A regulatory conflict between the Cayman Islands and the European Union is likely to have far-reaching implications for Israel’s venture capital industry, the financial backbone of the country’s famed startups.
Most of the venture capital funds that invest in Israel are registered in the Cayman Islands. Following a regulatory change there, the funds will be forced to consider shifting their incorporation to another country – possibly even to Israel.
This comes due to a chill in relations between the Cayman Islands and the European Union, which put the latter on its tax haven blacklist. Companies registered in blacklisted countries are liable to have their reputation suffer, and may not be able to raise money from European institutional investors.
The Cayman Islands, for its part, in an attempt to get itself off the blacklist, has passed far-reaching legislation over the past few days, obligating Cayman venture capital funds and private equity to meet regulatory standards that until now applied only to hedge funds. The new regulatory requirements are far-reaching and stricter, and involve greater costs and complexity for the funds. Of particular concern for the funds is the prospect of the new regulations requiring them to hand over data they don’t want made public.
An estimated 80% of venture capital funds active in Israel are incorporated in the Cayman Islands. To date, these funds had no interaction with Cayman regulators.
Dr. Ayal Shenhav, head of high-tech and venture capital at the Gross, Kleinhendler, Hodak, Halevy, Greenberg, Shenhav & Co. (GKH) law firm, says the new regulatory environment could be an opportunity for Israel to encourage the funds to incorporate here in Israel, which would benefit state revenues through lawyer and accounting fees, as well as by boosting Israel’s reputation.
Venture capital funds invest in companies primarily focused on research on development, or on producing innovative, information-rich products or processes the companies generally known as startups. Investing in startups bears considerably higher risk than other forms of investment, and the presumption is that this risk will pay off in an exit – when the startup is sold to another company, or goes public on the stock exchange.
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VC funds raise money from limited partners, which can include institutional investors, companies, or well-off individuals. The funds are managed by professionals with technological or business experience, who are often appointed as board members at the companies in which they’ve invested. In the course of their operations, the funds launch follow-up funds, which are typically named with sequential numbers. Each new fund launched by a single venture capital brand is considered a new partnership and requires new legal incorporation.
As opposed to hedge funds, VC funds are closed funds, in that their investors cannot cash in on them at any moment, but rather only at the fund’s maturation – typically about a decade. The capital is not left sitting in a bank account, but rather is transferred to the fund at the time when the money is needed to make a promised investment in a chosen startup. This lack of liquidity lowers the risk of embezzlement or fraud within the fund.
GKH is apparently the Israeli law office most involved in VC funds, representing about one third of the ones here. Among the Israeli VC funds that GKH founded – funds with Israeli managing partners, not funds actually registered in Israel – are Vintage, Amon, Vertex, TLV and Glilot. GKH also represents U.S.-based VC fund Insight Partners in all its investments in Israel, and in founding its office here.
It’s fair to assume that GKH also influences in which country VC funds are registered.
Shenhav, along with his colleague Layla Chertow, are still reviewing the new Cayman legislation, which is slated to take effect August 7.
However, they note that the Cayman Islands is now demanding that funds registered there submit the funds’ paperwork, which includes the names of managers, and possibly also information about their limited partners - information that the funds typically don’t like to share.
The Cayman Islands will also now be demanding an annual report signed by a Cayman Island-registered accountant. It’s not clear whether this report will be released to the public.
The law also requires that the funds conduct an external estimate of the valuation of the companies in their portfolios, and submit this every quarter.
“Currently, it’s the general partner conducting the value estimates,” says Shenhav. “There are norms as to how a company is valued – but it’s a very flexible analysis, and sometimes identical startups receive different valuations in the books of different funds. This analysis is presented to the VC funds’ potential investors. Now, getting an external value estimate involves costs and time, and the results may not necessarily suit [the VC firms].”
Another particularly expensive aspect of the new Cayman legislation is the clause requiring a fund to appoint a custodian to hold the VC funds’ shares in the startups in which it invests, and also an external administrator to handle the limited partners’ money and transfer it to the startups chosen for investment or the VC fund’s management company.
There is no actual tax implication behind encouraging VC funds to register in Israel; the funds’ taxes are set based on the residency of the investors, and not on where the fund itself is registered, says Shenhav.
However, having funds registered in Israel would boost state revenues from payments to service providers such as lawyers and accountants, and also boost Israel’s global reputation as a hot spot for venture capital, he says.
Hundreds of venture capital funds are active in Israel, which is the world capital for VC investments per capita.
Chertow notes that Israel competes for VC funds with the Cayman Islands and the U.S. State of Delaware. Registering in Israel takes two to three weeks; in Cayman or Delaware, it takes two to three days and can be done remotely and digitally, she notes.