratic Party organizations and officials has become a focal point of the U.S. presidential campaign, with Hillary Clinton criticizing Moscow for allegedly trying to influence the election, while her Republican opponent, Donald Trump, has contended that the e-mails, released by Wikileaks, show Clinton as corrupt. The recent disclosure that hackers stole data on 500 million users of Yahoo! in 2014 threatens to disrupt that company’s $4.8 billion sale to Verizon Communications.

Analysts predict even greater trouble ahead, particularly in the corporate world. According to a July report by KPMG, the number of cyberattacks on businesses rose from 3.4 million in 2009 to 43 million in 2014. Cybersecurity risks are mounting exponentially with the shift to cloud computing, the proliferation of mobile communications, and the growth of the Internet of Things, in which the web is used to operate or connect everything from factories to home devices to motor vehicles. “Altogether these trends will massively increase the surface area for attackers,” says Gregg Moskowitz, a New York–based cybersecurity analyst at Cowen Group.

Because threats are so varied, a large corporation may hire as many as 100 cybersecurity companies or vendors, each with its own specialty, to protect against hackers. There are at least 1,500 security vendors currently operating worldwide. Although consolidation is under way in the industry, nobody believes a monopoly or duopoly on the scale of Google and Facebook will emerge. “Security is too complex and far-reaching for any one vendor to credibly accomplish it all,” Moskowitz says. “And innovation should be encouraged to try to keep up with the very sophisticated attackers who exist today.”

Israeli cybersecurity companies have been quick to take advantage of this state of affairs. The sector generated $6.6 billion in export revenue last year, up 10 percent from 2014.

The country’s largest cybersecurity company, Check Point Software Technologies, seeks to protect corporate clients from cyberattacks by using a variety of sophisticated software applications to build firewalls. Based in Tel Aviv and San Carlos, California, Check Point went public with a $67 million IPO in 1996 and has seen its stock price multiply more than 20 times, to $77.18 on October 19. But growing competition has slowed its growth in recent years: Check Point posted a modest 3.9 percent rise in earnings last year, to $686 million, while revenue rose 8.7 percent, to $1.63 billion.

One of the company’s long-standing challenges is to improve the endpoint security it provides — that is, protecting a corporate network when it is accessed remotely through employees’ laptops, tablets, or smartphones. Check Point hoped to fill the endpoint gap by purchasing Sweden’s Pointsec Mobile Technologies for $586 million in 2006, but the company has failed to keep up with rivals whose endpoint security software is regarded as more effective. Check Point has also struggled to keep pace with U.S. competitors like Symantec Corp., Palo Alto Networks, and FireEye in offering security for cloud computing. “We are seeing a clear trend in the cybersecurity industry toward marrying network with endpoint capability and cloud,” says Moskowitz. “We don’t think Check Point can catch up without making acquisitions.”

But with $3.7 billion in cash and marketable securities on its balance sheet, the company can well afford to shop around. “We are looking very actively at various acquisition options,” Check Point CEO and co-founder Gil Shwed told analysts in July at the second-quarter earnings call.

Rival CyberArk Software considers Check Point’s strategy outmoded. “There was a misconception in the market that firewalls could keep out attackers, and a lot of money and energy went into perimeter security,” says Udi Mokady, CEO and co-founder of CyberArk, which is based in Newton, Massachusetts and has a R&D center in Petah Tikvah, Israel. As evidence of the failings of this approach, Mokady points to the spectacular firewall breach in November 2014 of Sony Pictures Entertainment that resulted in the release of reams of confidential data on managers, employees, and their families. The main suspect was North Korea, which allegedly retaliated against Sony for its film The Interview, a comedy about a plot to assassinate the country’s leader, Kim Jong Un.

CyberArk’s strategy focuses on neutralizing an attack after hackers have breached a company’s firewall. CyberArk seeks to protect so-called privileged accounts, which grant users authorized access to data essential to the administration and security of a business. Once intruders get past a firewall, they propagate and move throughout the company by accessing privileged accounts until they can control access to the company networks.

“Before that happens we find those privileged accounts and lock them up,” explains Mokady. “We literally vault them so that the only way to go through a company’s networks is through us.”

Check Point and CyberArk are rare examples of Israeli start-ups that resisted buyout offers. “A lot of Israeli start-ups limit themselves to the technology phase and base their business plan on exiting early and selling their companies,” says Mokady, who founded CyberArk in 1999. “We started out with the idea to build a large company.”

That meant securing the financing to replace venture capital firms that sold their positions to comply with the usual ten-year horizon of their investors. A crucial moment came in 2011, when most investors opted to sell their stakes. But the largest of the firms, Jerusalem Venture Partners, increased its holding from 27 percent to 38 percent, while Goldman Sachs Group took a 19 percent stake. JVP and Goldman kept their stakes until CyberArk’s $85.8 million IPO in September 2014.

JVP reported a more than 12-fold return on its additional investment in CyberArk between 2011 and the IPO. “This shows the missed opportunities by Israeli start-ups that don’t fully exploit their potential and by investors who aren’t strategic or visionary enough,” says Tzruya, the JVP partner most involved with CyberArk.

Last year CyberArk posted a 158 percent rise in net income, to $25.8 million, as revenue rose 56 percent, to $161 million. The company has seen its stock price nearly treble since its IPO, to $45.20 on October 19, giving it a market cap of $1.55 billion. CyberArk took advantage of its post-IPO heft to acquire two Israeli start-ups last year: It purchased Cybertinel, a specialist in sophisticated cyberattacks, for $20 million and paid $30.5 million for Viewfinity, a specialist in endpoint security.

Some Israeli cybersecurity companies have remained close to their military intelligence roots. “A majority of my friends both in my professional and personal life are from Unit 8200,” says Idan Tendler, who co-founded Fortscale four years ago and serves as its CEO. “Even my wife is from the Israeli intelligence community.”

Privately owned Fortscale, which has its headquarters in San Mateo, California, and its R&D center in Tel Aviv, seeks to protect its 2,000 large corporate clients from cyberthreats linked to their own employees. “We provide these companies with the ability to find malicious employee behavior — employees who decide to leak data and steal information, as we saw in the [Edward] Snowden case,” Tendler says. “We profile employees to detect this behavior.”

Fortscale uses some of the same techniques Tendler and his colleagues learned in their intelligence work tracking potential security suspects on the Israeli-occupied West Bank. It might involve an employee who recently was given access to his company’s most sensitive products or services and who has suddenly changed behavior — staying in the office until 2:00 a.m. or accessing the company data from a home computer. Fortscale uses data mining, machine learning, and analytics to determine if the employee is abandoning usual routines.

Often the employee isn’t the culprit. According to Tendler, in 80 percent of attacks coming from outside an enterprise, a hacker has hijacked the credentials, user name, and password of an employee. Making it even more difficult to detect an attack, a hacker might steal the identity of an outside contractor or vendor. This was the case at Target Corp. when hackers used the credentials of the discount chain’s air-conditioning vendor to steal the credit and debit card information of some 70 million Target customers during the Christmas 2013 shopping season.

A variety of Israeli companies have been created to cope with cyberthreats that haven’t yet materialized. One such start-up, Argus Cyber Security, offers protection against malware for the automotive industry as it enters the age of semiautonomous and self-driving vehicles. “Over the next ten years, autonomous and connected vehicles are going to become one of the great revolutions of our time,” predicts Ofer Ben-Noon, CEO and co-founder of Argus, launched in Tel Aviv in 2013.

Ben-Noon’s two previous ventures — a cybersecurity start-up to protect smartphones from hackers and a platform that syncs social networking and academic information for students — weren’t commercial successes. But when he pitched Argus to Magma Venture Partners, a Tel Aviv–based venture capital firm with more than $500 million under management, Magma agreed to provide early-stage financing. “In Israel, as long as an entrepreneur shows that he learns from a failure, it won’t be held against him,” says Yahal Zilka, Magma co-founder and managing partner.

Magma had already provided early financing for another Israeli cyberera automotive start-up: Waze, known for its mapping app, was acquired by Google in 2013 for $1.1 billion to advance the U.S. company’s self-driving-car program. “We familiarized ourselves with the automotive industry through Waze,” Zilka says. “So when Argus approached us, we immediately understood that a connected vehicle would require cybersolutions that aren’t yet offered by any existing technology.”

Argus’s leading product analyzes all Internet communications to and from a motor vehicle. If a hacker attacks the brake system, for example, Argus detects the malware in real time and blocks it before the brakes fail. The product, known as IDPS, is designed for both individual cars and commercial fleets.

The Israeli cybersecurity industry has mushroomed only in the past decade, but the country’s involvement with UAVs has a much longer history. Israel began to develop drones in the aftermath of the so-called Yom Kippur War, in October 1973. A surprise attack by Egypt initially pushed Israeli forces far back from their front line along the Nile River. Then a barrage of antiaircraft missiles knocked 102 Israeli planes out of the sky. The war exposed two profound weaknesses in Israeli defense: an inability to closely survey enemy forces behind the lines and the country’s small pool of increasingly vulnerable pilots. The obvious solution was an unmanned aircraft that could carry out a variety of missions and stay aloft longer than piloted planes at a fraction of the cost.

Unlike Israeli cybersecurity start-ups, drone development and entrepreneurs came out of the Israeli Air Force and state-owned Israel Aerospace Industries. Many of them joined Elbit Systems. From his 34th-floor office in downtown Tel Aviv, CFO Gaspar can see the blue-green waters of the Mediterranean rippling on the horizon, but closer by is what he considers the best part of the view: the white-towered Ministry of Defense headquarters, bristling with antennae. “They are our most important client,” he explains.

Founded 50 years ago and based in Haifa, Elbit has grown into a high-tech conglomerate of 12,000 employees working on ten mainly defense-related programs, including aircraft, naval vessels, land vehicles, communication systems, and electronic warfare. The company generated 27 percent of its $3.1 billion in sales last year in North America, 26 percent in Asia, and 20 percent in Israel. Earnings rose 18.7 percent last year, to $203 million. Elbit’s shares, which trade on the Nasdaq Stock Market and the Tel Aviv stock exchange, rose 27 percent in the 12 months ended October 20, to $96.70.

The company doesn’t break out its UAV sales, even though it is the world’s biggest maker of military drones and claims 85 percent of Israeli drone exports. According to the Stockholm International Peace Research Institute (SIPRI), which tracks global arms sales, no country has exported more military drones over the past three decades than Israel — although the U.S. has taken the lead in the past two years.

Over the past decade Elbit has sold more than $1 billion in drones and UAV services to the U.K. despite the growing boycott movement there against Israel. And last year the company inked a $200 million drone deal with Switzerland. At any moment, at least 20 Elbit drones — which are used for reconnaissance rather than for attacks — are airborne somewhere in the world, including over Afghanistan, Iraq, and Syria.

Elbit’s dominant position has forced Israeli start-ups to seek out niches in the growing global market for drones. They find an eager audience at the annual Autonomous, Unmanned Systems & Robotics convention, which was held outside Tel Aviv in September.

Military analysts and arms buyers were greeted at the convention entrance by a massive black drone named the Cormorant, which looked more like a giant bug than a bird. Taking off and landing vertically with up to 1,500 pounds of cargo and flying at speeds over 100 miles per hour, the Cormorant is designed to replace helicopters in urban areas and mountainous zones under heavy enemy fire.

“Helicopters are extremely vulnerable to antiaircraft weapons, and because of their larger overhead rotors they can only land on relatively flat and obstacle-free terrain,” says Rafi Yoeli, founder and CEO of the Cormorant’s builder, Urban Aeronautics, based in Yavne, 16 miles south of Tel Aviv. Although the Cormorant is also exposed to ground fire, its loss is easier to bear. “If a manned aircraft is shot down and the crew is killed or taken prisoner, that is a big deal,” says Yoeli, who began developing drones for Israel Aerospace Industries in the early 1980s. The Cormorant is built to deliver supplies and ferry casualties from war zones.

One of the most talked-about drones at last year’s AUS&R convention was also the smallest. Called the Hero 30, it weighs seven pounds, including a one-pound explosive charge, and is launched from a pneumatic tube carried by its operator into a battle zone. It can fly for as long as 30 minutes, hovering over and identifying a target and then ramming it with its warhead. “Your adversary moves around quickly and doesn’t give you enough time to call in the air force,” says Yair Dubester, director of UVision Air, a start-up that manufactures several Hero models in Tzur Yigal, 21 miles northeast of Tel Aviv. “The Hero 30 is designed to locate whoever is shooting at you and take him out.” The model has been used by U.S. Special Operations forces in the Middle East.

The latest trend in the Israeli drone industry is a growing focus on commercial civilian uses. And one of the earliest start-ups is Tel Aviv–based Dronomy, which specializes in surveillance of construction sites. Using either its own models or adapting Chinese-made drones designed for the consumer market, Dronomy relies on its own software and miniature twin cameras mounted on toy-size UAVs to inspect construction work and completed building façades from as close as six feet away. “There is a need for precise and consistent documentation of building sites for safety, marketing, and litigation purposes — especially in the U.S.,” says Ori Aphek, Dronomy’s co-founder and CEO. “A drone is an easy-to-use and quick tool for taking these measurements without the expense of on-site human surveyors.”

The Federal Aviation Administration predicts that U.S. sales of commercial drones will reach 600,000 this year and climb to 2.7 million by 2020. According to a White House fact sheet issued in August, commercial drones in the U.S. could generate more than $80 billion in revenue over the next decade.

Little wonder that Israeli military drone makers are scrambling to turn their UAVs to commercial uses. Urban Aeronautics is redesigning the Cormorant for nonmilitary customers outside war zones. “We envision a very large market, particularly for cargo deliveries,” says Yoeli.

Meanwhile, Elbit is attempting to convert some of its military drones for police surveillance. A top-of-the-line Hermes 900, which can stay aloft for more than a day, was sold to the Brazilian government for security and communications tasks during the 2014 World Cup and the 2016 Olympics.

Elbit executives predict that in shifting to commercial markets, Israeli drone makers will have to follow cybersecurity companies and focus more on software and services. “In hardware we don’t yet see what our competitive advantage would be,” says CFO Gaspar.

Even a high-tech nation that punches far above its weight has to know its limitations. •