International Trade Barriers for Technology Innovation
Avi Messica1 & Tamir Agmon2
1. The Center for Entrepreneurship and Innovation Management, Technology
Management Department, Holon Institute of Technology, 52 Golomb St., P.O.B 305,
Holon 58102, ISRAEL, avim@hit.ac.il.
2. Graduate Business School, The College of Management, 7 Itzhak Rabin Boulevard,
P.O.B 9017,Rishon Le-Zion 75190, ISRAEL, AgmonT@st.colman.ac.il.
1
Abstract
We studied the prerequisites for the formation of innovative high technology sector,
especially in small to medium size countries (but not limited to), by analyzing the
Israeli Hi-Tech experience over the past fifteen years and by interviews with local
industry professionals and entrepreneurs as well as variety of data sources. This work
puts emphasis on the formation of high-technology sector in the context of innovative
technology and at a strategic, system, level for policy makers. We find that the
prerequisites for the formation of a viable high technology sector comprise of the
following major components: creating or leveraging on a local comparative advantage
at the firm or sector level, importing professional high-risk capital, and reducing
tangible and intangible international trade costs by forming a suitable habitat,
infrastructure-wise, for the development of innovative-technology sector. We
recommend focusing first on the investors rather than on the entrepreneurs. We argue
that the Israeli experience is valid for countries that are interested in setting up or
strengthening their innovative high technology sector. Our findings and conclusions
are in some contradiction to the policies that are currently practiced by some of the
governments and regional organizations in the European Union and other countries as
well.
Keywords: Innovative technology; High-Technology; Technology Innovation;
International Trade; Comparative advantage; Venture Capital; Policy; Investment
2
1.
Introduction
Innovation is an important driver and facilitator of growth, especially in small and
medium size countries. However, in small and medium size countries innovation can
be translated into growth only through the generation of a competitive advantage in
the global markets. There are several prerequisites for the exposition of a country’s
relative advantage into the global market. We assume that these prerequisites can be
matched by the creation of intellectual property and the availability of highly skilled
engineering and managerial manpower. The development of comparative advantage
in the Israeli high technology (Hi-Tech) sector is evident from the sharp growth in the
exports of its Hi-Tech goods and services. Israel is a small peripheral country that did
not develop a world-class Hi-Tech sector prior to 1995. However, over 1995-2000
Israel has developed a global comparative advantage in the Hi-Tech sector as
measured by Balassa’s Revealed Comparative Advantage (Balassa, 1965). It produces
and exports roughly 1% of the global Hi-Tech production while its population is less
than 0.5% of the population of the industrial countries. Over the past fifteen years the
Israeli Hi-Tech industry underwent a double transformation. Its center of gravity
shifted from Military/Defense type of products to civilian commercial products and
the major source for funding innovative technology shifted from the government to
the local, newly formed, venture capital (VC) industry. This was a result of a
government launched special program called YOZMA (“YOZMA” means
“Initiative”) that set up the ground for the formation of the Israeli venture capital
industry. In 1992 the YOZMA program allocated a total amount of $100M for
investment in ten local venture capital firms that were yet to be established. For the
sake of comparison, the extent of funds that were managed by the American VC
industry at the time was roughly $7.5B (www.nvca.org). The results of the YOZMA
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program were overwhelming. By 2004, the $100M governmental investment was
estimated to generate $5B in exports. Table 1 describes the outcomes of the program.
Government #
Funds
VC Invested Survived
firms
ventures
(2004)
Employees
Total
Tax return
(2004)
exports
(2004)
(2004)
$100M
10
168
103
6,000
$1.2B
$100M
Table 1. The outcomes of the YOZMA program and its results for year 2004.
Over 1995-2005 the Israeli government infused more than $3B to the Israeli Hi-Tech
sector through its Office of Chief Scientist (OCS) at the Ministry of Commerce &
Trade. However, the local venture capital industry has raised, mainly from American
institutional investors, and invested more than $11B over the same period of time
(www.ivc-online.com), i.e. about four times the government’s investment. This huge
investment resulted in about $23B in IPOs and M&A deals. Over 1998-2003 the
Israeli ICT sector has grown up by 50%, its contribution to the Israeli GDP has
increased from 8.8% in 1998 to 12.4% in 2003 and the annual exports almost doubled
from $6.6B to $10.8B (www.tamas.gov.il). Moreover, it is estimated that out of every
$4 of VC investment roughly $3.5 are paid wages of which $1.5 are paid as tax. The
number of people that are employed in the sector rose up by 60% from 100,000 to
160,000.
Although funding is indeed a vital necessity there is more to it than just money. The
Israeli Hi-Tech sector features unique characteristics that could not be overcome with
funding alone. Most of the production of the Israeli Hi-Tech sector is either exported
in the conventional form of goods or services or in the form of selling innovative
technology (e.g. during 2006 there were 60 acquisitions of local companies by
4
American and other international firms). The latter form of exports is the expected
present value of future goods and services, some of which do not exist as yet or exist
in a preliminary form. This form of goods and services is subjected to specific
tangible and intangible international trade costs. For example, it is quite often that the
costs of transportation are insignificant in the case of Hi-Tech products. Shippment
cost is measurable and quantifiable and hence tangible. However, in the case of
merger and acquisition (M&A) deals the value of future goods or services is very
sensitive to the quality of the information that is provided which is quite often hard to
quantify or to asses, hence intangible costs are involved. Acquiring an Israeli start-up
company by a major global corporation requires a lengthy due diligence process for
understanding the technological, financial, legal, and the cultural aspects of the
company. Moreover, not only that the spoken language is different (Hebrew is written
from left to right) but the accounting, financial, and legal standards are not the same
as in the US or the UK not to mention differences in culture, mindset, character, ethics
and even trivialities such as different time zones. The large specific trade costs that
may incur can make such international transaction prohibitive. This description is
valid for many small to medium size countries in the EU and other parts of the world.
Trading Hi-Tech goods and services, particularly the future goods and services that
are based on innovative technology, is always associated with tangible and intangible
trade costs. The government of Israel was successful in creating a local comparative
advantage vis-à-vis the US market by reducing these international trade costs for
American investors and corporations. The reduction of these trade costs was
accomplished by making the cost itself an industry good. Namely, by transferring the
costs from the one-time buyer, or the one-time seller, to a professional financial
intermediary. This was accomplished by using public funds through an effective
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program (YOZMA) to catalyze the setting up of such system. In the Israeli case it has
bridged information gaps as well as reduced the trade costs between the Israeli and the
US markets.
It is important to note that we make a distinction between Israel and countries such as
Ireland or the like where the policy for the formation of Hi-Tech sector was based on
attracting international firms for setting up production facilities through incentive
mechanisms such as tax benefits. Such strategy is very successful in creating jobs but
is prone to future migration of international corporate to other countries in which
labor is cheaper as happened in the case of the Scottish Silicon glen. In
contradistinction, we focus our attention on countries such as Finland, Sweden, or
Israel in which the Hi-Tech sector is mostly based on the development and
commercialization of innovative technology rather than Hi-Tech manufacturing. In
this paper we focused on the prerequisites for growth through strengthening or setting
up innovative Hi-Tech sector in small and medium size countries. In section two we
analyze and discuss Deardorff’s (2004) model of local comparative advantage for the
Israeli case and the effects of international trade costs on technology innovation. The
local comparative advantage argument relates to the classic New Trade Theory (NTT)
comparative advantage argument of returns to scale. The special nature of the trade
costs pertaining to innovative technology and the relevant barriers are discussed in
section three. The role of venture capital funds in reducing international trade costs
and allowing for the import of foreign sector-specific capital is described and
discussed in section four. We show that most of the trading costs are assumed by the
venture capital funds (VC) that act as financial intermediaries. In the case of the
Israeli Hi-Tech sector it was necessary to create the right endowments that facilitated
the import of sector specific high-risk capital from the US. Lastly we summarize the
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opportunities for other countries to borrow the best from the Israeli experience and
conclude this report.
2. Local comparative advantage and innovative technology
2.1 Local comparative advantage
In a recent paper Deardorff (2004) defined the term local comparative advantage as
“the comparative advantage that a country may have relative to countries that are
close to it, either geographically or in other ways that reduce the cost of trade". In its
simplest form the local comparative model recognizes the fact that the consumer in
the target market is interested in the actual price that he or she pays for a given good
or a service and not in the autarky price of that good or a service in the country of
origin. In a modern service-oriented economy this difference, defined by Deardorff
(2004) as trade costs, is quite often significant and may comprise of several
components of which many are not related to geographic distances. Moreover,
international trade costs are dynamic. They change in response to technology changes,
to competition, and to the volume of trade between countries. Recently Deardorff
(2004) and Shachmurove and Spiegel (2006) showed that such changes are likely to
affect the patterns of international trade. A local comparative advantage depends both
on the market and on the traded goods. In general it is expected that in the absence of
any intervention trade costs will decline over time. Since trade is initiated and carried
out by firms, and not by governments, it takes managerial decisions to move goods
and services from one country to another. However, both governments and firms can
generate a strategic comparative advantage. For example, Israel is a world leader in
generic drugs and TEVA is the world leading corporate of generic drugs. This has not
happened by mere coincidence. Under the Israeli law and pharmaceutical regulations,
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Israeli companies are allowed to engage research and development (R&D) as well as
production of generic versions of patent protected drugs as long as they are not sold
on the market. This has created a unique local comparative advantage for the Israeli
generic drugs companies – and also led to an ongoing dispute with the US federal
government – since they can make all the necessary preparations for selling a new
generic drug within the patent protection period. It allows for TEVA to offer its
products on the first minute after which patent protection expired thereby generating
$7.5B in revenue with 14,700 employees. Being the first to market in the generic
drugs sector gives a company a significant marketing advantage. The Israeli regulator
has created local comparative advantage that provides Israeli generic companies with
a head start against foreign competition, especially American-based companies. To
further illustrate the formation of a local comparative advantage we consider
Checkpoint Software Technologies, an Israeli company that is the worldwide leader in
firewall and virtual private networks products for World-Wide-Web communications,
data security and the like. Three veterans of the Israeli Defense Forces that specialized
in the field of data security during their mandatory army service founded Checkpoint
in 1993. In fact, Checkpoint’s founders spent several years in the Israeli army
working with leading edge data security technology prior to setting up the company.
This background, as well as their experience and expertise, gained the company the
required comparative advantage to position it as a world leader in network security
ever since 1993, resulting in $700M in revenue and 4000 employees. In some specific
cases management or policy makers can create a local comparative advantage by
taking advantage of some distinctive features of the international trade. Such is our
third example that is borrowed from the traditional industry. Phoenicia Flat Glass is a
small size, Israeli, flat glass manufacturer that began losing its business with the
8
progress of trade liberalization and globalization. Expert views were that the plant had
to be closed down. However, the plant was acquired by a group of American investors
who refurbished it and began exporting a substantial amount of its production to
Mediterranean countries. This turnaround originated in taking advantage of
international trade costs that are directly to the specifics of the Israeli imports and
exports geographical trade balance. Namely, most of the Israeli imports are from
Europe and in the form of bulky sea-transported goods while most of the Israeli
exports are shipped by air to the US, Asia, and minor fraction to Europe. This results
in excess capacity of sea transportation from Israel to Mediterranean ports which
Phoenicia Flat Glass took advantage of. Hence the management significantly reduced
the shipment costs of flat glass from Israel to Italy, France, and Spain and that turned
out to be highly competitive with intra-European transport costs. Moreover, as a new
supplier in these markets the company had to overcome a credibility barrier that
usually manifests as customers concerns for production capacity, on-time delivery,
product quality and the like. The new owners had already a number of flat glass plants
in the Mediterranean basin thereby associated Phoenicia with this group of
manufacturers and provided it with the locality factor and the necessary credibility
among customers.
2.2 International trade costs
Identifying and reducing specific trade costs is an international business strategy that
is aimed at creating a local competitive advantage. It is particularly important for
firms in small and medium size countries. When successful, it hardly affects
international trade and prices but delivers significant advantage at the firm or country
level. Note, that in some cases policy makers can apply a Tour de Force, NTT-based,
9
policy and invest significant amounts of public funds in the formation of national,
sub-sectoral, center of excellence by funding a cluster of companies that will operate
in co-opetition or in synergy in order to form a competitive global center of gravity.
Such policies have been applied by the USA, Japan, South Korea, Taiwan, Israel, and
recently China.
Innovative technology firms specifically and the Hi-Tech sector in general are
routinely, unknowingly to some extent, applying this strategy by making use of
regulation, (e.g. TEVA), intellectual property (IP), special skills set (e.g. Checkpoint
Software Technologies) and the like. The international trade in innovative technology
goods and services is different than the conventional trade of goods and services for
immediate consumption. Economic models measure the gains from trade in terms of
increased aggregated consumption. However, in the Hi-Tech sector a large fraction of
the goods and services that are developed are for future consumption. Hence they can
be regarded as real options on the future consumption of goods and services. In many
cases of innovative technology it is not clear what will be the final form of the goods
and services that will be produced or even whether such goods and services will be
produced at all. This futuric nature of goods and services render transportation costs
insignificant. Hence, the trade costs are weighing toward intangible costs such as the
quality or the credibility of the information that is involved. This type of cost
manifests in the financial, accounting, legal, IP, managerial, ethical, cultural and other
aspects of the innovative technology. Some of which may pose intangible costs that
form barriers to overcome.
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3. The barriers and habitat for technology innovation
3.1 The Innovative technology cycle
We assume that the initial, pre-seed, funding gap is bridged by either public funds (or
self-funding) through conventional mechanisms such as incubator programs, grants,
convertible loans, royalty-based loans etc. This funding is usually used for feasibility
tests, proof of concept, patent filing, writing a business plan and any other activity
that may support the next round of funding. In most cases it is impossible for
technology entrepreneurs to raise funds from conventional sources, i.e. in the form of
debt, due to the absence of tangible assets, product orders or cash flow. Hence, in
most countries the source of funds that are available for innovative technology
ventures are either governmental, from wealthy individuals (angel investors), and or
from venture capital funds. Pivotal to the fundraising process is the business plan that
describes the technology and the business model. Initially, the innovative technology
is in the form of some sort of IP, e.g. patent, algorithm, trade secret, and the like.
Moreover occasionally the business model itself might be innovative (e.g. Google).
Hence for entrepreneurs the IP is the sole source of future wealth and as a result most
entrepreneurs are always reluctant to divulge to potential investors all the information
they posses. This puts fair disclosure, during a due diligence process, in conflict with
providing information for the sake of getting the investment. Once money was raised
there is an intensive period of technology development followed by additional rounds
of investment, possibly bringing in new investors into the company. The end process
of importing high-risk capital into the Hi-Tech sector is the exit transaction that
occurs in the case of successful commercialization of innovative technology. In such
case – normally after five to seven years - the company or parts thereof are either
11
offered to the public or get acquired by another corporate and both the investors and
the entrepreneurs meet cash pro rata.
3.2 International trade costs
For start-up companies that are located in small countries such as Israel the potential
acquirers are usually foreign corporate and therefore an exit is an export transaction.
For investors, the trade costs that are involved with innovative technology are
comprised of a combination of tangible and intangible costs. At start, investors have
to evaluate the credibility of the information that is conveyed in the business plan.
Namely, they have to consider the pertinent information with respect to technological
aspects such as feasibility, capability to deliver the right value proposition to the end
customer, price-performance ratio etc. Investors have also to evaluate intangible
aspects such as the managerial quality of the company’s key personnel or the value of
its IP. Contractual elements regarding proprietary aspects of employment, business
partners and the like should also be reviewed and much more. We classify the
international trade costs that are associated with innovative technology by the
following categories: financial & accounting, legal, technological, and cultural
(including managerial aspects and business ethics). Out of these, only the technology
category might bear similarities across countries (under the notion that it is being
reviewed by using universal engineering metrics). The rest of the categories are
usually country-specific and in most cases involve both tangible and intangible costs
that may turn significant enough to prevent a deal.
However, even tough Israel is characterized by many distinct characteristics such as
language, culture, ethics, legal system, financial, and accounting systems that may
incur high trade costs it succeeded in establishing a flourishing Hi-Tech sector. Over
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just five years (1995-2000) the Israeli Hi-Tech sector established a significant
comparative advantage in the global markets. Moreover, this comparative advantage
is primarily local as it pertains mostly to the US market and to few sub-sectors such as
ICT, semiconductors, generic drugs, enterprise software and medical devices to some
extent. So what are the prerequisites for setting up a successful Hi-tech sector and
specifically in a small or medium size country? This question takes us back to basics.
3.3 International barriers for innovative technology
Much like any domestic firm that seeks to operate in the global markets, any country
that strives to set up a successful Hi-Tech sector will face market entry barriers. These
entry barriers are proportional to both the size of the target market (e.g.
semiconductors, telecom, etc) and to the competitive investments that are made by
other countries in that sub-sector. For example, it is evidently clear that only few
countries can set up a local semiconductor fabrication industry - regardless of how
much lucrative this sub-sector is - because of the multi billion dollars initial
investment that is required. The recent $5.2B co-investment of Intel and Micron for
entering the Flash NAND market exemplifies this very well. Putting it in the right
perspective, Intel and Micron’s joint investment by far exceeds the aggregated funds
that the state of Israel invested in its Hi-Tech sector for the past decade!
If we assume that exports is the major source of economic growth for small and mid
size countries then it is clear that - for macro finance considerations - the quantity and
the nature of high-risk capital in such countries is not sufficient for sustaining
innovation-based exports in the long run. The only source for such capital is external
and lies within the major developed countries. There are three major arguments for
the need to import capital for technology innovation in small and midsize countries.
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First, such capital exists only in countries in which wealthy savers (incorporated in the
form of pension funds in countries such as the USA, UK and the like) allocate a small
fraction – but quite significant in absolute terms - of their portfolio for high-risk
investments. Hence, if a small country wishes to develop a viable innovative
technology sector than that would necessitate an investment that exceeds the fraction
of domestic savings that is allocated for high-risk investments. Second, in order to
transfer funds from institutional investors to risky entrepreneurial ventures there is a
need for risk and financial intermediation system that bridges the gap between risktaking entrepreneurs and risk-averse investors (Coval and Thakor, 2005). The US
capital market, as well as the UK, Germany, and other major capital markets
developed such a system in the form of a private equity sector. Lastly, professional
investors and venture capitalists are much more efficient than public funds in
maturing and commercializing innovative technology (Messica and Agmon, 2006).
Hence the import of sector specific high-risk capital is a must for small to mid size
countries that seek to create local comparative advantages in the global innovative
technology markets.
For a foreign investor the ideal investment is local, bears the potential of high gain,
and is initiated by entrepreneurs that share his or her language, managerial practices,
culture, and ethics. On top of that, in such investment the investor is highly familiar
with the tax, accounting, financial, and legal systems. Unfortunately, these criteria are
not met in most of the cases of foreign investment. Hence, the local government has
to reduce the relevant tangible and intangible international trade costs for foreign
investors. Moreover, in some cases some structural changes should be made.
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3.4 The habitat for technology innovation
Tables 2 and 3 summarize the actions that were taken in Israel either at the state or the
firm level (dictated by VC investors as part of their investment terms) in order to
address investors’ concerns and to reduce both the tangible and intangible
international trade costs for innovative technology investments. For the Israeli case
we considered American investors as a benchmark, but our findings are generic
enough to be applicable to many countries.
Habitat aspect
Resolves Barriers/Costs
Comment
Tax pre-ruling or a clear Tax issues (resolved by the Pre-ruling was an ad-hoc
mechanism that was used to
law and regulations for local tax authority)
upfront resolve taxation issues
foreign investors
for foreign investors in the
face of the surge of Hi-Tech
investments that has caught up
the Israeli tax authorities by
surprise
Stable currency and clear Currency
regulations
exchange
uncertainties (resolved by the
local monetary authority)
Major
Israeli
International trade dependent
CPA Accounting (structural)
offices are affiliated with
major US CPA corporate
Existence of local VC Legal,
Managerial,
Ethics, Local VC firm act as a
firms with a Limited Cultural (was resolved by the
“watchdog”
over
the
investment – a “must have” –
Partnership
(LP) government, structural)
that “speaks” the language of
structure
the investor.
15
Local
attorney offices Legal, Contractual (structural) International trade dependent
that include American
Law certified attorneys
plus US-based partner
offices
Table 2. Structural and system-level aspects that address different tangible and intangible costs for
foreign investors in Israel and comprise the Israeli habitat for technology innovation.
The Israeli habitat for technology innovation is not perfect nor is it optimal, even in
the face of the vast experience that was gained over the past fifteen years. To illustrate
that, the Israeli R&D law for funding technology innovation that was approved in
1984 was not investor-friendly since it forbade any export of knowledge or IP that
were developed by any type of government funding. This law posed an
insurmountable barrier for any M&A deal. However, in the face of reality the Israeli
OCS has always overridden this clause. On June 2005 the Israeli R&D law was
amended to allow for IP and Knowledge export at the cost of paying the government
its stake as conventional investor subjected to deduction of any past royalties that
were paid back by the company. However, the new version of the law is cumbersome
and still any M&A deal is subjected to the OCS approval. During the preparation of
this manuscript the Israeli Venture Capital Association (IVA) and the Israeli Stock
Exchange approached the Israeli Internal Revenue System (IRS) in request to
acknowledge investments in R&D companies as tax deductible. The Israeli IRS
positively considers the request but has not approved it to date. If approved, this will
reduce the tax liability of foreign investors. To further illustrate the vital need in
creating a suitable habitat for foreign investments we consider the important issue of
accounting principles. Currently the financial statements of most Israeli Hi-Tech
16
companies are prepared according to the Israeli Generally Accepted Accounting
Principles (GAAP) and the US GAAP. With the advent of liberalization of the global
financial markets, the Israeli leading accounting offices have already started adopting
the International Financial Reporting Standards (IFRS) in spite of the criticism for its
lack of transparency. The motivation for this move is not just to comply with the
European Union financial reporting standards. It is the investment and business
opportunities that it may open for their clientele, i.e. the Israeli companies. For
example, abiding by the IFRS will open the Israeli Hi-Tech sector for German
pension funds, which currently seek to make alternative investments, or to
Singaporean investors that are not acquainted with the Israeli or USA GAAP and
currently avoid investing in Israel. In general, IFRS compliance may open the Far
East markets for Israeli companies. The Israeli accounting offices are aware that such
a service may be beneficial for their clients and themselves. As a reference point,
Canada, for example, is not expected to adopt the IFRS earlier than 2010 and the USA
even later than that.
Action
Resolves Barriers/Costs
Incorporate the company Legal,
Accounting,
in the USA and set up a Ethics, and Cultural
Comment
Tax, The mother company, into
which the investment is made,
is
American
(Often
local subsidiary
incorporated
in
Delaware).
The subsidiary is used for
technology development. This
legal structure is also useful
for
the
final
stage
of
commercialization.
NASDAQ IPOs
Tax, Ethics, and cultural
Israel is ranked third in the
number of companies that are
17
listed on the NASDAQ stock
exchange
Copy Exact contracts
Legal, Contractual, Ethics
Contracts
in
the
Hi-Tech
sector are in English and are
compatible, often copies, with
what investors are accustomed
to see (under the Israeli law
limitations)
US/PCT patents
Even
IP
pending
patents
are
important
US-based
personnel
Office
and Legal,
Accounting,
Tax, A
Ethics, and Cultural
must
during
commercialization, may prove
redundant
and
expensive
during the R&D phase.
Table 3. Common measures that are taken Israeli managements in order to reduce costs and enhance
transparency for foreign investors in technological start-up companies.
Management can also take variety of actions in order to reduce international trade
costs, especially intangible costs. For example, investors in innovative technology are
always concerned with IP rights. Typical concerns are about breaching of patents that
are owned by another party, litigation, the company’s patent approval and protection.
Applying for patent through the Patent Cooperation Treaty (PCT) provides the
applicant extra protection of up to eighteen months as well as world wide – pending coverage (130 countries) than if applyed locally or solely in the target market.
Moreover, a pending patent has lots of value from investor’s perspective since it
signals that the IP that forms the basis of the innovative technology is credible and
was refereed by an independent authority. Applying English, or another international
language for that matter, as the formal communication and documentation language of
18
the company also reduces intangible costs (no need for documents translation). Such
actions and the like may reduce both tangible and intangible costs forming a better
habitat for innovative technology and making foreign investors comfortable enough to
invest.
4. Foreign professional investors as international financial intermediaries
4.1 Venture capital and risk intermediation
Recently Coval and Thakor (2004) described a new model of financial intermediation
for technological innovation. In presenting a conceptual model they defined financial
intermediation as "…an economy with overly optimistic entrepreneurs who require
funding from pessimistic investors. In such a setting, only a rational intermediary will
be sufficiently optimistic to find it worthwhile to invest in a technology for screening
entrepreneurs' projects, and yet be pessimistic enough to use this technology". VC
investors are the kind of rational financial intermediaries that bridge the gap between
risk-averse investors and risk-taking entrepreneurs and provide the necessary
credibility for making high-risk high-gain investments through a special set of skills
and practices. This framework serves for illustrating how intangible trade costs were
reduced in the Israeli case. As we pointed out earlier, in a small country like Israel the
high-risk capital that is required for innovative technology can be solely achieved
from the major capital markets. Moreover, the capital that is required for investment
in innovative technology is sector specific (Wong, 1995) in the sense that it brings
added value into the investment. This added value might be hands-on experience in
risky investments such as suitable managerial practices including crisis management,
accountability and reporting procedures, industrial contacts and networking and more.
These features extend beyond the scope of a conventional financial investment. In this
19
context, investment in innovative technology requires a specific professional skills set
that is provided by venture capital investors. Institutional investors usually supply
high-risk capital through such private equity and VC firms. As we pointed out earlier
public money is much less efficient than professional, i.e. VC, money in the
commercialization of innovative technology products. This relates to the above but
also to the fact that VC investors are compensated based on their performance through
a carried-over interest mechanism, namely they share the return-on-investment funds
with their investors. The information gap between risk-averse investors and
entrepreneurs widens when the entrepreneurs reside in a foreign country. Adding the
tangible and intangible trade costs of partial imperfect information on top of the
geographical distance makes things worse. In a recent survey of VC funds models
Meyer and Weidig (2003) argued that "the venture capital market is illiquid,
immature, and lacks transparency". Such environment is favorable for practicing
monopolistic competition that enables VC firms to set up a decision-making system
that reduces the trade costs that are associated with risky investments. The unique
structure of the VC firms, their investors, and the demand for high-risk capital by
technological entrepreneurs creates a monopolistic competition market for high-risk
capital. This position gives the VC firms the incentive to invest in information
transparency in order to signal about credible investment policy. Hence VC investors
go into the effort of screening investment opportunities by a thorough due diligence
process that addresses the concerns of their investors on issues such as financial,
accounting, legal, IP, managerial, ethical, cultural and more. For this reason, the
financial intermediation of VC firms on cross-border investments is crucial in
facilitating for risk-averse foreign investors to invest in innovative technology
ventures in foreign distant countries. In fifteen years retrospective, there is no doubt
20
that in the Israeli case the presence of American VC firms and investors was
instrumental in enabling the Israeli Hi-Tech sector to create its local comparative
advantage. A reflection of that is the fact that the number of Israeli firms that are
listed on the NASDAQ stock exchange is ranked third after the USA and Canada.
4.2 The government as a catalyst
Asymmetry is a problem that many small and medium size countries (or firms) face in
the international markets. By far and large, the relative benefit of building up Hi-tech
sector in a small or medium size country is greater than its contribution to the
international trade. For example, the importance of building up a new, local,
comparative advantage for Israel in the Hi-Tech sector by far exceeded the
contribution of its Hi-Tech sector to the international trade. Hence, in this case the
asymmetry works for the benefit of small and medium size countries.
The YOZMA program that was launched by the Israeli government addressed the
prerequisites that were considered so far. In 1992 the Israeli government had allocated
$100M for investment in new venture capital funds. This amount was committed to
fund up to 40% of the fund size of newly formed VC firms. The rest 60% were
supposed to be invested by reputable and experienced international investors. It took
about three years time for these ten newly formed VC firms to raise the rest of the
funds from global reputable investors and reach a total of $210M, these funds
currently manage more than $4B. Table 4 presents the original YOZMA member
funds, their international investing partners, original fund size and current fund size.
21
Israeli Fund
International
Original fund size
Current fund Size
($M)
($M)
Investor
Gemini
Advent (USA)
25
550
JVP
Oxton (US, Far-
20
670
20
1000
20
242
25
185
Kyocera
20
260
(Germany),
20
980
20
40
20
72
20
80
East)
Pitango
(formerly CMS (USA)
Polaris)
Vertex
Vertex
International
(Singapore)
Walden
Walden
Venture
partners (USA)
Concord (formerly AVX,
Nitzanim)
(Japan)
Star Ventures
TVM
Singapore Tech
Inventech
Van Leer Group
(Netherlands)
Eurofund
Daimler-Benz and
DEG (Germany)
Medica
Table 4.
MVP (USA)
The first ten Israeli VC funds that formed the Israeli habitat for high-risk high-gain
innovative technology investments, their initial foreign investors upon inception, the funds raised at the
time of inception and the extend of currently managed funds.
22
Moreover, the program gave the Israeli VC firms a five-year call option to buy out the
government stake thereby increasing the upside potential for foreign investors. Real
options analysis indicates that a call option for buyback is significant risk mitigation.
Nine out of the ten VC firms exercised this option by 1997. This allowed the
government for a controlled exit out of the VC sector, in fact privatizing it on-demand
and at the will of the VC firms. Note that the local VC investors were entrepreneurs
themselves that allocated the resources and the efforts that were required to make
international investors comfortable enough to invest in Israeli ventures. In this way
the Israeli government harnessed local businessmen to act as agents of change that
turned into international financial intermediaries by the end of the process. Luckily,
the YOZMA program had a perfect timing. It was launched at a time where the US
VC industry was relatively small and when the global Hi-Tech sector, as well as the
last ICT revolution, was just picking up (prior to the wide spread of the internet, cell
phones, laptops and the like). Still, the $210M that was raised could hardly overcome
the entry barriers of the global Hi-Tech markets. However, it triggered a process of an
external flow of funds, into other newly formed VC firms, which provided the
necessary critical mass of funding as well as the required experience and skills set
that purchased Israel the entry ticket into the global Hi-Tech market. Note that in this
case the government did not act as the driving force for stimulating technological
innovation. Rather it acted as a catalyst to ease the way for market forces to get into
action by reducing tangible and intangible international trade costs. Currently there
are about 120 investment organizations in Israel of which about 85 are VC firms that
manage roughly $12B (For comparison, in 1992 there was just a single fund that
managed $20M). Table 5 outlines the basic features of the YOZMA program. Note
23
that the program itself has nothing specific to Israel apart from the fact that there was
no VC sector in Israel prior to it.
Policy
Term
Comment
Portfolio approach
Set up 10 VC funds
Government act as a fund of
funds
Set up a government VC fund
Direct investment
with $20M
Up to $8M per fund for up to
VC allocated funds
Minority holding
40% equity stake
Five years option to buy back
Buyback option
the government’s stake
To
Government
Representative
in
signal
government
involvement and commitment
the
investment committee of
each fund
Engage
complementary
programs

Incubators program
To

MAGNET
involvement and commitment as
program
(academy plus industry
consortiums
for
signal
government
well as deal flow generation
the
development of generic
technologies)
VC Structure
Limited Partnership
Mandatory,
to
reduce
risk
exposure for foreign investors
Foreign investors
Equity investor (not debt)
Mandatory,
experience,
to
bring
skill
networking, and reputation
Table 5. High-level features of the YOZMA program
24
in
set,
4.3 The habitat for innovative technology
A recent report on the Israeli policy for innovation development has identified system
failures or barriers that YOZMA succeeded to overcome. These are as summarized in
the following table (adopted from Trajtenberg, 2005)
Barrier
Difficulty in accessing professional
Solution

Sharing the risk with the local private
investors (Government share in YOZMA was
reputable foreign partners
40%)
Assembling critical mass of

Upside incentive

Participation of World-Class foreign VC firms
is mandatory
capabilities
Critical mass of financial resources

Selective choice of local investors

Direct government investment through the
YOZMA fund ($20M)

Fund of funds investment through YOZMA
($80M) in 10 VC firms

$1 YOZMA vs. $1.5 private investors (total of
$250M for investment)
Coordination

Joint planning and execution of the program
(YOZMA officials with the private investors)

OCS representative on the BoD of each VC
fund

Parallel
execution
of
complementing
programs (Incubators, MAGENT, etc.)
Early stage investments
Assuring fast learning curve

Requirement – Early stage investments

LP form

Requirement – Foreign VC as GP or LP

Set up a new VC firm
25
Country/Government signaling

$100M of government funds

Extensive interaction during planning and
execution
VC firms selection

Implementation of complementary programs

On going process, if an important criteria was
identified it was added to the list of
requirements from the following VC
Table 6. The Market failures, or barriers, that the YOZMA program succeeded to overcome. Such
barriers are typical for small and medium size countries.
Noteworthy, during the late eighties and early nineties Israeli policy makers have
been experimenting with different funding mechanisms for the Hi-Tech sector using
variety of policies including setting up public VC funds (traded on the Tel-Aviv stock
exchange) with government downside protection (investors money was insured by the
government insurance company INBAL). All these trials, and derived policies, failed
for the following reasons: applied Push Strategy and focused on increasing the pool of
VC firms by using public money, the use of public money for stimulating
entrepreneurship, ignored taxation issues for both local and foreign investors, unclear
monetary policy as well as unfavorable taxation, ignored the need for high-level
professional investors and ignored cardinal issues that are associated with VC
organizational structure. The YOZMA program exercised Pull Strategy in which
public money was used to reduce international trade costs and stimulate the market
forces to get into action thereby triggering positive feedback for building up the local
VC sector, possibly unintentionally but still very successful.
26
Summary
We studied the prerequisites for the formation of innovative high technology sector,
especially in small to medium size countries (but not limited to), by analyzing the
Israeli Hi-Tech experience over the past fifteen years and by interviews with local
industry professionals and entrepreneurs as well as variety of data sources. We
assume that these requirements can be matched by the creation of intellectual property
and the availability of highly skilled engineering and managerial manpower. Even in
the face of rapid globalization, unprecedented trade liberalization, the ICT revolution,
and modern transportation that significantly reduces shipment costs, international
trade is not free of costs nor it is frictionless. The policy of various regional
organizations and governments should acknowledge the importance of the local
comparative advantage concept. The Israeli experience in the Hi-Tech sector is an
example of how a specific form of international financial intermediation can reduce
trade costs and become instrumental in creating a local comparative advantage.
Meeting the investment requirements of international investors is a must for realizing
the potential of technological innovation in the international trade. Unfortunately, in
many cases the public policy is focused on the technology and the entrepreneurs. We
argue that the optimal policy for governments and regional organizations that seek to
establish foothold in technology innovation is to focus on attracting experienced and
credible international investors and that market forces will take care of the rest,
including stimulating local entrepreneurship. The Israeli experience has taught us that
the following prerequisites have to be met in order to increase the chances of success
in setting up innovative technology Hi-Tech sector in small/mid size countries. These
are:
27

Attracting professional sector-specific capital. Namely establish comparative local
advantage via the attraction of foreign venture capital or private equity funds by
using public money to mitigate their risk and increase their upside return.

Adopt a portfolio approach to create an industry-wide reduction in trade costs.

Reduce uncertainties and costs to minimum (including tangible costs that can be
controlled such as taxation, knowledge transfer limitations, foreign currency trade
limitations etc.)

Build a suitable habitat for nurturing innovative technology. Namely, setting up an
effective communications infrastructure by focusing on the relevant dimensions of
information in financial & accounting, legal, technological, and cultural in order
to signal credibility and transparency.
We argue that the Israeli experience is valid for many countries that are interested in
setting up or strengthening their high technology sector. We recommend for
governments to focus on attracting professional high-risk investors at the first stage
rather than on the entrepreneurs. We also recommend governments to adopt a catalyst
role rather than an enabler role. Every country has its local barriers that have to be
overcome in order to take part in the global game. This can be accomplished by
setting up the proper habitat for the market forces to get into action. If done properly
then positive feedback will take care of the rest of the process. Our findings and
conclusions are in some contradiction to the policies that are currently practiced by
some of the governments and regional orgnaizations in the European Union and other
countries.
28
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