Hunting for Bargains in Startup Nation

High valuations in initial Californian financing rounds make the Israeli startup scene especially attractive to foreign investors.

Bloomberg

The year 2014 began as a record-setting one for the Israeli high-tech sector. There was $1.6 billion-worth of investment in startups in the first half of the year, the IVC business research firm reported – the highest level since 2000. A whole range of firms launched major private capital financing rounds, including the Internet firm IronSource, which raised $80-$85 million at a company valuation of $850 million.

There have also been increasing signs of a new Internet bubble, with investment in the field also coming from private investors outside the tech sector.

In Silicon Valley, an unprecedented number of private firms – more than 30 of them – raised funds, at corporate valuations of over $1 billion, and the New York Stock Exchange is breaking records with its performance. And as signs of a bubble grow abroad, they in turn fuel the scene in Israel as well.

On the other hand, new data on the value of Israeli startups offer signs that things are actually cooling. For example, 29% of their financing rounds in the first half of the year were at lower corporate valuations than the companies’ prior rounds. In other words, in retrospect the prior valuations were not justified and they have subsequently been adjusted downward.

The figures are from a half-year survey carried out by the Israeli Shiboleth law firm, in conjunction with the Silicon Valley law firm of Fenwick & West. The study analyzed the legal terms involved in investments of at least $500,000 in Israeli companies. All of the transactions involved investment by at least one venture capital firm, while investments solely involving early-stage private investors were not included.

Unlike the trend in Israel, in Silicon Valley only 7% of investment rounds were at lower company valuations, while 78% of the valuations were higher. In the second quarter of 2014, this was the largest such difference between companies that had gained and lost value since the survey began in the United States at the beginning of the millennium.

In Israel, by contrast, currently only 62% of financing rounds were at larger company valuations. Last year, the figure was a record 80%.

“In Israel, there are more financing rounds at declining levels than in Silicon Valley,” affirms Lion Aviram, head of the high-tech practice at Shiboleth. “This means that, to a considerable extent, the performance of companies hadn’t supported the prior valuation. Investors have continued to demonstrate their confidence and the companies have continued to raise capital, but at lower corporate valuations.”

The drop in valuations in connection with financing rounds is similar to what followed the global economic crisis of 2008, and the phenomenon is substantially more widespread than during the recovery period of 2012-2013.

“In Silicon Valley, there have been almost no declining corporate valuations. It could be that the quantities of available cash for investment there supports rising values,” says Aviram, adding that in Israel there are no venture capital funds large enough to provide the necessary funding to grow companies in the sector at rising corporate valuations.

The survey also reveals, however, that investor appetite for Israeli startups has not waned. Fully 40% of the financing rounds in the first half of this year were initial investments. Such “A” round financing, Aviram says, is a good gauge of investors’ faith and optimism in the sector here.

In Israel, 18% of investment has been second-round financing; another 18% third round; and the rest at later stages. In Silicon Valley, by contrast, a smaller portion of the investment is first round, and Aviram says many investors there are increasingly skittish over first-round financing, much of which has been at very high valuations. “You have to remember that in Silicon Valley, there are superstars that will get extremely high valuations that don’t exist in Israel. With regard to the other companies, the gap between Israel and the United States is narrowing.”

In addition to the lower early-round valuations in Israel, he adds, there is another factor prevailing in the Israeli startup sector. Investors looking for new promising companies here also find lower prevailing valuations, which in turn spurs increasing interest in startups in Israel.

Aviram estimates that a comparable startup in Silicon Valley will be valued 50% to 100% higher than its Israeli counterpart, making the Israel firms a bargain from that standpoint.

New sources of investment

Both foreign investment funds and individual American investors have been beating their path to Israeli startups, but they are also being joined by investors from new places, including Russia and China.

Despite the declining valuations among many Israeli startups, the Shiboleth survey includes several other measures that indicate investor confidence in Israeli high-tech. “In the past, usually there was a correlation between the legal terms and a rising number of financing rounds where the valuations were on the decline,” notes Aviram. “This time, we are seeing that the trends are diverging. In legal terms, we are still seeing a high level of liberality and flexibility for the benefit of the entrepreneurs – for example, giving preferential rights to investors in an exit.”

For her part, Shibboleth partner Limor Peled, who was also involved in the survey, adds, “There is a trend whereby investors rely less on legal defenses involving preferences, and feel comfortable with the choice of companies. Their outlook is less defensive.”

When asked if we are in a bubble, Aviram says, “It’s not the bubble of 2001. During that period, kids could raise money. If a bubble is currently developing, it’s because of the valuations, and not over the question of who can raise funds. It’s not easy to raise money now. The Standard & Poor’s index is at its peak,” he says, in reference to the S&P 500 index with the highest market caps on the New York and Nasdaq exchanges. “So this makes it possible for publicly traded companies to make acquisitions at high valuations, and for companies to carry out public offerings at high values. As a result, there are major exits in every direction.

“When there is a correction in the financial markets,” he concludes, “there will also be a backward correction in the valuations of the startups. In the meantime, the company valuations in Israel are still reasonable, and they give investors access to a market that is similar to Silicon Valley from a cultural standpoint.”