Ever since Dan Senor and Saul Singer published “Startup Nation” in 2009, investors have been captivated with the 65-year-old nation of eight million people that has produced 69 Nasdaq-listed companies and the world’s highest-per-capita concentration of high-tech startups and engineers.
However, in the excitement of decoding Israel’s entrepreneurial culture, I believe many U.S. investors have overlooked the blend of advantages that make Israeli startups so compelling — especially compared to Silicon Valley startups. As a result, investors have missed the best windows of opportunity, and the formula for a successful partnership with Israeli startups.
While Israel’s reputation for innovation is a good enough reason to invest, it’s the combination of top tech talent, capital efficiency and intense focus on the U.S. market that makes Israeli startups so promising. But for an Israeli startup to reach its highest potential, U.S.-based investors must understand this trifecta, invest early, and work hard on behalf of their Israeli portfolio companies.
The key to Israel’s tech talent and capital efficiency is the Israel Defense Forces. In Israel, an investor can get access to superior engineering talent at a fraction of Silicon Valley’s cost. In the U.S., the top MIT or Stanford computer science grads might expect $150,000 to $200,000 out of the gate. By comparison, an IDF officer who served in an elite intelligence or computer science unit might expect one third of that pay.
In terms of both quality and cost, the IDF arguably provides the world’s best education for tech engineers and entrepreneurs. Unlike seven in 10 American college seniors who graduate with an average of $29,400 in debt, IDF officers receive five to six years of free education. While American grads feel pressure to chip away at debt with a steady salary, IDF grads are prepared for the risks of entrepreneurship. Their classroom and on-the-job training is certainly on par with an MIT or Stanford education, if not better. This is why dozens of tech giants including Oracle, Microsoft, Intel, Google, Apple, IBM, Facebook and Cisco Systems have all opened R&D centers in Israel.
The ambition and U.S. focus of Israeli entrepreneurs is important because the main challenge for Israeli startups is accessing the U.S. market. In a sense, hands-on U.S.-based investors “complete” the Israeli startup if they work hard at customer acquisition, partnerships, key hires and follow on financing. But Israeli startups normally never see American capital until Series B or later. The U.S. connections come too late to make the greatest possible impact.
There are several reasons why American investors arrive late at the scene. First, they usually lack direct access to early-stage Israeli entrepreneurs. Second, U.S. investors find it challenging to evaluate Israeli startups at the seed stage. Compound these factors with the unfamiliarity of a foreign country, culture and legal system, and most U.S.-based investors want to wait and see. They miss the chance to invest at the seed stage when the valuation is lower, the potential upside is higher and their American connections are most valuable to the startup companies.
So, when the investment is timed properly at the seed stage, what do the numbers look like? With top Israeli talent and U.S.-based investors, how does capital efficiency give Israeli startups an edge over Silicon Valley startups?
When U.S.-based investors put the right amount of money into a capital-efficient Israeli tech startup early, their dollars go further than they would have in Silicon Valley. Further by a factor of three, I believe. So, instead of investing $6 million to $9 million in a Silicon Valley-based startup, U.S. investors may choose to invest $2 million to $3 million in a comparable Israeli startup to achieve similar traction. In both cases, the investors end up with about one-third of the company on average.
Assuming that most early-stage investors seek a 10x return on investment, in order to satisfy the investors the Silicon Valley-based startup would have to exit at a $180 million to $270 million valuation, and that’s without considering any further financing. Contrast that with $60 million to $90 million for the comparable capital efficient Israeli startup.
And this is where the value of investing in capital-efficient early-stage Israeli startups lies: These startups tend to have more exit options than their Silicon Valley counterparts. A $60 million exit valuation could potentially satisfy both founders and investors, while both could still agree to “swing for the fences” and scale to a much higher valuation. Israel’s capital efficiency therefore tends to create better alignment of interest between founders and investors.
In many cases, Israeli startups have achieved huge exits while remaining relatively capital efficient. Trusteer, a provider of cybercrime solutions, raised only $10 million and sold to IBM for $650 million in 2013. The community-based navigation app Waze received $67 million and sold to Google for $1 billion. Viber, a free app for calls, text messaging and photo sharing, scaled on $30 million and sold for $900 million, while Intucell raised $6.5 million and sold for $475 million. These B2B and B2C examples illustrate how a blend of Israeli tech talent, capital efficiency and U.S. commercialization can lead to exceptional outcomes.
When investors fund an Israeli tech startup, they don’t need to pick the next Facebook, Google or Dropbox — but they very well could. Israel’s world-class talent and prolific startup culture will generate innovation for years to come. More than ever before, U.S. investors that visit Israel come back enthusiastic about the plethora of startups and investment opportunities, and the ambition and tenacity of Israeli entrepreneurs, the “one degree of separation” that makes everyone accessible, the early-morning to late-night meetings and networking events in Tel Aviv’s lively cafes, bars and restaurants, and the groundbreaking, IDF-inspired technology at every turn.
To take full advantage of the Israeli tech opportunity, U.S. investors must recognize that they can maximize capital efficiency and increase the odds of a lucrative exit by investing at an early stage rather than waiting until Series B. Of the 5,000+ tech startups in Israel, the overwhelming majority want access to the U.S. as early as possible. The opportunity is there waiting for investors who have the local Israeli knowledge and U.S. presence to bridge the gap. In turn, Israeli entrepreneurs will need to seek out investors with hands-on experience, industry knowledge and the drive to help their startups thrive in the U.S. market.
Yoav Andrew Letersdorf is founder and managing partner at YL Ventures, which invests early in cyber security, cloud computing, big data and Software-as-a-Service software companies, and accelerates their evolution via strategic advice and Silicon Valley-based operational execution. Reach him @ylventures.
This article originally appeared on Recode.net.