The years 2017-2020 in which the decline in the number of startups occurred were among the best years for Israel’s tech industry and included a record number of investments and public offerings of Israeli companies. This raises the question: should the decline concern policymakers, and if so, what should they do?
Our findings point to two sources of the decline: the maturation of the ecosystem, reflected by the steep competition for resources, especially human capital, and shifting global trends alongside a decline in the SMA sector. Accordingly, two different reasons may be cause for alarm: The first relates to the composition of new startups (and accordingly, the composition of Israel’s future innovation ecosystem), and the other relates to their overall number.
Startup composition: Should the decline in SMA startups worry decision-makers? This industry is characterized by fierce competition alongside relatively low technological entry barriers (most companies in this industry rely on existing technologies, rather than on technological breakthroughs). In addition, the overwhelming majority of startups in this industry are built on “standard” software (web pages, social networks, mobile apps, etc.) and therefore there is great mobility between it and other industries. An entrepreneur or programmer in a social media company can easily switch to fields like Fintech, Cybersecurity, and others. It is therefore unlikely that employees in these fields will encounter difficulty finding employment as a result of a decline in this sector.
Likewise, we assume that the number of entrepreneurs whose ideas are limited to this industry is small. Regarding investors, we also believe that the decline of this sector does not take away resources from Israeli technology, and it is doubtful whether there are investors who specialize only in SMA. The other side of this mobility is that an increase in demand for this industry in the future will prompt the transition of many entrepreneurs, human capital, and financial capital back to this industry, relatively seamlessly.
The above analysis would be very different if the decline in the number of new companies occurred in industries with low mobility requiring specialized expertise, like life sciences or semiconductors. The loss of entrepreneurial capital in such industries would present a much greater risk to them, as opposed to the SMA sector.
The number of new startups: Addressing the question of whether a decline in the overall number of startups is worrying necessitates a discussion, if only in principle, on the question of the “optimal” number of new startups. This question is of course meaningless, since it is not clear what “optimal” means, and to whom. Nevertheless, it is important to examine the ecosystem in the face of the objectives set by the government in recent months – first and foremost the objective to increase the number of high-tech employees. Whether the target is 15% of the workforce or one million people – one fact is clear: it requires the proliferation of growth companies – large Israeli technology companies employing many employees in diverse professions.
From this perspective, startups are potential growth companies. Therefore, a large number of new startups every year increases the prospects for the emergence of a wider tier of mature Israeli technology companies. Given that many startups fail and close after a few years, the decline in the number of new companies will negatively impact the potential for the creation of established companies.
That said, it is important to consider the chronic and acute labor shortage in the high-tech sector, especially of software developers. Unlike financial investments that can double in size from year to year, the number of potential tech employees grows at a slow rate of just a few percentage points per year. Therefore, too many startups (most of which will not grow to become established companies) increases competition over a small pool of employees, driving up wages and (indirectly) impeding startups’ ability to develop into large companies.
The “correct” number of new startups – and the answer to the question should there be concern over the decline in the number of new startups – should take into account both of the above considerations. We do not believe that more startups automatically results in a stronger ecosystem. That said, we believe it is imprudent to ignore warning signs relating to a continuous decline in the establishment of new startups. Should the government act to increase their number to offset the trends we pointed to in this study? We certainly think there is room to prepare such an occurrence, but interventions beyond the standard support from the Israel Innovation Authority are premature in our opinion. As our research has shown, one industry accounted for the majority of the decline, and a similar decline was also noted abroad. As the decline in this sector does not pose serious harm to entrepreneurship, its impact on the ecosystem is limited.
The longer the trend of the decline in entrepreneurship and the rise in resources required to establish new startups continues, Israel’s technology industry could find itself at risk of losing its ability to produce a substantial number of growth companies. It could be that these trends are early signs that we need to prepare for a structural change in the technology market in the near future (especially when considering the lack of any indication that the average quality of startups has increased, alongside the decline in their number). It should be noted that the unprecedented success of the Israeli high-tech sector that we are currently experiencing mainly reflects the quality of startups established before the decline analyzed in this study.
In general, we think active government intervention to correct negative trends in the ecosystem (beyond generic involvement based on known market failures) requires a relatively high threshold of understanding the problem and its causes, as well as high conviction regarding the efficacy of an intervention.
The relatively short span of time since the beginning of the decline and the partial information on the scope of the problem (especially due to the delay in receiving complete data on the number of new startups), alongside COVID-19, make it difficult to identify the relative contribution of each of these trends to the actual decline.
That said, we believe that even though it is too early for immediate action, the number of new startups should be closely tracked, as well as their ability to raise early funding rounds. In addition, more research should be conducted regarding the decline in the number of new startups with an emphasis on the decline in the proclivity towards entrepreneurship.