GLOBALIZATION AND FIRM DYNAMICS IN THE ISRAELI SOFTWARE INDUSTRY: A CASE STUDY OF DATA SECURITY This paper focuses on some microeconomic aspects of the process of globalization, namely the patterns of growth of very successful Israeli companies in a specific but very important IT area-Data Security. The background to this focus is the process of globalization of the last two decades of the millenium; the associated surge of high tech industries in many countries worldwide (including Israel); and the emergence of a new type of high tech cluster in Israel spearheaded by the Software and hi tech Communications Equipment areas (of which Data Security is part). The success of Israel’s high tech IT sector during the 90s would not have been possible without the continued deepening of the globalization process during the last decades of the millenium and of the continued IT technological revolution. Globalization of technology & knowledge, organizational forms, capital markets, and skills created new opportunities, which some countries more than others (or earlier than others) happened to exploit due to their flexibility and capacity to adapt. Israel was one of the first countries out of the US, which was fortunate enough to have exploited such opportunities, at least during the 90s. Evidence of this is the fact that US venture capital companies invest in Israel more then in any country out of US. Israel’s success with high tech and its ‘reconfigured cluster’ seems to have been linked to the following factorsThe “Silicon Valley” model of IT high tech has and is diffusing to other countries; Strong links to US (and to some extent other countries’) Asset and Capital Markets were forged; Significant Foreign Investments into Israeli hi tech, particularly in IT areas, have occurred; Strong Personal, Professional & Business links and networks have been forged between Israeli engineers, managers, investors and their counterparts in the US (to some extent also elsewhere). Objectives of Paper There are three main objectives of this paper: 1. An analysis of Firm Dynamics in the Data Security Area of Israel’s Software Industry. 1 2. An analysis of the Emergence and Development of the Data Security Area itself. 3. Theoretical (and some potential Policy) Implications. The central focus of the paper is the dynamics of growth and internationalization of companies, which we trace through a combination of in-depth interviews, assembly of additional information on each one of the 19 companies, and conceptual (Appreciative) theory to build growth profiles of very successful companies. The conceptual framework is summarized in figure1. Figure 1: Company Growth and Potential Impacts Cluster effect Firm Outcomes Phases of Growth Growth Profiles Initial Conditions Entrepreneur Background 'Initial' invention Performance "Social" Impact Firm Strategy Policy 2 Sample / universe The sample included 19 firms, which comprised the total Universe identified at the time of the research. We have distinguished three stages in the growth of the industry- stage 1 (early 1980-1992), stage 2 (middle, 1992 -1996) and stage 3 (growth, 1996 - 1999). We also distinguished between three levels of (private) performance of individual companies according to level of sales and market capitalization (at 10/1999). This include: Very successful companies (four, two founded in Stage 1 and two in Stage 2); successful companies (6), and other (which includes failures, promising new companies, and struggling companies). Very successful companies comprised almost 90% of total sales and market capitalization of the whole industry. Table 3a: FIRM PERFORMANCE CATEGORIES VERY MODERATELY OTHER (O) SUCCESSFUL (SS) SUCCESSFUL (S) CheckPoint Com2 Emerging Failure Struggling Memco Com10 Com11 Com12 Com7 Aladdin Com15 Com5 Com6 Com13 NDS Com1 Com9 Com14 Com4 Com8 Com3 Table 3b: Companies by Performance Category and Foundation Date Stage1 SS S A: Early (1980-1992) 2 2 B: Middle (1992-1996) 2 2 3 2 6 6 9 C: Growth (1996-1999) Total 4 O 1The current stage of the industry, which began in 1999, lies beyond the scope of this paper. This stage involves creating a unified platform enabling interoperability of all devices. The SVN platform created by CheckPoint is the leading example of this. 3 Growth Profiles The focus of the study is the four successful companies and more specifically their growth profiles a combination of growth phase sequences and strategy. This is justified for three reasons the first being the fact already mentioned that these companies represented such a high proportion of the industry so that their behavior would fairly closely represent that of the industry as a whole. The other two reasons relate to the cluster and to the policy perspective adopted in the paper. On the one hand, the existence of successful companies having gone well beyond the start-up phase is important for other younger & smaller companies for a number of reasons such as demonstrating the possibility of becoming a global company, managerial spinoffs, cooperation etc. These cluster effects of very successful companies (which our research indicates represented part of their social or economy-wide impacts) seem to be of extreme importance in this era of globalization. Finally our research reinforces the view that a strategic priority of technology, innovation and industrial policy of Israel is the creation of large global companies particularly in high-tech industries. This country is SU-intensive but it is relatively weak in leveraging its R&D capabilities in terms of value added and employment domestically, partly because of the absence of large, domestic companies. Thus the identification of profiles of growth of very successful companies is a paramount priority of policy-relevant research of the type we are undertaking here. The very successful profile of growth involves a main sequence with an IPO undertaken at the beginning of the first post SU phase of company growth--the market penetration & product line enhancement phase (phase two of company evolution). See Figure 2. This main sequence involves three out of the four very successful companies. In all cases, the IPO not only enabled market penetration but also was an important milestone in the consolidation of all companies. There are two patterns of consolidation (phase 3 of company growth) under the main sequence: an indigenous consolidation pattern (CheckPoint and Aladdin); and being acquired by a large foreign company (M&A1, the case of Memco). Both variants involve mergers and acquisitions with/of other companies--domestic, foreign or both. The difference resides in potential social impacts. There are reasons to believe that they are higher in the domestic consolidation case than in the other case where the local Israeli Company was acquired by a foreign multinational. This because of the potentially stronger cluster effects of 'domestic' consolidation compared to those of the post 4 acquisition phase of acquired companies (in particular truncation of the process of accumulation of assets related to markets, marketing and clients/customers). Finally, a fourth very successful company -NDS- was acquired by a foreign multinational early in the first post SU phase. In this case M&A1 substitutes for an IPO. IPO in the post acquisition phase of an acquired company plays a different role in company growth than that played by an independent company. In the independent company case it seems to be part of a strategy of market penetration and it accelerates the accumulation of assets including reputation, visibility etc and other factors which set the stage for successful consolidation. The upshot is that there seems to be a generic profile of growth for very successful companies in the Data Security area, with variations depending on whether or not the company was acquired and at what stage it was acquired. There also seems to be differences in potential impacts between the two broad categories of company consolidation - indigenous and acquisition by others. This statement is subject to caveats: it depends on what happens in the post acquisition phase of the nonindigenous case; and recognition of the fact that not all companies in all areas can expect to survive let alone be very successful through the indigenous path. An important factor of very successful indigenous companies is there being "key agents" in the growth of other companies by demonstrating the possibility of succeeding without selling out to others, and by other more specific aspects of their successful strategies which other companies can emulate. Another precondition relates to the values and preferences of entrepreneurs namely the desire to create local, global companies and to "create real companies that solve real problems" (in contrast to creating companies in order to sell them to others). The background of entrepreneurs is also important in successful and very successful companies relative to others, in particular the greater frequency of Army and Hobbyist backgrounds and the presumption that company background was also more adequate in the former than in the latter cases. 5 Figure 2: The Phase Sequence of Very Successful Enterprises M&A2 First Big Sale or Marketing Contract Indigenous Consolidatio n IPO A1 M&A1 A1 M&A1 IPO A1 A1 Phase1 Product Development Phase2 Market Penetration & Widening Product Line Phase3 Consolidation Explanation The upper Main Sequence leads to Indigenous Consolidation (CheckPoint, Aladdin) or to Foreign Acquisition of the Israeli Company --M&A1 (Memco). The lower Special Case involves M&A1 early in Phase2 (NDS). Notation M&A2 represents acquisition of other companies (domestic or Foreign) by the Israeli company. M&A1 is acquisition of the domestic company by a foreign one. 6 Implications and policy The analysis has generated some additional implications concerning the impact of “Globalization". The main ones are: 1) For those countries like Israel where the Globalization process in combination with ‘national adaptation’ has facilitated access to world asset and capital market and in comparison with the situation prevailing during the 80s - the private return to inventors/SU investors is less dependent on acquiring or accessing ‘complementary assets’. Globalization also generates additional means for acquiring these assets (e.g. through IPO or M&A); and large private returns may coexist with weak or low economy wide gains since implementation of the ‘outputs’ of R&D may easily take place abroad; 2) IPOs have direct and indirect effects on company ‘asset accumulation’. The former relate to Reputation, Management Skills and Capabilities, and Social (Relational) Capital; the latter are the cash and shares which may enable a promising SU company to access complementary assets in its target market; 3) IPOs are part and parcel of the ‘Growth Strategy’ of a company rather than simply a mechanism for “exiting” of investors, VCs etc. A major potential implication of the analysis of this paper is that very successful companies, which remain indigenous, may play important roles in enhancing the social profitability of domestic inventions, R&D and SU companies. We are not saying that all good or promising companies should remain indigenous, far from this (also, some have no choice but to be acquired or perish). What we are saying is that most probably a mix between the two types of very successful companies--including a solid representation of global, indigenous companies-- is adequate at the current stage of the Israeli hi tech cluster (were very few IT companies beyond 800 M$ turnover exist and were widespread M&A1 activity is taking place). Note that the broader institutional & taxation context and the existing “environment for business” are not and cannot be neutral with respect to this issue. So even those who would like ‘market forces’ to decide could not be sure that the actual ‘outcome’ is adequate let alone optimal. We are also Preliminary analysis of the very successful companies suggest that both “R&D leverage” effects and “Spillovers” of Check Point, Aladdin and Memco (till its acquisition by Computer Associates) are high, compared to those of the remaining company (and compared to the post acquisition phase of 7 Memco). Both types of effect depend to some extent on the accumulation of ‘complementary assets’ such as those related to markets, marketing and other clientrelated assets; and to production. A typical (although not unique pattern) post acquisition situation is one where the previously independent Israeli company is transformed into an R&D laboratory for the its large multinational parent; whereas companies which remain Israeli perform a large spectrum of post R&D activities with important linkages to the National Economy and to Employment (not only of R&D personnel but of other personnel as well). Moreover, the three companies mentioned above (Memco till its acquisition) made enormous contributions to other companies of the Israeli IT hi tech cluster through a variety of mechanisms. These include facilitating ‘scaling up’ through e.g. vital help in marketing (through OEM agreements or other means); through investments in and acquisitions of other younger companies; through the reputation effects they generated and the business models which they offered to these other companies, and through participation in CheckPoint’s OPSEC forum. While most of these effects are qualitative they are nonetheless real and, pending additional research, have very important policy implications. The major potential policy implication pertains to the ‘Strategic Dimension’ of Innovation and Technology. Side by side with the need of a reconfigured pattern of R&D support (which considers existence of VC companies) a major strategic objective should be ‘growing large, indigenous companies in the IT area’. This objective is presumably important not only for Israel but for other small, technologically advanced economies. At the operational level, this implies first and foremost, supporting the emergence of VC and continuing to support companies’ R&D through subsidies or other means at least till a well developed VC industry is established (in Israel such an industry is quite well developed); institutional and tax reform concerning mergers and acquisitions among local companies; adequate regulation of Telephone, Cable, Satellite, Internet and Mobile services; a privatization strategy of the national Telecom company oriented to the above mentioned strategic priorities; the full implementation of ‘dynamic’ competition policy with a world market perspective, etc. If these aspects of policymaking are geared to the above mentioned priorities, then they a) will generate the possibility of ‘International Expansion’ (end of Phase 1, beginning of Phase 2 of company growth) of good Israeli SU IT companies through facilitating access to world asset and capital markets; 8 b) will create at least ‘neutrality’ with respect to the IPO or M&A1 option of such companies at the end of their SU (and beginning of Market Penetration) Phase; and c) may generate a measure of ‘level playing field’ vis a vis the context under which counterpart or competitor companies in other countries may operate. Complementing these measures at the Consolidation Phase would see other actions such as the reinforcement of the Magnet Program in Israel which supports cooperative, generic research; and creating conditions to facilitate Strategic Partnerships with major international players in the principle world IT markets. Further work must be undertaken to consolidate the policy implications of the analysis2. We believe that the links insinuated or surmised from this paper between microeconomic analysis & conceptual theory on the one hand; and policy analysis on the other are important in fully moving to a more explicit, dynamic and systemic Innovation and Technology Policy in this country. 2 A separate document further develops the policy implications of the research. See Avnimelech, Gayego & Teubal 2000: "The Role of Academic Research in Innovation and Technology Policy Formulation in Israel: General Principles and an Illustration from a Study of Very Successful Hi Tech Global Companies", typescript. 9