The lean Israeli startup is a thing of the past

The lean startup myth  credit: Gil Gibli

Set-up costs are soaring, and conditions at the multinationals are just too good.

About a decade ago, the "Lean Start-up" wave swept up thousands of entrepreneurs who swore to follow its principles zealously, so as to fulfill their dreams of leading a successful high-tech company. Concepts such as minimum viable customer feedback (MVCF), build-measure-learn loops have become standard, and have largely become the foundation upon which the local startup scene has based itself to this day.

The Lean Start-up theory fit Israeli high-tech like a glove. A decade ago, it was still considered a small industry in which everyone knew everyone, and in which colleagues, customers and competitors were not afraid to give direct and honest criticism to one another.

According to the Lean Start-up concept, early encounters with customer needs reduce the risk of blind, wasteful development of a product that might not interest the market, and thereby reduce the need for massive capital raising. The term was very appropriate for the period during which the theory was developed: just two years after the great banking crisis of 2008-2009, which also led to a wave of high-tech companies closing, and a lengthy freeze on high-tech investment, which began thawing out only years later.

More than a decade later, even companies that adhere to the Lean Start-up theory are having a hard time meeting its definition. Last year was a year of plenty, with early-stage companies raising millions, and sometimes tens of millions, of dollars. One example is fintech company Sorbet, which raised $21 million in its first round of funding for its platform that helps employees turn unused paid time off (PTO) into cash. Other companies are Talon Cyber Security, which developed a browser-based cybersecurity platform for the enterprise, and raised $26 million in first round, and cloud data security company Cyera, whose entrepreneurs were demobilized from Unit 8200 just two years ago and has since raised $60 million in two rounds alone.

These companies are, admittedly, extreme examples, but the trend is clear: establishing a start-up has become a more costly task than ever. According to data released by Bank Leumi and research firm IVC earlier this week, the median seed round for young companies rose from $1.8 million in 2015 to $4.25 million in the first quarter of the year.

So, for example, Tamar Bar-Ilan and Yotam Segev of Cyera raised $4.5 million from venture capital fund CyberStarts, founded by Gili Raanan and Lior Simon, at the pitch and presentation stage just a scant few months after they were released from the army. "Start-ups need to run faster today than in the past," Bar-Ilan explained, talking to "Globes" about the need to raise large sums from the outset.

"The technology environment is dynamic and changing faster and faster, and as a start-up, you have to grow faster to help organizations implement your technology safely and quickly. Today, you can’t afford to take your time and spend years on development."

High-tech also has a cost of living

The huge sum raised by the pair, even before a working product was developed, was spent exactly on Lean Start-up principles: they recruited good friends who had worked with them in the military at handsome salaries, and set out on a world-wide journey to meet potential customers, hear their data security needs, develop lean versions for them, and make adjustments according to the feedback received.

"This isn’t suitable for every entrepreneur, but it definitely suited us," says Bar-Ilan. "We were open-minded and willing to receive help from everyone. More experienced or serial entrepreneurs might come up with a different approach. But for us, it was the key to success." Success was not long in coming. A year later, after being successfully adopted by a number of clients, and signing several multimillion-dollar contracts, the company raised another $56 million in a round led by Doug Leone, Global Managing Partner at Sequoia Capital.

Yuval Cohen, founder and managing partner at StageOne Ventures and one of Israel’s most experienced VCs, who specializes in early-stage investment, lists three main reasons for the meteoric rise in costs required to establish new companies. "Payroll costs have risen sharply within a decade," he told "Globes". "Take, for example, a software engineer with five years experience. That cost has risen from the order of $120,000 a year to about $200,000 a year. There weren't numbers like these in the past."

But it’s not just salaries. The costs of computing infrastructure, which is mainly in the cloud, have also become a significant burden for companies, at even their earliest stages of activity. The fact that three companies - Amazon, Google and Microsoft - control this area, has created a kind of high-price cartel. "Although cloud service allows enormous flexibility for start-ups just getting going, and while cloud computing is more convenient and the right thing to use, when a company grows a bit, it becomes a very heavy expense, sometimes the second most significant cost component after workforce expenses," Cohen says. This is borne out by the emergence of a hot new market - companies that streamline and discount enterprise-grade cloud services, including Israel’s Granulate and Epsagon, which were sold to international corporations.

The third component is high demand on the part of investors, at least up until last year, for participation in funding rounds of mature and growing companies, sometimes at the expense of young companies. According to a 2021 study by Frost & Sullivan and Herzog Fox Ne'eman, despite similar numbers of companies, the rate of investment in seed-stage companies out of all investments in companies, fell from 6.5% in 2020 to 2.8% in 2021, while the rate of investment in pre-IPO companies rose significantly, from 5% In 2020 to 17.9% in 2021.

"You have to be crazy about your startup to leave a good job"

Cohen is particularly concerned about the phenomenon of the number of companies being funded at the early stage is smaller than, or at least equal to, the number of companies funded at later stages: "It seems illogical, because you would expect to see a kind of funnel, that is, a large pool of young companies from which some mature and successful companies emerge, but in practice the situation is the reverse."

In all of 2021, 119 rounds of capital raising were held for growth companies, according to research firm IVC. In that year, only 87 seed and pre-seed companies raised capital. This trend of a decline in the number of start-ups was also found in a study published the other week by the Israel Innovation Authority and the Start-Up Nation Policy Institute (SNPI), according to which the number of new start-ups in Israel has been declining since 2014, by about 14% every year.

The study offers, by way of explanation, the dominance of development centers of international corporations in Israel. 200 more centers have been added since 2014, a factor that prevents potential entrepreneurs from leaving their jobs in favor of establishing a new company. "For you to leave all the good that an international company has to offer and become an entrepreneur you probably have to really want it and be crazy about it," said Mor Assia founding partner and co-CEO of investment platform iAngels, which targets young companies. "Employees with entrepreneurial inclinations receive plenty of offers from their company to become so-called in-house entrepreneurs, or intrapreneurs - meaning, entrepreneurs working within the corporation - which leaves them a long way from the status of entrepreneurs."

But Assia also has another, more prosaic explanation for the decline in startup companies, that does not relate directly to the cost of setting up new companies: "Unlike in the past, when entrepreneurs would register their company with the Registrar of Companies, and then raise $100,000 to $200,000 from a private investor, today, the company is set up much later, months after the founders have left the companies where they worked previously, and developed an initial product from home - 'bootstrapping', which means starting from scratch.

These entrepreneurs start by raising capital at much higher rates after a few months of work, usually one or two million dollars, and only then do they set up the company. If they fail to obtain funding, they can very easily go back to their jobs. "They know the supply of jobs in the high-tech industry is so vast that they can afford to leave work, sit at home and develop a product, and if they don’t raise their first million, there are always endless other options."

Pre-seed is the new seed

Eyal Niv, managing partner at Pitango First, which specializes in early-stage investment, says that even pre-seed funding, meaning capital raised at the pitch and presentation stage, has also increased greatly.

"Today, a million or two dollars will already be raised in these stages, generally from angels, that is, private investors, while VC funds will participate in the seed stages, which range from $3 million to $5 million," he says. "This is also partly because of the demand. Many professional investors, like hedge funds or private equity funds that have traditionally invested in the stock market or in mature companies, have begun investing even in early stages companies, because they see the returns they can generate."

But there is another reason why investors like to pour money into seed-stage companies. The risk in investing in start-up companies has decreased. "In the past, they used to cite statistics according to which one in ten start-ups would survive over time. Today, the chances are much higher," Assia notes. Niv also addresses the issue: "One of the biggest risks facing start-ups has gone away, and that is the risk of not being able to raise money. If, in the past, even successful companies had difficulty raising capital, nowadays, if you have a product with demand, nice growth, and numbers that add up to nice profit margins, you will probably raise funds. The entrepreneurs are also better quality: they know how to choose their product better than ever, and know better how to adapt it to the market. They are quicker on their feet, less idealistic, grounded in reality, and don’t want to waste anyone's time."

Where venture capital funds don’t venture

Sagi Dagan, head of the Growth & Strategy Division at the Israel Innovation Authority, is responsible for, among other things, identifying young companies in areas where there are market failures that VC funds avoid, such as foodtech, medical devices, chips, optics, and quantum computing. He notes a 20% increase in the number of seed rounds between 2017 and 2021, but in many cases the increase is actually related to an increase in the cost of fixed assets - computer and laboratory equipment - and not to a crowd of venture capital funds willing to open their wallets. "Despite the amazing growth in foodtech, I almost never encounter Israeli venture capital in this industry," he maintains. "This industry is already responsible for 17% of the world’s start-ups, with lots of Israeli companies and institutional investors, but almost without Israeli venture capital funds. If we as a country want to manage a high-tech portfolio - we must bet on the sectors that could be the next big thing in 20 years."

To enable the government too to invest in early-stage companies, Dagan recently completed a process in which the Israel Innovation Authority will cease supporting technology projects at large companies - done in the past to encourage employment - in favor of investing in seed-stage and early-stage companies.

Published by Globes, Israel business news - en.globes.co.il - on April 24, 2022.

© Copyright of Globes Publisher Itonut (1983) Ltd., 2022.

The lean startup myth  credit: Gil Gibli
The lean startup myth credit: Gil Gibli
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