Trends in the Israeli venture-capital industry

We have all witnessed the enormous expansion of the economic environment in which Israeli technology companies operate.

By ATIR JAFFE, GUY LACHMANN
An electronic board displaying market data is seen at the entrance to the Tel Aviv Stock Exchange (photo credit: REUTERS)
An electronic board displaying market data is seen at the entrance to the Tel Aviv Stock Exchange
(photo credit: REUTERS)
2016 is turning out to be one of the most prosperous years ever for the Israeli high-tech industry. This prosperity, reflected by the enormous sums invested in local technology firms, brings about a change to some of the mind-frames to which we were accustomed in local venture capital (VC) transactions. It has also enhanced the effects US VC trends have on the Israeli market.
In a recent study published by the IVC Research Institute and KPMG, approximately $4 billion was invested in Israeli high-tech and biotech companies during the first three quarters of 2016, leading the index to new records. These sums represent an increase of approximately 400% from the total investments in 2012, approximately 250% from the 2013 figures and approximately 150% from the sums invested in 2014 and 2015. These are certainly incredible figures, which prove the strength of the Israeli high-tech sector. Furthermore, it is presumable that some of these investments will bear fruit over the next few years leading to an increase in mergers and acquisitions (M&A) transactions by local companies.
This same study names another change in the industry and its characteristics. Despite the booming rise of investment funds, the number of reported transactions remained almost identical to the comparison data from 2012-2013, which were considered relatively poor years from a VC investment perspective. This highlights an upsurge in investment sums per transaction and more companies’ securing of significant investment sums.
Naturally, this dichotomy creates unique characteristics specific to Israel’s industries. This increase in investment leads to an increase in the valuation of fund-raising companies helping secure new investors. It is well known that the Israeli market suffers from significant valuation gaps compared to the average valuations Silicon Valley companies manage to secure; a familiar source of frustration for Israeli entrepreneurs and a reality that sometimes results in their moving to the San Francisco region in search of foreign investors.
One of the reasons for this is the industry’s investment model under which investors receive preferred shares. Among the rights attached to these shares is the right to receive their investment funds back before company shareholders. Therefore considerable pressure is put on founders, managers and other executives to repay investors, leading many to seek other solutions to guarantee they will not be left behind should an acquisition occur. The shareholders must also reap their reward for their hard work over the years. It is also in the best interest of investors, who observe the broader framework in which they and the company operate, that founders, managers and employees of these companies keep a fair share upon acquisition of the company. As long as they have the power to influence the decision-making process and protect their ventures, management will hold several tools in its arsenal to ensure that these important elements are remunerated.
Some companies have adopted a “Carve Out” plan, aimed at guaranteeing that management would be first to receive exit funds or at the very least a predetermined share of the proceeds. Other companies adopted non-equity- based programs, forming part of the manager and founder employment terms. There are also instances of a combination between the two. Other arrangements for handling the remuneration of managers and employees upon an exit deal include the payment of future pay-per-performance payments from the surviving or acquiring entity. This toolbox reflects a new set of considerations that mature companies face as the industry progresses, the investment size increases and the local market becomes more complex. Such demands are usually favorably regarded by the investors, but in more mature companies, where founders less often fill managerial roles, this isn’t always the case.
The trends mentioned above are typical for mature companies and are reminiscent of behaviors currently impacting Silicon Valley tech companies. In essence, these approaches are aimed at increasing the legal protection founders and managers enjoy while competition increases between VC funds on the West Coast for the opportunity to invest in more successful companies and promising entrepreneurs. These trends also appear to a certain degree in earlier stages of the companies’ life-cycle – our impression is that they increasingly make their way to Israel and 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.
Along with the above, we have all witnessed the enormous expansion of the economic environment in which Israeli technology companies operate. During 2016, many dozens of accelerators, incubators, shared work spaces and similar ventures emerged in the local ecosystem. They are aimed at meeting the market’s growing needs, and reflect the deep understanding of investors that giving more attention to young companies has advantages and will bear fruit in the future. Local VC funds also realize they must be active players in the early-stage market to avoid missing high-quality investment opportunities.
Ultimately, intensive early-stage activity highlights an approach from a different angle: from the “family and friends” way to more sophisticated tier-one players, small VC funds and modern fund-raising platforms, such as crowdfunding. This increases the supply of available funds for young entrepreneurs and improves the potential and performance of local start-ups. These trends also show the willingness of entrepreneurs to prolong the venture’s early stage as much as possible, to reach the crucial fund-raising stage with business and technological readiness and maturity. Such preparedness provides them with better chances of ensuring high-valuation fund-raising.
Adv. Atir Jaffe and Adv. Guy Lachmann are partners in the high-tech group at Pearl Cohen Zedek Latzer Baratz.