Start-up Nation - the End?

The data for 2012 leave little room for doubt concerning Israeli high-tech: Available funding sources for start-ups are drying up.

Israel’s high-tech companies raised $1.92 billion in 2012, down 10% from the previous year, according to IVC Research Center. Investment by venture capital funds experienced an even sharper decline: Deals involving at least one VC fund totaled just $1.37 billion, a 22% drop from 2011.

Looking ahead, Israeli venture firms are running into difficulty raising funds for both ongoing and new investments, and their ability to support start-ups has weakened. In 2012 they succeeded in raising just $607 million, 30% less than in 2011 according to survey figures by IVC and KPMG Somekh Chaikin.

Capital available for investing by Israeli venture funds totals $2.1 billion, but just 23% of this amount, a total of $484 million, is estimated by IVC as being earmarked for initial investment in new start-ups with the rest targeted for continuing investments. Start-ups will likely need to continue locating new funding sources at the early stages.

The government’s share is also eroding due to the deep deficit and the need to cut the budget, while private investors dubbed “angels” step into the void. Despite the drop in high-tech investment, there was an increase in investment in young start-ups. Seed money, largely provided by angel investors, reached a five-year peak: 157 early-stage start-ups raised $146 million.

Angels have become the main source of funding for young start-ups, particularly in the Internet and mobile communications fields. With an amount of less than $1 million, sometimes from a number of angels, quick and efficient start-ups have been able to develop a product, enter the market, and generate revenues.

The government has also recognized the importance of private investors and created an incentive to encourage them. The Angels Law was passed in 2010 as part of the Competitive Advantage program spearheaded by Haim Shani who was director-general of the Finance Ministry at the time., with the aim of bringing private investors together with high-risk knowledge-intensive start-ups.

Qualified investments

The law created a tax benefit by permitting qualifying investments in start-ups to be recognized as deductible expenses for tax purposes from the first year of investment. However, it isn’t certain that the rise in investments at the seed stage can be attributed to the law since it didn’t apply to Internet and mobile communication companies.

The law initially sparked interest among investors, but its usefulness was thrown into doubt in November 2011 when many discovered it was too restrictive. Only 57 companies had applied for eligibility by the end of 2012.

During the three-year period of benefits provided by the law, at least 70% of the start-up’s expenses must be classified as research and development. Revenues for the start-up in the first two years mustn’t exceed 50% of its R&D expenses, creating the absurdity of investors having a vested interest in the company’s lack of growth. Eligibility is only approved at the end of three years another drawback.

Angel investor Tal Bar-Noah had a particularly busy year in 2012, investing in 10 start-ups. But he didn’t benefit from the Angels Law because none of his companies met its stringent criteria.

“Angel investments are based on companies whose products can be quickly ascertained as workable without a particularly large investment,” he says. “These are mostly Internet, application, or gaming companies. A law that requires a substantial investment in R&D, without understanding that the world has changed and that Internet companies need to receive benefits, isn’t very relevant.

“The number of angels investing in many companies is declining, so the state needs to encourage people like us to continue investing,” Bar-Noah continues. “I don’t know of any angel who utilized the law: It was irrelevant.”

So who can make use of the law? “Almost nobody,” says attorney Ayelet Torem of the Amit, Pollack, Matalon & Co. law firm and a member of the angels committee at the Israel Advanced Technology Industries (IATI) association. “Everyone wants the law to be more widely used, but its wording can only be changed through legislation.”

“We didn’t succeed in creating the desired impact,” says Micha Pearlman, head of R&D and higher education in the Finance Ministry’s budget department. “The main reason was the uncertainty it posed for the investor, who had to wait a long time to make sure he’s eligible.”

An aggressive law

The initiators of the law have now banded together to formulate a new law to fulfill its original purpose. These include the treasury’s budget department, the chief scientist at the Industry, Trade, and Employment Ministry, the Israel Tax Authority, and the high-tech lobby headed by MK Robert Ilatov (Yisrael Beiteinu) which will submit the bill to the Knesset either directly or visa the Arrangements Law.

“The previous law was very innovative and aggressive from an international perspective,” claims chief scientist Avi Hasson, adding that new taxation measures are being examined to support R&D.

The law will permit investment by partnerships so that angels can join together, through a fund for example. Also, companies that received support from the chief scientist under other programs won’t need to repeat the bureaucratic process for additional approval.

The ITA estimates lost tax revenues from the law in 2012 at less than NIS 100 million. “The goal was to encourage high-tech because there are obstacles at the initial stages,” says a senior tax official. “There are financing difficulties, and the goal was to encourage seed companies to ensure Israel will have a high-tech industry five or 10 years from now.”