The Slow, Necessary Decline of Israeli Adtech

Israeli adtech has had an outsized influence on the global online advertising market, relative to the country’s small size. However, aside from a handful of successful acquisitions by AOL, Nielsen Holdings PLC and Singapore Telecommunications Ltd. over the years, most Israeli adtech startups have not been able to cash in as expected, leaving entrepreneurs and investors disillusioned. For more than a year now, public market investors have made their view on the market abundantly clear, meaning that even those few large, profitable and otherwise successful Israeli adtech startups have had the IPO door shut in their face. Of course, it’s not just Israeli adtech that has failed to deliver. Aside from Criteo (CRTO) and The Trade Desk (TTD), there isn’t a single public adtech company worth more than $500 million.

While I have met and evaluated dozens of adtech startups over the years, I could never bring myself to make an investment, and I consider myself lucky to have dodged one of the dominant local investment themes of the last decade. Most venture funds in Israel now share my opinion, but to my surprise Israeli entrepreneurs and employees continue to enter the segment and are shocked to discover that their sector is still out of favor.

If you are considering entering this market, read this and reconsider.

When Online Advertising Became Adtech

Adtech came of age in Israel in 2008 as the online ad sector transitioned from a creative-led industry to a data and algorithms-led industry. Back then, online display advertising was rapidly moving towards programmatic trading on real time bidding exchanges, opening up the market to new entrants. Acquisitions by Yahoo! (RightMedia) and Google (DoubleClick and AdMob) provided a series of false signals to the market that venture-backed adtech innovation would fuel the next M&A boom. It didn’t, but the “online advertising” market had successfully rebranded itself as “adtech,” thereby dramatically improving the appeal of the sector to prospective investors and employees. A new tech sector was born.

Adtech was clearly a strong match for Israeli technical and business competencies. Smart algorithms were easier to develop than smart products and powerful data science from Tel Aviv was likely to outperform a strong creative from New York. For the most part, adtech businesses could be built and managed remotely, helping Israeli startups overcome distance barriers, and most importantly, venture investors were willing to fund it.

Israeli venture investors were smitten with the idea of young, revenue-generating startups. Some adtech startups were even “bootstrapped,” a word so seldom used in Israel that there is no Hebrew equivalent. Despite low product margins and relentless competition (often from other Israeli startups), the promise of a big adtech payday convinced investors to pay valuation multiples more akin to those paid for enterprise software startups.

Aside from a couple of high-profile Israeli exits in the sector (e.g., Amobee and eXcelate), the acquirers never paid up. Competition never ceased. Margins only went down. Still, the entrepreneurs kept coming and the investors kept on identifying the next trend. At any given moment, the adtech market was hurriedly moving to new ad formats, new platforms, new customer sets or new business models. In 2008 it was rich media, SEM (search engine marketing) management, semantic algorithms, and incentive marketing. A couple years later it was video, Facebook, mobile apps, local campaigns and retargeting. Now it's native web, content marketing, AI-powered campaigns and performance-based payment models.

There is always some new angle, because advertising dollars continues to move from offline to online, bringing new advertisers, new end customers, new tactics and growing budgets. The market is also clearly becoming more technologically sophisticated. Moreover, the ability to generate a profit with minimal upfront investment suggests it might be the ultimate sector for angel-backed or bootstrapped startups. But as I explain below, adtech startups do not scale gracefully or age very well. Both scale and time are enemies in this fast moving market, which in turn limits exit values and turns off venture investors.

Since I still see entrepreneurs and investors asking me incredulously why I wouldn’t want to look at a fast growing, nearly profitable adtech company, here are my six reasons in no particular order:

1. The Google/Facebook duopoly is enjoying all the growth – Despite all the innovation and money pouring into the sector over the last decade, a duopoly now dominates the online ad market. Google and Facebook account for 73% of all ad revenues, and more concerning, for a whopping 99% of growth in the sector (the rest of the sector is no longer growing in aggregate). They have made it their business to control the online real estate where consumers spend their time, which in turn serves as a conduit to navigating the remainder of the web. Adtech startups can still nibble at the edge of the Google and Facebook ecosystems, but the larger they grow, the more likely they are to bump into Google and Facebook’s own growth strategies. Their dominance should also frighten companies that provide ad buying and analytics tools. The broader the applicability, the more compelling a case can be made for Google/Facebook to develop such tools in-house and provide them en gratis.

2. New formats and methods provide only a temporary advantage – There is always a new format generating fantastic click-through rates (CTRs) as it proliferates through the web, but all these formats follow a distressing pattern of decline over time as fatigue settles in. You see, new formats are both stimulating and confusing to consumers like you and me. At first, we click to see where it leads, initially on purpose and then by mistake, but over time we learn to anticipate where that click leads us and not only avoid clicking, but successfully avoid even looking at the ad. New formats will rise and fall, but most of these come at the expense of users, whose web browsing experience is brutally interrupted by a targeted ad.

3. Aggressive content and ads will always win despite the best intentions – Ads that include pictures of barely clothed women, promise obscure dieting tricks, introduce new pseudoscience revelations, offer something expensive for free or include a click-bait title like “you won’t believe what happened next” are always the most successful ads. It doesn’t take a degree in psychology to see why. They are spammy, scammy and misleading, and even if a small fraction of consumer click on them, these are the ads fueling most adtech companies, and not because these startups create or even like the ads. They don’t create them, but since online advertising became about competitive bidding, the most aggressive ads naturally rose to the top and stayed there ever since. Large platforms and publishers create restrictions to avoid hurting their users, but the advertisers easily readjust or move to the platforms that will let them through.

4. Algorithms don’t scale in an open and transparent market - The data-driven, competitive bidding online ad market is perfect for new algorithms developed to optimize ROI (return on investment). The opportunity mimics the competitive bidding and transparency found in commodity and stock markets, but also poses the same challenges to scaling. Dozens of Israeli adtech companies were founded based on a better set of algorithms that delivered a significant improvement in performance at a small scale. Unfortunately, this is never sustainable. One of the reasons is the lack of sufficient, worthy inventory, since often there really are no good buys on the market. Even when a large inventory is available, the product is dedicated to optimizing the same aggressive ads described in #3 above. Still, the most important reason it doesn’t scale is that success invites competition. The same low barrier to entry that allowed a couple entrepreneurs with a better algorithm to start raking in profits will allow the next startup do to the same. There is no way for technology alone to create a sustainable advantage in adtech.

5. Product margins come at the customer’s expense – Early adtech companies were essentially arbitrage companies, buying and selling ads at a handsome profit. Entrepreneurs realized this was neither a scalable nor a particularly attractive way of building equity value, so they pivoted to selling their technology as a service on behalf of other media buyers. This looked a lot better than standard arbitrage, except the business was still inextricably linked to the media buyers' spending budget and their campaigns’ profitability. This seems fair to the buyer, but it highlights a key vulnerability of adtech. An adtech company’s revenues come directly out of the media buyers' pockets, akin to revenue sharing. Put differently, adtech profits come directly at the expense of their customers’ profits. This awkward customer/supplier relationship is constantly put to the test in the form of margin pressure in a race to the bottom.

6. Recurring revenue mirage – Most investors will concede that adtech revenue is not as valuable as software revenue, but in the early years of a startup the rapid growth, the appearance of recurring revenue and the ostensible low “churn” from its customer base can captivate even the most experienced investor. Big name spenders often become the early adopters, further confirming investor intuition that the startup is onto something, but the reality is a little different. Big online ad spenders will try anything and everything to gain an edge that lowers the cost of customer acquisition or introduces hope for a new scalable acquisition channel. Trial and error is the only way to scale as a marketer and there is little cost to diverting a tiny percentage of ad spend to something new and innovative. Even when the new channel does comprise a substantial percentage of a media buyer’s budget, the switching cost is sufficiently low as to create pressure on margins.

Several Israeli adtech companies have realized all of the above and have done their best to sell their services as software (SaaS spelled backwards). Those that manage this transition will survive and improve their chance of a successful exit, but it is far from trivial to convince customers who are used to paying for performance on a monthly basis to shift to paying a fixed fee regardless of performance. Even when the conversion is successful, the pricing of the software is still linked to size of the media budget, which of course varies with the success of the campaigns and with seasonality. This is what differentiates marketing tech from adtech. The former is not in any way linked to the amount or profitability of ad spending. My view is that the profitable companies will be niche companies that are very focused on a certain type of advertising media or on a specific type of customer.

So what does work in adtech? Not much. Companies that create completely new real estate and use their brand power to divert consumers away from Facebook, Google and Amazon will succeed. Think Pinterest, but this isn’t adtech, but rather an adtech monetization model developed and wholly owned by Pinterest. Opportunities also exist for companies that manage to legitimately and consistently acquire proprietary consumer/buyer data, but these are few.

In Israel, adtech giants like Outbrain and Taboola have carved out quasi-new real estate on third party websites, which generates new revenue streams for publishers while offering a new customer acquisition channel for buyers. They have pioneered content marketing and made publishers dependent on them (though not necessarily more profitable), but the rivalry between them is fierce and customer loyalty is largely bought with dollars. While content recommendations and content marketing is here to stay, consumer fatigue and publisher brand erosion will make it difficult to continue scaling. In the meantime, they continue to battle each other until one emerges as the Pyrrhic victor.

The third Israeli adtech unicorn is IronSource Ltd., which specializes in download monetization over the web and mobile-using data and incentive marketing to provide better converting ads. Their success is also attributed to their continuous expansion into additional digital ad formats, which provide them with an opening where there otherwise wouldn’t be one.

I have long been hesitant to publicly indict an entire sector of the high tech economy, but the continued prominence of adtech in Israel concerns me. Young entrepreneurs continue to pursue business opportunities in adtech, unaware of the sector's problematic reputation, when they could be doing something more rewarding and exciting. It may be in their self-interest, but some of the biggest detractors are themselves adtech entrepreneurs and refugees, who have been there and have no intention of ever returning.

Adam Fisher is a partner at venture capital firm Bessemer Venture Partners. In 2007, Mr. Fisher established the firm’s Israeli office. Before joining Bessemer Venture Partners, Mr. Fisher was a partner at Jerusalem-based venture firm Jerusalem Venture Partners, working from New York, Jerusalem and Beijing.