Solon Partners

I am always on the lookout for new ideas on how to spark entrepreneurial spirit and create fertile conditions for growth of innovative start-ups. As such, as soon as I got my hands on Senor and Singer’s book ”Start-up Nation. The Story of Israel’s Economic Miracle” I tore into it looking for what could be transferred or copied by Estonia.

In theory, the two nations have much in common – tiny nations with small populations and unusual languages, menacing presence of oil rich neighbors (that have more than on one occasions invaded), no abundance of readily convertible natural resources or cash crops, and a recent past dominated by central planning and socialism. In reality, the likelihood of successfully localizing the Israeli model in Estonia is rather low.
In “Start-Up Nation” Senort and Singer describe how within just 20 years Israel created a world famous high-tech economy and one of the biggest venture capital markets in the world. Authors illustrate the uniquely Israeli landscape that created synergy from the close proximity of great universities, strong gorvernment investment into high-tech R&D, and a particularly strong and innovative national character forged by the government through the national service sytem.
When in the 1990s the government provided funding to encourage venture capital to invest in Israeli startups – the synergy was commercialized into an $18.1 billion technology export industry (2008) from near zero. As Erel Margalit put it “Venture capital was the match that sparked the fire.”

“Start-Up Nation” leaves the impression that Israel’s success can be generally divided into three broad influences: investment into education, investment into military R&D, and investment into culture of innovation.

Investment into Education
Israeli educational system is very effective at producing scientists and engineers, while successfully absorbing Russian, Ethiopian and other emigration in the millions. According to the OECD, 45% of Israelis are now university educated, and these universities are very good.
In 2008, Weizman Institute and the Hebrew University were chosen as the best two places to work in academia (outside of the US) by Science magazine. Israel now produces more scientific papers per capita than any other nation. Israel is a top 10 producer of patents in the field of nuclear science. Hebrew University is ranked #12 in in global biotech patent rankings (Telaviv University is #21). Israel has numerous nominations for Nobel Prizes and has recently won several prizes in economics and chemistry. Of course, all of this has required consistent government support for investment into raising the quality of the education to the world class level.
Investment into Military R&D
Constant threat of military conflict with hostile oil rich neighbors has forced Israel to invest billions of dollars every year into military R&D. Investment into projects such as the Merkava tank, Lavi jet are known by name, but in addition to these specifically military applications, there were many international projects with readily transferable technologies and innovations in the fields of  satellites, missiles, optics, communications, cryptology and many others. The military R&D projects trained several generations of highly qualified and experienced engineers and technology professionals with unique cutting-edge know-how and expertise. Moreover, the Israeli government through its mandatory national military service targets for extra development the most promising leaders and scientists through specially designed military leadership programs.
Every year all high school students have an opportunity to try out for the elite military units topped by the Talpiot. Talpiot only considers the top 2% of the students, less talented students have to settle for less prestigious military units. If Talpiot  candidates pass the 41 month training course they then commit to six years of further development in advanced military service. Today many of the Isreali NASDAQ listed tech companies are founded or run by Talpion alumni. As a result the authors claim that:

In Israel, one’s academic past is somehow less important than the military past. One of the questions asked in every job interview is , Where did you serve in the army

Thus Israel’s start-up engineers and future CEOs have by age 25 not only faced academic challenges, they have learned improvisation and innovation in leading combat operations against terrorists with millions of dollars in technology, learned responsibility in leading troops into battles and made rapid executive decisions literally under enemy fire. Israel has masterfully managed the technology transfer in leadership and technology skills learned through modern military service into profitable uses in the civilian technology markets.

Investment into a culture of innovation
Authors describe how Israelis are brought up in a culture of improvisation and innovation on the “edge of chaos.” A key to survival in the environment with few natural resources and hostile neighbors is thinking outside the box and challenging conventions in order to even up the odds.
The geopolitical reality of Israel is that it is surrounded by 250 million Arab neighbors (some more friendly than others) that are financed by the proceeds from the sale of 1/3 of the world’s oil reserves. In such difficult environment Israeli leaders have had to adapt to finding unexpected and unconventional solutions. Isrealis have learned that to tease out the best from a team a real leader should be ready to resist group-think and defending the status quo:

Maximize resistance—in the sense of encouraging disagreement and dissent. When an organization is in crisis, lack of resistance can itself be a big problem. It can mean that the change you are trying to create isn’t radical enough . . . or that the opposition has gone underground.

This is something that is specifically taught to everyone in the military through the after-action review process for analysis of all military missions. The ability to accurately and honestly admit and assess own and teams’ weaknesses and thus find ways for improvement is highly valued and rewarded. Israelis learn from early on that:

It’s ok to try and fail. Success is best, but failure is not a stigma; its an important experience for your resume”

An excellent demonstration of this culture has been the Yozma venture capital fund of $20 million combined with $100 million investment into creating 10 Venture Capital funds (each made up of local VC in training, foreign VC, and Israeli investment bank/company). Today these funds manage approximately $3 billion of capital and support hundreds of Israeli high-tech companies. There are now over 45 venture capital funds actively operating in Israel, and Israel has over the same period doubled its share of the global VC investment with respect to Europe (15% to 31%). The key for gaining support from the VCs was that from the beginning the government wrote in a cheap buy out clause (equity plus reasonable interest if the fund was successful). The idea of the program was: “while government shared the risk, it offered investors all of the reward.”

Relevance for Estonia
Unique synergies of the Israeli ecosystem is instructive, but not readily transferable to Estonia. Despite strong efforts none of the Estonian Universities have ever broken into the the top 500 rankings, and are unlikely to do so in the next decade based on the current level of investment and international professors’/students recruitment policies. Under the given budgetary and political limitations it would be difficult to finance, but effective and rapid change can be achieved for example through making it possible for all Estonian university students to study abroad for 1 year, and making it a graduation requirement. But long term solution will require more investment form the state as well as strategic private partners.

Israeli military history is also difficult to transfer to Estonia. Estonia currently has virtually no military to civilian technology transfer. The last remaining Estonian military company E-Arsenal (which had been attempted to bring optical technology manufacturing into Estonia) was recently turned into a real estate company to manage its Tallinn property. Estonia should certainly consider providing direct government financing for private companies able to bring high-tech military R&D projects into Estonia. Estonia’s current active participation in NATO operations, NATO’s cyber-defence centre in Tallinn, and Tallinn potentially winning the EU IT headquarters project – Estonia should be able to participate at a minimum in communications and cryptography projects which could bring unique know-how with advanced technologies to Estonia.

Finally, there is much to be learned from the Israeli experience of venture capital incubation through building incentives for privatization into the program. The likelihood that local VC firms begin to strengthen and emerge would be significantly enhanced by this approach. The private VCs are much better able to deliver the “smart” part of smart money – by providing, in addition to investment, better level of access to credible mentoring, introductions to international investors, top professionals, prospective acquirers, new customers and strategic partners. This seemed logical enough for the Irish in 2008 when they launched a €500 million “innovation fund” designed to copy the Yozma model.

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I have noticed over the past few months at various business conferences and networking events a curiously steady rise in attendance by legal professionals. Where before 2007  many top professionals were too booked-up to spend time trawling for new clients, now client relations, conference appearances and networking are back in vouge.

Alan Heuer has an insightful story in the New York Times describing the downsizing taking place at New York top firms. Associates and partners are being let go to adjust to the drop in business.

The recession is crashing the business model for NY full service commercial law firms, which in good times used to compete amongst each other for the right to pay first year incoming baby-lawyers  $160,000 per year plus bonuses. With the Lehman Brothers collapse, CDO catastrophy, and surrounding economic crisis the capital markets transactional work dried up. The transactional deal-flow ran down to a trickle, and there had already been a long drought of  IPO work.

Lawfirms work mostly on a cash on hand basis, and do not carry large reserves. As such, very quickly there is not enough money to keep the large numbers of associates waiting for new work.  The firms have been forced into  firing both partners and associates and telling new recruits their start date will be delayed by a year. Heuer Reports:

In the first quarter of 2009, demand for legal services in New York decreased by nearly 10 percent over 2008, according to the Hildebrandt International Peer Monitor Index. At least 10,000 employees at major firms across the country have lost their jobs so far this year, according to the macabre but wildly popular “Layoff Tracker” run by another blog, lawshucks.com.

Steve Verrier a Partner at White & Case (2,000 lawyers in 34 offices in 23 countries) described his choices upon assuming the management of the firm as follows:

Do nothing, which risked the firm’s survival; couch layoffs as decisions based on poor performance; or own up to the crisis and bid large numbers of lawyers a harsh but needed goodbye.

They decided for the layoffs. A partner at White&Case explained the atmosphere has changed significantly at the large firms: “The problem is we’re supposed to all be in this together. But at some point, you stop and think: ‘Well, maybe we’re not.’ ”

Crisis forces innovation in the legal field.

Clients are beginning to look ever more closely at the legal bills they receive. Large businesses have started to employ legal auditing service companies. Essentially they audit the clients’  legal bills, identifying incorrect entries as well as inefficiencies and possible over-billing. The company gets paid a percentage of the “savings” achieved. As one can imagine, the performance fee structure ensures sufficient motivation to find mistakes and cost-cutting opportunities.  For example, Stuart Maue saved Kmart $15 million in legal and professional fees in the bankruptcy proceedings.

Denver based Law firm Watson& Associates just announced that it is now offering a  flat-price full-service packages for businesses. The reasoning is as follows:

The firm hopes its innovative approach to helping clients reduce the staggering fees typically associated with legal advice will strengthen the firm’s position as a business partner, rather than a line item in the budget.

We are hoping that law firms will also recognize their role in bringing the economy back, by offering legal services to startup companies which hope to rapidly grow their business on a discount basis, or in exchange for some equity (where this structure is allowed by the bar) or structured on growth basis. By sharing in the risk with the entrepreneurs, the law firms are creating a network of grateful and loyal entrepreneurial customers and their referrals, but also are investing into ensuring the survival of their own future client base.

This is an opportunity for lawyers to help out seed and early-stage companies by giving them some basic services and business contract forms cheap or free, instead of charging heavy fees later by telling the company about the damage done to the valuation, money lost to overtaxation, or intellectual property lost because they could not afford lawyers and failed to use proper legal forms.

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The startlingly honest and straightforward admission by President Obama came under questioning by Steve Scully during the C-SPAN interview. President Obama cites the failure to fix the US health care system as the long term reason for this fiscal crisis, and in the short term the extreme demand for money to rescue the financial sector, the auto industry and address the “huge recession.”

The current US national debt of $11 trillion comes out to$36,000 pear each living US citizen, and has continued to increase on an average at the rate of $3.8 billion per day since 2007. Of course US is not alone in this situation as IMF has calculated that average government debt for the richest G20 countries will exceed 100% of their GDP in 2014, compared to 40% in 1980 and 70% in 2000.

The growing debt burden has been mainly financed by printing money (technical term - quantitative easing) as we have reported in our previous posts here and here. However, the concern for rising debt has now pushed UK and US creditworthiness to the brink and put their AAA national debt credit rating very much at risk. However, tough budget cuts must still wait a while, as current stimulus spending is necessary to bring life back to the US economy. This creates for a very tough challenge for any world leader.

Full transcript of President Obama’s interview is available from C-Span here, but the relevant portion of the interview went as follows:

SCULLY: You know the numbers, $1.7 trillion debt, a nationaldeficit of $11 trillion. At what point do we run out of money?
OBAMA: Well, we are out of money now. We are operating in deep deficits, not caused by any decisions we’ve made on health care so far. This is a consequence of the crisis that we’ve seen and in fact our failure to make some good decisions on health care over the last several decades.
So we’ve got a short-term problem, which is we had to spend a lot of money to salvage our financial system, we had to deal with the auto companies, a huge recession which drains tax revenue at the same time it’s putting more pressure on governments to provide unemployment insurance or make sure that food stamps are available for people who have been laid off.
So we have a short-term problem and we also have a long-term problem. The short-term problem is dwarfed by the long-term problem. And the long-term problem is Medicaid and Medicare. If we don’t reduce long-term health care inflation substantially, we can’t get control of the deficit.

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I read from Uri’s blog (written in Estonian language) today about his banker buddy from Southern Europe commenting on people getting laid off all over Europe due to the economic crisis.

The banker suggested that in Europe, where laying off people generally is very costly and involves potential law suits, several (big)companies are using crisis as a perfect scapegoat for letting people go. He also added that in most cases, these people would have been fired long time ago, but these companies just did not have a plausible and safe enough reason to get rid of them until the meltdown. The key for the downsizer is to blame it on external reasons, globally applicable if possible!

“World markets are all down. We can’t possibly afford to keep you around anymore.”

“Our revenues are down. It is sad, but we are forced to let you go.”

“Our export clients aren’t buying anymore. Your department needs to be shut down despite your great personal performance.”

“Everybody is talking about cutting costs and staff. So, letting you go now is only fair, right?”

Rather interesting observation I would say. It certainly makes (brutal)sense when considering how hard it is to fire workers in normal conditions due to inflexible socialist regulations that make it prohibitively expensive to adjust staff  according to changing market conditions.

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Wolves are circling the prey

I have been asked several times in the past six months - if and when will the mega-rich start buying up the best of the distressed assets. I must admit having heard rumors about local business tycoons and groups of wealthy Swedish business sharks hoarding piles of cash, ready to pick the low hanging fruits. But my honest answer is - I am not sure if Estonia has that much of valuable assets to buy up at all, distressed or not. In Estonia and its neighboring countries there is little to no transparency to determine the actual purchasing power and liquidity of the rumored buyers. 

In US however, the wolves are ready for a moose hunt and their preys know it. Kara Swisher pointed out that high-tech giants are sitting on a huge amount of shiny acquisition dollars. Take a look at these enormous reserves:

• Microsoft (MSFT): $20.7 billion
• Cisco (CSCO): $29.5 billion
• Apple (AAPL): $25.6 billion
• Intel (INTC): $11.8 billion
• Oracle (ORCL): $10.6 billion
• Hewlett-Packard (HPQ): $10.2 billion
• Google (GOOG): $15.9 billion
• Yahoo (YHOO): $3.5 billion

To continue the fauna analogy, this wolfpack (clearly on steroids) is patiently following the moose herd (i.e. start-ups) to go after the ones that show sings of weakness and can’t keep up with the pace of others (i.e. run out of money). It is clear that the wolves could already make their move right away, but they are holding it back to maximize their gains. They bet on the dire economic landscape that will become even harder to pass for the moose, allowing the hunters to optimize their attack when the prey is completely exhausted.

Thanks to the internet, we have front row seats for witnessing the brutal outcome of this hunting season. Stay alert and let the chips fall as they may because there is little hope for the moose.

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There are several videos explaining the ins and outs of the credit crisis, but the following video, created by Jonathan Jarvis, is by far one of the best in getting the message through via excellent visualization.

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Internatioanl pharma giant Pfizer is about to acquire pharma half-giant Wyeth (its market cap is half the size of Pfizer’s) for a staggering USD $68 billion. This leaves many people wondering where does the money come from to finance such a monstrous deal. According to International Herald Tribune article, it appears that the banks are again in shape of financing such marquee customers as Pfizer. Especially after having received hefty chunks of the bailout money: 

Pfizer’s bid is being financed by four banks that received U.S. government bailout money: Goldman Sachs, JPMorgan Chase, Citigroup and Bank of America, these people said. Such banks have been criticized for not doing more lending since they received the government funds. In addition, they said, Barclays, which acquired Lehman Brothers out of bankruptcy in the fall, is also providing financing.

For some reason a quote from George Orwell’s book Animal Farm comes to mind - “All animals are equal but some are more equal than others.”

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Want to check whether your CEO has accepted the fact that economy has its breaks on and it won’t get prettier for a while? Then read Guy Kawasaki’s Tough Talk for Tough Times: What the CEO Should Be Saying Now posting and see if you find some similarities. Hopefully not…!

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