Doing Business In: Israel
Pearl Cohen Zedek Latzer BaratzView firm profile
Pursuing and advancing its reputation as the “Start-Up Nation”, in 2017, the State of Israel continued to emphasize innovation at the forefront of its culture and business environment. The international Bloomberg Innovation Index of 2017 ranked Israel as the 10th largest country of innovation. More than ever, Israel offers countless investment opportunities for global and domestic strategic partners, private equity and venture capital firms. Individuals can also invest in Israel as angel investors, as limited partners in venture capital funds focusing on Israeli investment, through crowd funding and public offerings around the globe.
This prosperity of Israel’s Start-Up Nation is reflected by the record sums invested in local innovation-driven companies and the increased sum-per-transaction across multiple industry segments, from cyber security and AI to biotechnology and medical devices.
In tandem, garnering such success demands of local companies and law-firms to carefully consider the manner in which they protect their key assets, primarily their talent and intellectual property. This article explores recent trends in the Israeli High-Tech industry and details its existing complexities and challenges.
Israel’s extensive and prosperous innovation industry has long been attributed to the country’s cultural focus on innovation and out-of-the-box thinking. Bill Gates has been quoted saying that there is a greater concentration of talented hi-tech manpower in Israel in comparison to other countries, almost to the extent of Silicon Valley. The industry began domestically as a strong base for research and development in information technologies and later spread globally. Large multinational companies have established R&D hubs in Israel including, in the ICT sector alone, Apple, Cisco, Google, IBM, Intel, Motorola and Microsoft. For example, a large part of the Windows NT operating system developed by Microsoft and the Pentium MMX Chip technology were designed for Microsoft and Intel, respectively, at their R&D facilities in Israel. More recently, European, Chinese, Korean and now Japanese companies have increased their interest in Israeli technologies as well.
Israeli scientists developed the cell phone, flash drives, voicemail, voice over IP, real-time Internet messaging, a pill-sized swallow-able camera, Waze, Wix, expandable Stent and drip-irrigation, among a long list of other innovations that have impacted the people around the world. Key Israeli industries include (1) life sciences, pharmaceuticals, medical devices and improved medical processes (e-health), (2) cyber security, (3) tech, telecom and media and (4) defense.
According to the IVC research center, in 2017, Israeli high-tech companies raised $5.24 billion across 620 transactions, reflecting an increase of 9% from 2016 during which $4.83 billion were raised across 673 transactions. Moreover, in 2017 the total transaction value for exits of Israeli companies reached $23 billion and included two mega-exits, which each exceeded $1 billion. Discounting the two mega-exists, the total transaction value in 2017 was $6.6 billion, reflecting an increase of 19% from 2016.
Since the 1980s, more than 250 Israeli related companies have been listed for trading in the U.S. and currently 84 Israeli companies are listed on the NASDAQ, 5 are listed on the NYSE, and 6 are listed on the AMEX. Israel has the greatest number of listed companies in the U.S. after China. Over the last 5 years, more than 500 Israeli companies have been acquired. The expanding list of Israeli companies that have been acquired or gone public, have the effect of increasing the appetite of VC and other investors scouting for the right Israeli companies to invest in.
These numbers become more impressive as you realize that Israel’s population is only 8.5 million people and its land mass is approximately the size of the State of New Jersey, one of the smaller US states.
Over recent years, the tendency of listing Israeli companies in the U.S. and other foreign markets has continued to grow, whereas the number of publicly listed Israeli companies on the Tel Aviv Stock Exchange has decreased. This trend is not only attributed to the attractiveness of the foreign markets for Israeli companies and start-ups, but also due to the small and limited local Israeli market.
In an attempt to reverse this trend, the Israeli Securities Authority, has promoted over the past two years extensive and somewhat dramatic legislation and regulations, all aimed to ease the strict regulation that applies to Israeli listed companies, and to attract Israeli companies back to the local capital market. Among the recent legislative amendments are the exemption for small cap companies from filing quarterly reports and requiring only semi-annual reports instead, the approval of filing reports in English instead of Hebrew for certain companies contemplating listing in foreign capital markets in the future and waiving certain disclosures, thus allowing the companies to prepare shorter and more concise public reports.
The low interest rates prevailing in the Israeli capital market during the recent years has attracted many companies, both Israeli and foreign, to issue traded debentures on the Tel Aviv Stock Exchange. During recent years, many foreign real estate companies, such as Brookland Upreal Limited, Moinian Limited, KBS SOR (BVI) holdings Ltd. and others, usually with real estate in the U.S. and Canada, have issued debentures in Israel and have raised vast amounts of capital on the Israeli market. Given the current low interest rate, the most common trade product over these past few years has been bonds, whereas equity raises are less common and in a smaller volume.
Early stage funds and other investors from outside of Israel are increasingly trying to find the right Israeli companies to invest in. Because of the smaller size of early stage investments, these investors had not historically targeted the Israeli market. In addition, we are witnessing a change of mind-set in the typical terms of early-stage engagement and investment in these technology-based companies. These trends are typical of mature companies and are reminiscent of behaviors currently impacting Silicon Valley tech companies. In essence, new approaches are aimed at increasing the legal protection for founders. Competition increases with VC funds for the opportunity to invest in more successful companies and promising entrepreneurs and as such the pendulum has begun to swing back towards the founders in the weight of rights offered to investors. These patterns also appear in earlier stages of the companies’ lifecycle and are slowly developing to become customary in the local ecosystem. These are contractual features aimed at creating a friendlier environment for companies and entrepreneurs, reflecting the adoption of a more moderate, pro-founder perspective by investors.
According to the IVC, Israeli high-tech companies raised $4.83 billion during 2016 and $5.24 billion during 2017, which are new records since the investment statistics started being kept. These sums represent an increase of approximately 270% from the total investments in 2012, approximately 220% from the 2013 figures, approximately 150% from the sums invested in 2014 and 120% of the 2015 investment amounts. These are certainly incredible figures, which show the attractiveness of the Israeli High-tech sector. Presumably, some of these investments will bear fruit over the next few years leading to a further increase in M&A transactions and IPOs of Israeli companies .
Investment from 2016 and 2017 show more investments from the Far East, specifically, by Chinese investment funds and strategic investors. The first Chinese company investment into an Israeli technological company took place in 2010. Today, Chinese investors and Chinese companies that invest in Israel are commonplace, while recent Chinese foreign-investment regulations have been enacted to encourage strategic and technology-related investments over pure financial equity holdings.
In addition, Israeli infrastructure projects and investments continue to increase, as Israel has discovered gas reserves off its shores and modernizes its aging highways, public transportation, ports and other national infrastructures. The increased participation of multinational conglomerates in Israeli infrastructure tenders, has a healthy side-effect of contributing to the globalized interest of investing in Israeli industries and technologies. In the field of energy, several projects are underway, employing renewable energy technologies including solar, thermos-solar, pumped storage and the like.
Along with the above, we have witnessed the enormous expansion of the economic environment in which Israeli technology companies operate. In recent years, dozens of accelerators, incubators, shared work spaces and similar ventures have emerged in the local ecosystem which are sponsored by Israeli hospitals, universities, municipal authorities, tech giants such as Samsung, Microsoft, IBM, Intel and others. They are aimed at meeting the market’s growing needs by giving more attention to entrepreneurs and their startup ventures.
The local incubators, accelerators and hubs offer early-stage startups critical mentorship, tools and resources that help entrepreneurs flourish. Examples in Israel range from Japanese market-oriented incubators such as The Samurai House; to BizTEC, an accelerator that assists the Technion’s (Israel leading engineering university) students and graduates in bringing their ideas to by using the university’s resources to speed up pre-seed and seed companies’ trajectory and success.
Deal Structure Trends
Valuing stock at early stages has proven to be problematic as it does not always reflect and accurately predict the company’s future scalability while delaying the process of procuring investment. Thus, the current trend in Israel is that investors and companies alike are turning to use agreements that enable them to postpone such early valuation, such as a convertible loan agreement or Simple Agreement for Future Equity (AKA “SAFE”), based on which lenders may elect, in the future, to convert the loan amount they provided into equity at a considerable discount. The end goal of this investment strategy is that companies may procure financing at an early stage without committing to a specific premature or miscalculated valuation.
The Israeli high-tech financing ecosystem has completely adopted the Silicon Valley terminology in describing the development stage that a company has reached by reference to the series of preferred stock that has most recently been issued. Silicon Valley standards have migrated as far as Israel and have been commonly used as part of local fundraising transactions. These involve, for instance, the almost complete shift to non-participating preferred stock as part of structuring startup company liquidation preferences and the adoption of more founder-friendly approaches by VC investors, aimed on strengthening founder motivation and incentives. Similarly, we have also witnessed abundant early-stage pre-seed funding activity during 2017. More companies raise money in the pre-seed funding stage which in turn yields greater valuations for Series A funding and considerably larger deal volumes.
Unconventional methods of funding are becoming more common in the local Israeli startup scene, and Israel is by far today in the forefront of the global blockchain and crypto-currency activity. The tokenization and ICO trend is gaining more and more momentum, albeit growing concerns by regulators and a somewhat fragile legal basis for operation. Local securities laws make it very challenging for Israeli companies to tokenize their technology and sell such tokens to the general public. Nevertheless, many local companies chose other friendlier jurisdictions for these operations, all based on novel Israeli technology and local research and development.
In the last few years, Israel has seen many more acquisitions of Israeli companies or control of Israeli Companies by Asian companies, in a market which was traditionally dominant by US investors. In addition, the number of acquisitions of Israeli companies by other Israeli companies has continued to rise. 2017 reflected an all-time high of M&A activity with some phenomenal acquisitions of Israeli companies by foreign giants (most notably the acquisition of Mobileye by Intel for an approximate amount of US$ 15 billion). Finally, Israeli companies are increasingly seen expanding – specifically in sales – by the acquisition of foreign companies. Proposals are under discussion allowing for simplification of tax deferred mergers, split-offs and acquisitions.
Tax and other incentives for investment in Israel
The Law for the Encouragement of Capital Investment provides for various tax incentives to attract capital to Israel and to encourage economic initiative and investments of foreign and local capital. In many cases, capital gains generated from the sale of securities by a non-Israeli shareholder may be exempt from Israeli tax and the tax rate on dividends will often be governed by a tax treaty for lower rates. In addition, Israeli companies may be entitled to government grants and tax rates that can be as low as 10%. Finally, there are binational grant programs such as the Israel-U.S. Binational Industrial Research and Development fund where Israeli and American companies cooperate on R&D, manufacturing, marketing and sale.
Non-Israel Venture Capital Funds
Israel provides (through an individual tax ruling) VC funds with tax incentives to encourage investment by non-Israeli partners in Israeli or Israeli-related ventures. For the most part, and subject to several requirements (e.g., number of investors in the fund and the amount the fund, foreign partners in a VC fund will be tax-exempt on capital gains derived by the Fund and other income will be taxed at a preferential rate provided by an applicable tax treaty (to the extent applicable). Additionally, even when a fund operates in Israel through an office located in Israel (which may result in the constitution of a permanent establishment), Israel provides the non-Israeli partners with tax and filing exemptions.
Acknowledging the impact of the high-tech industry on the Israeli economy and the challenges start-up companies face in raising seed investments, Israel adopted a unique tax incentive law applicable to seed investors (the Angels’ Law). Pursuant to the Angels’ law, investors that purchase stock of an Israeli company, which is a research and development company, are entitled to deduct the amount of their investment in such company as an ordinary deduction (which can provide a 48% tax saving). Under the Angels’ Law there are several requirements to be eligible for the tax incentive, most of which relates to the operation of the company in the field of research and development.
A Few Tips
Israeli Corporate law is similar, from a legal point of view, in many ways to US law but there are a several facts to be aware of when contemplating your first Israeli transaction:
- Israeli private companies are required to file certain information with the Israeli Companies registrar which information is available online for a nominal fee. This information includes the articles of association, identity of directors, identity of shareholders (including their respective holdings) and any liens on the assets of the company. While not all companies’ have fulfilled their obligation to update the Companies Registrar, this registry might be the first place to start.
- Often technology-based companies have received governmental R&D funding. The governmental funding was supplied in order to encourage both R&D and manufacturing in Israel which can entail certain payments or penalties to the government if the government-funded intellectual property transferred outside of Israel.
- Public Israeli companies often have one shareholder or a group of shareholders that hold more than 50% of the voting shares of the Company. This can result in an easier method of acquiring control. Traditionally, Israelis are known to be tough negotiators but make good partners after the deal is finalized.
- The Israeli work-week is Sunday through Thursday and most businesses are closed on Friday and Saturday.
Intellectual Property Considerations
The rapid growth of the innovation driven industry is interconnected with the need for protection of intellectual property. Therefore, securing intellectual property has become an integral part of securing and ensuring success and the Israeli legal system has a well-structured outline and the robust laws to do so.
Intellectual property rights in Israel are protected through both statutory and common law systems, many of which are based on early British Mandatory law. Today, Israeli case law has become a source of nuance and modernization in terms of intellectual property, as legislation has been amended throughout the years to meet new developments. That said, international law practices, e.g. in the US and Europe, still have an impact on Israeli legislation and case outcomes.
Recent Trends – IP Ownership
Under the Patents Law, an invention made by an employee as a result of his employment and during the period of employment belongs to the employer, unless the parties have agreed otherwise.
Recently, joint ventures between universities, hospitals, the Israel Defense Forces, big tech companies’ employees and start-up companies have become popular. Nevertheless, typically it is the institution, rather than its employees, who owns the Intellectual Property, except where there is an explicit agreement that determines otherwise. Thus, the clash between the desire of significant institutions’ employees to collaborate with start-ups companies and their lack of ability to own and assign the IP developed by them can create disputes and uncertainty.
Accordingly, many disputes at present involve the question of ownership, whether the invention is a “service invention” (thus property of the employer) or whether the invention is the property of the inventor. It is a question to be decided in view of the circumstances and often depends upon the contractual arrangement. Case-law highlights the importance of determining ownership of an invention at an early stage and documenting ownership in writing.
Indeed, the difficulty of disputes over intellectual property with such powerful and large institutions has resulted in researchers leaving academia and finding work in the high-tech sector or forming their own ventures instead. Universities have even responded with the creation of entities that deal exclusively with technology created at the university to commercialize this technology and bring a stream of revenue to such university.
Israeli IP-related legislation is progressing in accordance with trends in innovation, both in theory and in practice, yet the complexity of ownership issues remains. Accordingly, local cooperation with academia, governmental bodies and such other significant institutions should be treated with caution due to IP ownership considerations. Nevertheless, the State of Israel encourages entrepreneurs to engage with domestic companies and local firms to commercialize IP on a global scale.
Overall, the Israeli market is one that is constantly changing and reacting to the global environment, most specifically to technology and venture-funding epicenters such as Silicon Valley. The existent early-stage activity highlights a switch of approach from the “family and friends” funding to more sophisticated tier-one players, small VC funds and modern fundraising platforms such as crowd funding. This increases the supply of available funds for entrepreneurs and improves the potential performance of local start-ups. These trends also show the willingness of entrepreneurs to prolong the venture’s early stage as much as possible, in order to reach the crucial fundraising stage at a higher valuation with business and technological readiness and maturity.
Undoubtedly, the Israeli market offers a tremendous number of investment opportunities. Successful investing requires investors to structure and identify the suitable deal and early-stage involvement. The networking ecosystem in Israel is well developed with conferences, meetups and networking parties. It is recommended to visit Israel to experience the buzz and take part in the Startup Nation.
With mass amounts of innovation and record-breaking success in Israel’s various tech sectors, there are business considerations and legal matters that must be addressed. Being a responsible investor requires a deep understanding of when and how to get involved and under what terms and conditions. Often times this means using the right deal structure, such as investing through convertible securities in order to expedite early-stage growth in a more accurate way or embedding modern liquidation preference models for larger financing rounds.
In order to achieve strong returns in the Israeli high-tech industry, one must intertwine the business and the legal considerations, engage with the right individuals and companies while making sure that the Company invested in has rigorously protected their crown-jewels, their technology and the related intellectual property rights.