Israel’s technology sector continues to grow

Economist Intelligence Unit

– Israeli start-up companies, which form the core of Israel’s world-renowned high-technology industry, had a record year in 2017. Start-ups raised a combined US$5.2bn during the year, 9% more than in 2016 and a record, according to a survey by the Tel Aviv-based IVC Research Centre. Fundraising by Israeli start-ups has been rising steadily since 2012, when it was just US$1.8bn. Other indicators of the sector’s health also suggest a strong year. Israel appeared to grow through a period of weakening in the global venture-capital and start-up sector in late 2016 and early 2017 and continued its expansion for the remainder of the year.

On the exit side, the total value of merger and acquisition (M&A) deals and initial public offerings of start-ups soared to US$23.8bn in 2017, figures from PwC Israel show. M&A activity was led by two very large deals-the US$1.1bn acquisition of Neuroderm by Japan’s Mitsubishi Tanabe Pharma in July 2017 and Intel’s US$15.3bn acquisition of Mobileye, an automotive technology company, in March 2017, the largest-ever purchase price for an Israeli firm by a foreign company. Moreover, Israeli venture capital funds-although they have long ceded their leading role as investors to foreign funds and other classes of investor-raised US$1.3bn in 2017, similar to the average for the past three years.

After a brief lull, global high-tech investment is booming

Israel is riding on a global surge in high-tech investment. In the US, venture-capital firms deployed US$84bn in more than 8,000 companies in 2017, the highest number since the dot.com era around 2000, according to PitchBook, a venture-capital and M&A research firm. Low interest rates have made alternative investments like start-up technology firms much more attractive, and strong stockmarkets have incentivised entrepreneurs and
investors with the promise of lucrative exits. In addition, a host of new technologies in areas such as automotives and
artificial intelligence (AI) have lured investment capital, and cybersecurity-a particular strength for Israeli firms-continues to attract financing in response to costly, high-profile hacking attacks. In each of these areas Israeli start-ups have attracted a lot of global attention. IVC data show that investment in Israeli cybersecurity start-ups climbed by 33% in 2017, while AI investment grew by 17% and investment in auto-tech, which was given a big boost by the Mobileye deal, increased by nearly 26%.

The numbers, however, are also being inflated by companies’opting to stay private for longer and securing higher valuations further along the development chain; historically, Israeli start-ups had sought to sell at much earlier stages of business development. For instance, Mobileye is a relatively well-established firm, founded in 1999, that had a successful initial public offering on the US NASDAQ in 2014. In Israel, despite the sharp increase in fundraising, the number of transactions actually declined by 8% to 673 in 2017 compared with 2016. The average fundraising round was US$8.5m for each deal, compared with just US$3.6m in 2013. Indeed, all of the growth in
2017 was due to four giant US$100m-plus rounds. Valuations are going up not only because companies are waiting longer to exit but because the supply of capital is exceeding the supply of start-ups, especially as investors increasingly opt to put their money in more mature, safer start-ups rather than riskier seed-stage companies. In Israel, IVC found that investment in seed and early-stage companies fell in 2017 as the segment’s traditional funders, such as technology incubators and angel (private) investors, reduced their capital outlays by 49%. This
is not an aberration: investment in the early start-up segment has been in decline for the past five years.

2018 has started strongly, but risks are rising

The general consensus in the industry is that 2018 will be another strong year. Israeli venture-capital funds alone have about US$3bn in capital yet to be invested. Chinese investment, which was briefly disrupted in 2017 amid uncertainty over Chinese capital controls, has been back on track since August. India could now emerge as another source of investment in Israeli start-ups amid rapidly developing bilateral commercial ties, much of it based on technology.

However, there are clouds on the horizon. The rising valuations and the excess of demand for firms to buy over the supply of viable entities suggest a boom-and-bust scenario cannot be discounted. For one, the Israeli shekel is close to its strongestlevel against the US dollar in seven years, which threatens to squeeze even start-ups with no sales or pretensions to profitability because each US dollar of capital they raise buys less labour, which is paid for in local currency. For more mature start-ups trying to build sales, their costs are higher and the time-to-profits will take longer, all other things being equal.

Meanwhile, US tax reform legislation approved in December may deter US investment and/or encourage Israeli technology companies to relocate some or all their operations to the US. The particulars of the US reform have not been spelled out, but the Israeli government and the local technology industry are both concerned by the ramifications of a potential deep cut in US corporate taxation from its current 35% rate (Israel’s headline
rate has been falling since 2016 and was reduced to 23% at the beginning of 2018) and other measures intended to encourage firms to invest in jobs and physical capital in the US. The increase in US interest rates could also make the relative attractiveness ofinvesting in technology start-ups a less inviting proposition.

Victim of its own success?

The longer-term challenge for the industry is the tightening
supply of engineering and other talent. Figures from Ethosia, a
local placement firm specialising in technology jobs, says that
the average monthly salary for hardware and software engineers
with two years or less of experience rose by 20% in 2017. Between
local wage pressures and the strong shekel, start-ups face an
increasingly difficult cost environment, particularly given that
they rely on the overseas rather than the domestic market. The
government’s Israel Innovation Authority is embarking on a
ten-year programme to double the number of technology workers and
is easing the way for companies to bring in foreign workers into
the sector, but the impact will not be felt for some time.
Meanwhile, firms are not waiting and are relying more heavily on
outsourcing abroad. If the US tax reform does encourage US
multinationals to bring jobs home, as many in Israel fear,
employment at the hundreds of US research and development centres
may be cut back drastically, which would help to ease the labour
shortage.

The government is belatedly trying to address the skills shortage
but this may come too late if costs continue to spiral. The
sector’s level of specialisation and expertise in key
technologies means that it will continue to attract funding as
long as global market conditions are favourable, but the downside
risks have risen.