BloGiza: The Government Rides to the Rescue (?)

The last couple of years have not been particularly kind to the local high-tech industry. Although Israel was spared the worst effects of the global crisis, the local economy and especially the local tech-based economy has had to deal with knock-on effects of the general meltdown.

Specifically, we have seen a dramatic reduction in capital available for both VC funds and startups. Since the beginning of 2009, only one VC in the local market has managed to raise a new fund, and this was Sequoia Israel who could leverage Sequoia’s international positioning. Many of the local VCs who had managed to raise new capital prior to the crisis are working with smaller-than-planned funds.

Unsurprisingly, this has affected that amount of new money flowing into startups here, which is at one of its lowest points in a decade.

Over the past few weeks, the Government has unveiled a number of new initiatives which Prime Minister Netanyahu and Finance Minister Yuval Steinitz hope will help save Israel’s high-tech economy. Steinitz, working with his Director-General, Avi Shani, and a Knesset subcommittee dedicated to the issue have come up with a number of ideas designed to address the problems of Israel’s high-tech sector at all levels.

The measures that have been announced are:

Encouraging local institutionals to invest in VC funds instead by providing a financial safety net
Provide tax benefits and breaks for investors in seed-stage companies (the so-called “Angel Law”)
Attempt to establish Israel as a leading center for the development of technology geared towards the global financial sector, in the same way that Israeli high-tech companies became leading players in the Communications space over the last 15 years
As part of this repositioning, encouraging multinational financial institutions to establish R&D centers for financial technology within the framework of the CSO
Encourage Israeli companies to grow instead of selling themselves out early. The idea is to provide tax incentives for medium- and large-size local tech companies to acquire smaller tech companies and in this way to establish themselves as large growing concerns.
Create additional exit opportunities by encouraging companies to go public on the Tel Aviv Stock Exchange
Focus government R&D spending towards specific areas of interest
Improve the quality of science and technology teaching at the high-school levels by creating programs to train teachers in these subjects, re-training ex-high tech employees as teachers, and encouraging current high-tech employees to teach on a part-time basis in the schools
Encourage additional sectors of society (e.g. the ultra-orthodox and Israeli Arabs) to participate in the high-tech economy by subsidizing part of their salaries in high-tech companies
Encourage academics who have left Israel to return by providing tax breaks from future earnings based on technology that they develop

It’s an ambitious plan and one that addresses a lot – if not all – of the main problems facing Israel’s high tech sector. Whether or not it will work is another question.

My gut feeling is that the plan will be only partially successful at best. Without going into a point-by-point critique, some thoughts:

Regarding incentives for local institutional investors to invest in Israeli VC, this is one of these “yes, but…” things. On the one hand, Israeli institutionals are indeed an untapped source of LP potential. This is increasingly important, since institutionals in the US and Europe are both more hesitant to invest money in the asset class and more inclined to put their money in funds targeting other emerging markets such as India and China.

However, the local pension and insurance funds are not currently geared for significant investments in VC and it would take significant incentivization on the part of the Government to get them there. Even then, the amount of money that they could theoretically put into the asset class is limited. This by itself won’t solve the funding crisis for local VCs looking to raise new funds.

Regarding the re-focusing of Israel’s R&D efforts towards financial technology, again “yes, but…”. Other emerging countries, for example Taiwan, have had success in steering their high-tech industries towards government-defined areas of interest such as semiconductors and biotech. I have two issues here, one philosophical and one practical.

On the philosophical side, one of Israel’s great strengths as a high-tech superpower has been in the creativity of our entrepreneurs and technologists. If a large portion of government and specifically OCS funding is directed towards financial technology, might that not stifle a lot of this creativity that might lead to other large opportunities?

On the practical side, encouraging the establishment of R&D centers, as well as the other components of the plan based on providing tax breaks and benefits are all great in theory. However, they all have a good chance of falling apart in the execution phase especially if the tax authorities are not re-tooled to handle these changes.

After all, the government already provides tax incentives for high-tech today but it makes companies and investors go through 12 levels of bureaucratic hell in order to enjoy them. If this continues to be the case, will multinational financial institutions feel that it is worth the hassle of setting up R&D centers here?

The relative lack of large-scale local tech companies has been a key concern for the better part of a decade. We have talked endlessly about whether Israel needs or can establish more “Israeli Nokias” to stand alongside Amdocs and Teva, and the complexities involved. I’m not sure the current plan offers strong enough incentives to do so.

The idea that you can encourage medium size Israeli tech companies to grow into large size tech companies, and large companies into global leaders all by helping them acquire smaller companies is at the very least out-of-the-box thinking. However, it still doesn’t address the main reasons that lead medium-large companies to and M&A exit before they can become large.

Companies usually sell out because they have funding concerns. Either they start to run into cash-flow problems or else are need a relatively large amount of financing in order to ramp up into major-size IPO-able international leaders.

The current government plan as formulated does not provide real solutions to this issue. Encouraging more IPOs on the TASE is nice. However, the TASE is a relatively small exchange with some liquidity issues. The plan might help companies that would ordinarily be sold for the low tens of millions IPO for mid-ten to millions. But in order to IPO in a manner that can establish a large sustainable company, you need to go public on NASDAQ.

Which brings us right back to the funding issue. As Giza’s Managing Partner Ori Kirshner noted in this piece on The Marker TV, one of the real problems facing Israeli VCs and startups is the lack of available late-stage funding. Israeli funds are relatively small in global terms, and those funds who have the capital to invest will look just as actively at investments in India and China.

The issues of reversing the brain drain and improving the quality of technical education in the schools are both good ones, but they will struggle if not handled in the broader context of problems facing Israel’s education system as a whole. (Which is a whole other blog post, if not a series of blog posts). Short version: in order to provide a more educated and effective high-tech workforce, it’s not enough to concentrate on high-school science training. Israeli students need much better training in math, science, and English from the elementary school level onwards.

I’m not saying the government plan is a wash. It addresses a number of key social concerns (especially the low participation of large sections of the work force) in a logical manner. And, if the plan doesn’t get mired in a bureaucratic morass, stands to introduce a bit more flexibility into the local high-tech market and perhaps even end up as a net gain for the Israeli economy.

But without a significant increase in the amount of capital flowing in from overseas – both from LPs and global venture funds – the local high tech industry will continue to face serious challenges, despite the best intentions of the government.