JERUSALEM (Bloomberg) - Israel's long-held status as a hotbed of tech innovation is under threat.
Despite record venture capital investment last year in young technology companies, growth in the so-called "startup nation" is slowing.
While the tech sector grew faster than gross domestic product (GDP) nearly every year between 1998 to 2009, in the five years following it surpassed national growth only once, in 2012.
The Finance Ministry acknowledged in a February report there was a stagnation of the industry that fueled Israel's economy for the past two decades. Last year, Israel slid to 22nd place, from 15th in 2014, on the WIPO Global Innovation Index, which annually ranks the innovative capabilities and performance of 141 economies.
The nation scored lower marks for human capital and research as well as market and business sophistication.
Both the percentage of the workforce operating in tech, and money spent on research and development (R&D) as a percentage of GDP, have remained flat over the past 10 years.
Meanwhile rival economies are picking up the slack. While Israel has invested about 4 per cent of its GDP in R&D since 2000, Korea doubled funding and surpassed Israel in 2013 by investing 4.29 per cent of GDP to Israel's 4.11, according to OECD figures.
The problem isn't that Israel has stopped innovating, but that the ecosystem innovation needs to thrive has been neglected. Government hasn't increased the percentage of money it spends to nourish ideas or changed immigration laws to allow companies to import engineers necessary to offset talent shortages.
Regulations have made it hard for smaller companies to flourish and local institutional investors to participate in the new economy. Unique ideas and the entrepreneur culture still draw world class investors, but for how long?
"I've been going around the world saying we are the second biggest innovation center in the world after Silicon Valley and, at the moment, that is still true. But other countries are growing faster and are going to be bigger in absolute terms," said Saul Singer, author of the 2009 book "Start-Up Nation" that gave Israel its nickname.
"Basically every country in the world is building an innovation system," he added. "We are acting like it is just Silicon Valley and us."
Alphabet chairman Eric Schmidt warned Israeli entrepreneurs and investors in Tel Aviv this month that Beijing and northern Europe were becoming "worthy competitors" for the title of "startup nation".
"You need to work harder on this and move as fast as you can because you have strong competition," he said.
As many as 10,000 skilled computer engineers are needed for the sector to grow amid a critical talent drought, Erez Tsur, co-chairman of Israel Advanced Technology Industries, an umbrella group, has suggested.
SimilarWeb, an Israeli startup that analyzes web traffic for corporate clients such as Airbnb, faced this challenge directly when it couldn't find adequate engineers fast enough at home. Last year it opened a development center in the Ukraine, where qualified computer specialists were hired within a month.
Moving the engineers to Israel wasn't an option, as getting work visas for non-Jews is "almost impossible," said Or Offer, co-founder and chief executive officer of SimilarWeb. And when Jews immigrate to work for the company, there is the mandatory military draft for men and Israeli women, Offer said.
"You see the conflict here," he added. "It's hard to bring non-Jews and when you convince Jews to come, the army takes them."
A shortage of skills isn't a fresh problem. About a year ago companies such as the US units of SanDisk and Broadcom said finding qualified workers locally is one of their biggest challenges and one of the "top problems" for Shahar Bar-Or, Israel site manager for SanDisk.
Wix.com, an Israeli website development company that trades on the Nasdaq with a market value in excess of a billion dollars, names other issues at play. Anomalies in local tax structure create a situation where Israeli companies may end up paying twice as much for their compatriots than foreigners.
"If I'm an Israeli company growing basically by acquiring other companies, it is a growth path that is harder to achieve,"said Nir Zohar, president and chief operating officer of Wix. Exhaustiveregulations for publicly-traded companies apply even to Israeli companies that only list abroad.
"The result is you have to comply with English rules of the road, drive on the left, but also with Israeli rules and drive on the right, and you only have two lanes," said Zohar. "In general, it doesn't make sense. Regulation is there to protect investors and our investors are American, not Israeli."
Israeli Prime Minister Benjamin Netanyahu has acknowledged the challenges and said the government is attacking the problems "on multiple fronts," putting in place changes that will allow companies to import talented engineers as well as working on plans to expand incubator programs, increase budgets to university computer science departments, and ease regulatory and tax burdens.
On regulation there is much to do. A World Bank survey launched to encourage economies to compete toward more efficient regulation this year ranked Israel 53 out of 189 economies in ease of doing business, a steep drop from 29 in 2010.
It may not be easy. Eugene Kandel, who served as head of Israel National Economic Council for six years before becoming head of the non-profit Start-Up Nation Central, said reforms are often stymied because solving the technology industry's problems "doesn't bring any votes" in a country preoccupied with the "have" and "have-nots".
Foreign Investment Karin Mayer Rubinstein, chief executive officer of Israel Advanced Technology Industries, warns the government "not to be so in love" with the idea of "startup nation" that it fails to take necessary steps to maintain growth.
More needs to be done to encourage local investment, she said. Of all money raised by Israeli startups last year, 85 per cent came from foreign investors, according to IVC Research Center.
Without local institutional financing to bolster venture capital funding, the entrepreneurial spirit in Israel will dry up because those who benefit from exits will be foreigners.
Even more important than not working for the world, is opening up to it, said Start-Up Nation author Singer. Israel should tackle its talent drought by lifting restrictions on foreigners and allowing in not just engineers, but technology entrepreneurs, who would create their own businesses in Israel, joining the ranks of more than 7,000 startups in the Jewish state.
"We can be almost as big a magnet as Silicon Valley," Singer said. "Instead of taking advantage of the fact that the rest of the world wants to innovate with us, we are keeping our doors closed. There is a window of opportunity while we are temporarily larger in size and more experienced than they are."
Israel should also follow Silicon Valley's lead in teaching coding to children from kindergarten age in all demographics, said Wix's Zohar. "That way we can become a real high-tech nation and the Arab minority and ultra-Orthodox can be part of it," he said.
Campaigns to encourage study of advanced science and math, introduced to address Israeli aggregate high school test scores that are below OECD average, aren't enough, he added. And state programs launched to train under-represented populations for technology jobs, alongside private initiatives from companies such as Alphabet, have drawn Arabs and ultra-Orthodox into the new economy, but not in large numbers.
If the government would just wake up and take the steps needed to build the human capital needed to grow the industry, Israeli entrepreneurs would be able to build world leading companies, said Michael Eisenberg, founder and partner at early stage venture fund Aleph.
"We should be able to build an Apple and a Google in Israel in 2016. There is no reason why not. We just need enough talent to do it," he said.