Your Taxes: Financing an Israeli Business

The principles of production explained by Adam Smith in ‘The Wealth of Nations’ in 1776 still remain more or less true today.

By BARRY PLOTKIN & LEON HARRIS
May 1, 2011 22:59
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Adam Smith wrote in “The Wealth of Nations” in 1776 that the four factors of production are: land, labor, capital and enterprise. This still remains more or less true today.

Land – factory buildings, equipment and other tangible fixed assets. Nowadays we also add to the list intangible assets such as intellectual property – patents, trademarks and so forth.

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Labor – employees and middle management.

Capital – finance which we will discuss later on.

Enterprise refers to several parties who are directly involved in creating and running a company: the person with the initial business idea; the founders who set up the business and makes it happen; and the upper management leadership (CEO, CFO, CTO, etc.) who consolidate and expand the business, take it public, initiate action against perceived threats to their business, and so forth. These entrepreneurs and management do not employ guesswork; they develop, apply and re-develop a strategy.

These are the elements of capitalism or free enterprise. Capitalism has had its ups and downs over the centuries, but the alternative concepts of communism and dictatorship have proved to be short-lived in historical terms. A modern business must apply capitalist principles to advance its development according to its chosen strategy.

Fundraising Capital is money for operations.

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Companies large and small need finance, just as a car needs fuel to run, and the way it is utilized for their operation and activities is the global measurement of success or failure.

The new product being developed in the company’s lab (R&D) may be a world-beater in a few years time, but salaries and expenses must be paid now, if all the people involved are going to be able live and work. This requires financial credit in the form of investment money which is paid for by the owners in the form of shares in the company ownership. Bank loans may be hard to obtain when there is no income or other securities available to repay them.

Finding investment money is very time consuming and disruptive for the smooth running of the company.

Once sales revenues begin, investment from the R&D stage must be recouped.

Clients take time to pay usually and when they do pay, some of the money must be re-invested in advertising, trade shows, more R&D and so forth.

When raising funds, you must prepare a business plan with a budget which takes all the financial needs into account and any others specific to your business.

Typically, fundraising is done in several rounds. This is because not all the money needed may be raised in one round. Most investors want to see the company successfully achieve milestones (R&D progress, revenue progress, etc.) before committing more money.

Who are the investors? These can include: · Founders, and their families & friends.

· Angel investors (private wealthy individuals).

· Venture capital/private equity funds.

· Institutional investors (pension, savings and mutual funds, finance and brokerage houses).

· The government (e.g. R&D grants from the Office of the Chief Scientist and Israel’s bi-national funds; fixed asset grants from the Investment Center).

· Large enterprises that need your product.

· Employees – stock option or purchase plans to retain and incentivize good employees.

· And the public if you raise money on a stock exchange in Israel, the US, London, Toronto, etc.

What do the investors look for? Investors look for good companies that seem likely to generate dividends and/or capital gains in the medium term – typically (but not always) in the next three to five years. The world economy may be in periodic volatility, and peace in the Middle East may be elusive, but a good company with a good strategy will aim to generate value for its shareholders over time.

More specifically, investors typically expect a company to have all of the following: · A good product with unique features that is scientifically proven.

· Good demand for your product from sufficient paying customers - this signifies marketability and also helps to show that the technology works.

· Good management - proficient CEO, CFO, CTO and other executive management.

· A business plan setting forth a clear concise strategy for profit.

· A well-thought out marketing strategy and a business model.

· Clear presentation of the company by its senior management.

· Good well-protected intellectual property – technology, brand name, etc.

· Sales revenues – or at least sales contracts or other solid commitments. In practice, in a small country like Israel, most sales will need to come from international markets.

Have you planned for this? · Stable, skilled employees.

· All regulatory approvals necessary for unrestricted selling of the product.

· Follow-up products, new applications or markets in the pipeline.

Fees for finding investors for a company Typically, for a private finance round, assume four percent to 6% of capital obtained for the company in cash plus 4% – 6% in options/warrants. This has to be carefully structured to avoid unnecessary VAT (16% in Israel). Service providers who locate investors for you deserve to be reasonably rewarded for their efforts according to the going market rate. If you try to negotiate the fee down to the point that it is unattractive for them they will likely avoid you or at best, invest most of their time to their other clients.

What about loss of control? If you accept outside investors, their capital will dilute the founders but will hopefully increase the overall value of the company later on. The founders will generally not lose control over the business as they are needed to run it – most investors are passive investors just bringing much needed money to the table.

A few will be strategic investors who can open important doors to customers, etc.

Business model The business model of a technology company needs to be well thought out in order to implement its strategy into practice.

Here are a few elements to consider: · The marketing strategy – how will you find customers? How will you attract them to your product? What will be your pricing policy? · Should you sell products or should you provide them as part of a service under your control? · Is a BOOT (Build Own Operate Transfer), leasing or licensing model likely to make you more money? · Should you provide the basic product cheaply but charge a lot for consumables/replacement parts later? · Is it easier to license the IP to third parties for a royalty or franchise fee? What about withholding taxes on these? · What will be your optimal supply chain? Which company(ies) in the group will purchase raw materials, hire labor, process, distribute and sell to customers? · Where will you establish companies? Remember that American customers prefer to buy from Americans, Japanese prefer to buy from Japanese, etc.

· How will international operations be managed? · Which company will own the intellectual property? How will it conduct R&D? How will it make the IP available to other companies? · Which company will manage business risks and how? There may be many risks – bad debts, currency risks, product defects, inventory theft, country/political risk, etc.

Are there Is insurance or hedging or regulatory approval needed? Tax Strategy Do you have a well-planned international tax strategy? On the operational side, Israel offers reduced corporate and dividend tax rates for “preferred enterprises.” Every dollar of tax saved on profits may add around $15 to the market value of the company.

Most Israeli companies fail to check out withholding taxes and VAT or sales tax on their revenues even if they are not yet in profit. Also needed is a transfer pricing policy – tax authorities around the world (including Israel) require related companies to conduct transactions between themselves on arm’s length market-based terms.

This requires a transfer pricing study and is an opportunity for tax planning.

Equity investors may now enjoy an Israeli tax deduction when investing in Israeli tech companies if certain conditions are met.

Foreign investors are now exempt from Israeli capital gains tax. But beware VAT and withholding tax on loan interest, Check out detailed rules regarding share options. As always, do your homework and consult experienced corporate, technical and tax advisors in each country at an early stage in specific cases.

barry-p@maventures.biz, leon@hcat.co

Barry Plotkin is an engineer and MBA and a Director at MA Finance. Leon Harris is a certified public accountant at Harris Consulting & Tax Ltd and a Director of MA Finance.

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