Israeli incubators blaze a trail

Turning to the stock market is the latest development for the incubators as they seek cash to boost the prospects of their fledgling start-ups.

“Companies in incubators traditionally have had trouble getting venture capital money,” says Julie Kunstler, managing partner at venture capital firm Portview Communications Partners.

Kunstler attributes this to the limited “match” between incubators and VCs.

One obvious mismatch is that incubators take greater risks, investing in sectors that VCs shy away from, such as drug development.

Israel’s incubators are also geographically dispersed, leaving many remote from where the country’s VCs are based. “Most VCs in Silicon Valley [California] will only drive one hour away. And can a company in the boondocks attract the right management team?” says Kunstler.

In addition, any VC that wants to make an investment must also negotiate with the entrepreneur and the incubator management team thus adding a whole layer to the VC process, she says.

But Rina Pridor, Director of the Technological Incubators Programme, which falls under the remit of the Israeli Government Office of the Chief Scientist, stresses that incubators are the main source of start-ups for VCs and investors.

The incubators’ role – backed by government cash – is to support entrepreneurs’ projects and ideas at the very earliest phase. “We give these people a real opportunity to express themselves,” says Pridor. “These are ideas that private money wouldn’t touch.”

The Israeli versus the European model

There are significant differences between the way incubators operate in Israel and Europe. In general, European incubators are about providing a suitable accommodation for start-ups – often with laboratories on site, and help with business development – but where any company that can pay the rent can be a tenant.

Incubators in Israel, on the other hand, go out and select the companies they will house and make direct investments in return for equity. All projects must be approved by the Office of the Chief Scientist in order to qualify for a government loan, and incubators must contribute the equivalent of at least 15% of the loan in their own money.

Track record

Pridor stresses the track record of the incubator programme. Over half of all the projects that graduate from the incubators continue to operate as companies two years on. In contrast, less than 10 per cent of start-ups in the US are operating three years after start-up.

“We have taken high-tech incubators further than anyone else in the world,” says Pridor.

Israel’s incubator programme was set up in 1991. Besides acting as a catalyst for the very first phase in entrepreneurship, the programme was intended to provide a channel for creativity and technical capabilities of the many highly trained engineers and scientists that immigrated to Israel from the former Soviet Union.

“We wanted the economy to take advantage of the immense capabilities pouring into Israel,” said Pridor. The programme also aimed to foster high-tech development in regions beyond the existing hubs of Tel-Aviv and Haifa. (See Table)

For the first ten years the incubators were run as non-profit organisations, but in 2002 the Office of the Chief Office started a privatisation programme.

“It was mostly stick rather than carrot,” says Amir Gal-Or, chairman of incubator Maayan Ventures. “Incubators that were weak, if they were not privatised, could be shut.”

The CEO of one privatised incubator, who did not want to be named, said, “The incubators funded by government money were not professional enough.”

Early-stage money

Orna Berry, a venture partner at Gemini Israel Funds Ltd, and a former chief scientist agrees: “The motivation was to increase the money available at the early-stage, pre-seed investment, and impose better management [of the start-ups].”

Since 2002, 13 of Israel’s 24 incubators have been privatised, with two more set to join. Meanwhile all the remaining incubators, while not privately owned, have attracted private investment, a development encouraged by Pridor’s office from 1998. The money to take the incubators private has come from different sources, including VCs and angel investors.

To further attract private investment, the Office of the Chief Scientist has increased its subsidies to incubator start-up projects.

“With a privately held, or publicly traded incubator, the government can add additional funding and is more flexible regarding time constraints,” says Berry. Projects in regular incubators receive a grant of around $300,000 over a two- to three-year term, while those in privatised incubators can get a "soft loan" of $400,000 typically. Both classes of incubator must contribute 15 per cent of the budget, but privatised incubators’ contributions usually exceed this minimum.

Privatisation benefits the Office of the Chief Scientist in that it no longer needs to finance the incubators’ day-to-day operations.

Incentives ‘appear to have worked’

The privatisation incentives appear to have worked. “We are private - for profit,” says Maayan’s Gal-Or. “We take higher risks than VCs – not because we like to take risks – but because of the government subsidies.”

VCs agree that since becoming privatised, incubators have upped their game. “They have become more aggressive and more commercial,” says Neil Cohen, founder and managing partner of Israel Seed Partners, a venture capital firm.

Pridor highlights that $75 million were invested in incubator graduate start-ups in 2005. “This is $75 million that wouldn’t have been spent but for the incubators.” That’s because entrepreneurs approach incubators with projects that are too high-risk for VCs. In comparison, the total government incubator budget was $30 million in 2005.

And now the privatised incubators are turning to the stock exchange for more capital. Ma’ayan Ventures raised $15 million following its float late last year.

Gal-Or sees many advantages in floating Maayan, though he admits there are risks involved. The incubator now has cash in the bank, enabling it to manage companies, while involving fewer partners. He also believes that being the first to float has led to significant visibility for Maayan and for its portfolio of companies, increasing partnership options.

Having cash also puts the incubator in a stronger position when negotiating with VCs. “They cannot reduce the valuations [so easily],” he says.

Gal-Or dismisses the suggestion that as incubators become accountable to the market, they will increasingly behave like early-stage VCs, undermining the incubators’ very purpose as risk takers. “The only thing that would change that is if the government stopped its funding,” he said.

But Pridor admits her office is sensitive to the possibility that incubators could change. “We are very strict and will not fund a project if it is mature enough for VC funding,” she says. “All the while we provide most of the funding, we can ensure incubator projects meet requirements in terms of risk.”

“The danger is not that incubators become risk-averse, but rather a different one,” says Cohen. “That down the road – in three years’ time - none [of the floated incubators] produce. In terms of returns, the model fails.”

But given the programme’s overall record, Pridor believes success will continue. “Why should it change simply because incubators have floated?” she says. “We are on the right track. With better results we can continue to develop and take on even riskier projects.”

Cohen also expects more change. “The high-tech sector in Israel has developed beyond recognition in the last decade,” he says. “It would be very disappointing if the incubators are not on the same curve.”

Table 1: Israel’s incubator programme at a glance