Israeli start-ups go West for gold rush, but who profits

JERUSALEM — A 27-year-old Israeli software entrepreneur passed the first test toward fulfilling Israel's new high-tech dream.

Benny Lehmann raised $3 million in the first round of funding for his start-up company.

If all goes well, Lehmann will steer his nascent Jerusalem-based firm, Digital Fuel Technologies, toward success by providing a solution to major problems faced by the emerging application service provider industry.

But amid the excitement of setting up a new business that perhaps, someday, could become the next rising Israeli star on the technology-heavy Nasdaq stock market, Lehmann is not all smiles.

Traveling halfway across the world on 18-hour flights every month for business meetings in California's Silicon Valley has taught Lehmann what many of his peers have already discovered — he must move to the United States for his company to succeed.

"I've got to be close to the customers and potential future investors," he says, acknowledging that he will probably have to relocate within months. "It's very difficult. I feel much more comfortable here in Israel. But this is the only way to build a company today."

As hundreds of new start-ups are established in Israel each year, Lehmann's dilemma is one faced by a growing number of entrepreneurs. Venture capitalists who helped finance his start-up said registering in the United States is the only way for him to succeed.

Yored, the derogatory word once used to characterize Israelis who have decided to live abroad, is nowhere to be heard in the high-tech context. The move abroad has simply become a requisite necessity to build a company in a global business environment; however, the trend shows that Israel's high-tech sector is at a major crossroads even as it reaches astonishing new heights.

The quandary Israel faces as it tries to keep companies at home was clearly visible last May when Lucent Technologies, the world's biggest telecommunications equipment manufacturer, bought Israeli-founded Chromatis Networks for $4.5 billion in stock. It was a record deal for a company founded by Israelis.

But like most Israeli start-ups, Chromatis is not completely Israeli anymore. Chromatis is registered in Virginia, while maintaining a research and development center in Petach Tikva, near Tel Aviv.

Although Chromatis' original investment team was led by Jerusalem Venture Partners, an Israel-based investment group, most of the investors who profited from the deal were American.

The question is whether there is a clash between the needs of investors — who are pumping a record $2 billion into the venture capital industry alone this year — and the best interests of the Israeli economy, which is to keep companies based at home.

High-tech players complain that the business environment and tax system in Israel turns off foreign investors, who insist that companies register in the United States to make their lives easier.

Not only is this creating a brain drain of the smartest players in Israeli high-tech — since the founders usually leave with the company — but it could deprive Israel's economy of tax revenues, thousands of potential jobs and indirect economic benefits of building global companies based in Israel.

For its part, the government has taken some steps to improve some elements of the tax regime, under recent sweeping tax reform proposals. However, those reforms face fierce political objection from the Histadrut, Israel's powerful trade union federation, and they may never get pushed through the political system.

In any case, says Avi Ben-Bassat, director general of the Finance Ministry and the architect of the reforms, the government cannot advocate policies that favor a particular industry.

While he agrees that high-tech is the "leading industry of the state of Israel" he says the government must "create a comfortable economic environmen," not favoring "one sector or another,"

Chemi Peres, also a managing director at the Polaris fund, disagrees. He says the playing field must be completely leveled if Israel is to benefit from the creation of a sector that will be viable for the long term.

If not, Israel could end up being just a big research and development center for Silicon Valley companies.

"The Israeli economy has two options," he says. "Either to have the industry set up as Israeli companies, and gain everything associated with it, or to have all Israeli companies go and register as foreign companies and we will lose all the benefits,"

"This is one of the main challenges facing the government," he adds. "Either way, the industry will grow by itself."