The Israeli economy faced significant challenges over the past year, with additional fiscal pressures anticipated in the near future. Preparing financial statements has become increasingly complex against the backdrop of the country’s longest conflict, which carries profound and lasting macroeconomic implications. These circumstances raise thorny questions for financial managers about how to assess and quantify the potential impacts

As companies prepare their 2024 financial statements, they are already focused on producing cash flow forecasts to evaluate goodwill impairments for previously acquired operations. This process unfolds amidst a prolonged conflict impacting the local economy, with long-term macroeconomic consequences. Globally, the technology sector continues to face headwinds, and Israel’s technology industry is experiencing heightened strain due to the effects of the Iron Swords War. The disruption includes many professionals being called to prolonged reserve service, plans to extend mandatory military service, and a sustained increase in the size of the army. As a result, Israeli technology firms have scaled back growth plans, with some freezing hiring entirely, signaling significant changes within the sector.

In this challenging environment, credit rating agencies S&P and Moody’s downgraded Israel’s credit ratings about a month ago to A and Baa1, respectively. This marks a two-notch downgrade by S&P and a three-notch downgrade by Moody’s within the past year. The agencies cited the escalating conflict with Hezbollah, the likelihood of prolonged hostilities, and increased geopolitical and security risks as primary reasons for the downgrade[1]. These developments occurred before October’s Iranian missile attack and the subsequent Israeli response.

Can Impairment Testing Be Delayed?

Accounting standards require annual impairment testing for intangible assets with indefinite lives, which must be conducted at the same time each year. However, if events or circumstances arise that may reduce the value of the asset, more frequent impairment tests are mandated. This ensures that any potential declines in value are promptly identified and accounted for in financial reporting[2].

To determine whether impairment indicators exist, several factors must be evaluated. These include business factors, such as significant changes or anticipated developments that could negatively affect the relevant business area. In addition, one must consider market conditions such as increases in interest rates or yields that may impact discount rates, and, for public companies, a comparison of the asset’s market value to its book value.

Despite the credit rating agencies’ pessimism, the Israeli economy has demonstrated resilience, with a relatively modest underperformance since the start of the year. As an example, the Tel Aviv 125 index has shown only an 8% yield gap compared to the Nasdaq, both of which are at record highs. Historically, wars have had minimal long-term effects on company valuations. However, the unprecedented uncertainty currently affecting the local economy has elevated the specific risk premium for Israeli companies, potentially leading to higher discount rates. While cautious optimism about the long-term outlook is possible, ignoring present indications of value declines amid this uncertainty could be difficult to defend before regulatory bodies.

Expert Valuation Services: Collaboration Is Key

S-Cube is the largest valuation firm in the technology sector in Israel, performing approximately 650 valuations per year. However, despite over 17 years of experience in valuations, purchase price allocation (PPA), and impairment testing, S-Cube believes that no one knows a company better than its founders and finance professionals. Therefore, the cash flow forecasts that serve as the basis for determining the value of the activities valued in our work are not dictated by us, but are based on normative market data and the assessments of the companies’ management.

Our experienced team of analysts advises, guides and directs the company’s management in building and establishing forecasts, in a manner that is consistent with the past results of the activity, with the normative profitability rates accepted in the industry and with the current and expected macroeconomic environment. These valuations, which are recognized by leading accounting firms (the Big Four), are defensible, reasonable, and reflective of the available data and assumptions. This collaborative approach ensures valuations that meet both professional standards and the realities of the businesses being assessed.

[1] Israel Long-Term Ratings Lowered To ‘A’ From ‘A+’ On Heightened Security Risk; Outlook Negative

    Moody’s Ratings downgrades Israel’s ratings to Baa1, maintains negative outlook

[2] IAS 36 Impairment of Assets

 

What is said in this article is provided for informational and general purposes only. The aforementioned does not constitute “investment consulting” and/or “investment marketing” as defined in the Law on the Regulation of the Practice of Investment Consulting, Investment Marketing and Investment Portfolio Management, 1995 and/or a substitute for the above and/or a substitute for legal, financial, taxation advice, financial or any professional and personal advice. The S-CUBE company and/or the IBI group and/or any of the group companies will not be responsible for any loss or damage caused to any third party due to reliance on the above information.

Just before an exit or IPO, tax authorities may challenge the 409A valuations to increase the tax liability. This is when issues can arise, potentially jeopardizing the deal. What are the risks, and how can they be avoided?

In the absence of regulation in the field of valuations, some entities offer services that should raise red flags for management, such as predetermined results, unusually low prices, or overly short timelines that do not allow for thorough work and future audit protection. While these services might meet immediate needs, they can be harmful in the long term. When a company is preparing for an exit or IPO, tax authorities may challenge these valuations to increase the tax liability. This can complicate and at worst, torpedo the deal. Therefore, before starting the valuation process, it is crucial to assess the appraiser’s reputation and ability to defend the work before boards of directors and leading CPA firms. Do the company’s advisors recommend contacting the appraiser or avoiding their services? Does the appraiser have certification and the ability to comply with the 409A rules? In a few years, when an exit is on the horizon, will there still be anyone to turn to?

What is Section 409A?

Section 409A is an American code that defines rules regarding employee compensation, including stock-based compensation. It is essentially the American equivalent of Israel’s Section 102, which requires the appointment of a trustee and a 24-month period from the date of option or share allocation for employees to benefit from tax advantages. Similarly, under 409A, employees can defer the tax event from the grant date to the exercise date of their options if certain conditions are met, primarily that the options are not granted at a discount. In simple terms, the exercise price must be at least equal to the Fair Market Value (FMV) of the company’s stock. For public companies, this is straightforward as the market price is quoted daily on an exchange. However, for private companies, a valuation is required. The US tax authorities provide some relief for private companies, allowing a valuation to be valid for 12 months for granting options, provided no material event has occurred. While a material event is not defined by law, common practice identifies events such as funding rounds, IPOs, and changes in business activity as material events.

How does one choose a methodology for valuing private companies for the purpose of 409A?

The valuation methodology should align with the company’s stage of development. For instance, if the company has recently completed a fundraising round, its value must be determined using the Option Pricing Model (OPM). When there is no relevant value indication but the company can provide a cash flow forecast, the Discounted Cash Flow (DCF) model can be used, where predicted cash flows by the company’s management significantly influence the valuation. If management cannot provide a multi-year cash flow forecast but the company has substantial revenues or profit, a valuation can be performed using the multiplier method, based on the values of comparable public companies with similar activities, revenues, EBITDA, net profit, and net financial debt. Even if a company does not meet these criteria, its value can still be estimated using alternative approaches such as the cost approach, which considers the amounts invested in the company thus far.

Why should Israeli companies be concerned with US tax laws?

For American companies, including American subsidiaries of Israeli companies, U.S. law governs the granting of options to employees. This law is equally relevant for Israeli companies granting options to employees subject to American law, including any US-based employees as well as any employees holding US citizenship (regardless of their location of residency or dual citizenship). Therefore, Israeli companies that wish to grant options to their employees must verify whether American law applies to any of their employees.

Can an Israeli company be exposed because it has American employees?

Israeli companies operate under Israeli law, so if one or more of the company’s employees are subject to American law, the tax liability falls on the employees themselves, not the company. The obligation to report is on the employee, and the company does not have a withholding tax obligation in this context. However, since employees of private companies typically cannot meet the requirements of American law—specifically, estimating the company’s fair value for tax purposes—virtually all companies handle this issue on their behalf.

How do you correct mistakes that were discovered retrospectively?

In some cases, companies that have granted options to their employees may retrospectively discover that an employee, such as one with dual citizenship, was granted options not in compliance with Section 409A rules. There are two distinct scenarios depending on when the mistake is discovered: if the mistake is discovered in the same tax year the options were granted, the correction involves adjusting the exercise price to comply with Section 409A rules, requiring the employee’s consent but no other complications. If the mistake is discovered in a different tax year, the options must be canceled and re-granted, or a repricing process must be undertaken. This process is relatively complex, so it is essential to consult a CPA or attorney who is an expert in American tax law to execute this.

Why would a company with a single American employee do a 409A valuation?

While the immediate use of valuations is to determine the exercise price of options granted to employees subject to American law, these valuations can later be used for the company’s financial statements. For instance, they can calculate the accounting expense for granting options to all employees, determine the value of financial instruments such as SAFEs, and assess the value of all types of the company’s preferred shares.

Should exercise prices be the same for Israeli and American employees?

American and Israeli law do not require options granted to American and Israeli employees to have the same exercise price. Israeli employees can receive options at any exercise price, including zero, while American employees must receive options at an exercise price equal to or higher than the market value of the company’s stock to comply with 409A rules. Granting with a discrepancy is a human resources issue only. In most companies, it is common to grant Israeli employees options at a zero exercise price during the initial stages. As substantial activity begins in the U.S., companies often standardize exercise prices for all employees because of internal HR reasons.

The problem of “Cheap Stock”

After a company enters the IPO process, which typically takes about a year and a half, the problem of “cheap stock” may arise. This issue occurs when options are granted to employees during the full year preceding the IPO at a significantly lower exercise price compared to the expected share value in the IPO. This is a critical issue when preparing the prospectus for the SEC. Towards the end of the offering process, shortly before the pricing stage, the company must deliver a “Cheap Stock letter” to the SEC, detailing the quarterly valuations and all grants made during this period.

The SEC will audit these valuations, scrutinizing the company’s assumptions in relation to the expected IPO value, the methodologies used, and any secondary transactions near the valuation date. They will also examine the methodology of the Discount for Lack of Marketability (DLOM) applied. The SEC expects a gradual convergence to a value slightly lower than the expected IPO value throughout the period. If the SEC does not approve the valuations, the company must retroactively amend the cost of the options in its financial statements. This scenario is undesirable as it is very costly and may tarnish the company’s reputation with tax authorities, a situation no company or its financiers want to face.

Therefore, it is highly recommended for companies in this period to perform quarterly valuations. Initiating this process proactively, rather than waiting for an auditor’s recommendation, is advisable. The recommendation is inevitable, but starting early brings advantages. Valuations take time, and the shorter the schedule for completing this task, the higher the likelihood of mistakes, not to mention increased costs.

Beyond the exercise price, compliance with the various criteria required under the rules of Section 409A is nuanced and raises many questions, some of which we have answered here. For any additional questions, you are welcome to contact Roni Birenzweig, Senior Analyst and Head of 409A Valuations at S Cube (roni@s-cube.co.il).

 

What is said in this article is provided for informational purposes only. The aforementioned does not constitute “investment consulting” and/or “investment marketing” as defined in the Law on the Regulation of the Practice of Investment Consulting, Investment Marketing and Investment Portfolio Management, 1995 and/or a substitute for the above and/or a substitute for legal, financial, taxation advice, financial or any professional and personal advice. The S-CUBE company and/or the IBI group and/or any of the group companies will not be responsible for any loss or damage caused to any third party due to reliance on the above information.

What are investors looking for in the current environment, what opportunities have been created, and can the new government grants help? What are the effects of the war on the cyber field in particular, and where do SAFEs and down rounds come in?

Relative to the challenges facing the Israeli economy as a whole, and the technology sector in particular, the performance of Israeli tech firms has been excellent, especially when compared to counterparts in the US. Despite the backdrop of conflict and hurdles encountered by some international investors, the local tech industry continues to exhibit notable strength, garnering confidence from investors. Nevertheless, the global tech downturn has deeply impacted Israeli companies, compounding the strain on the domestic economy during this unprecedented period.

In this climate, securing financing has emerged as a task more difficult than usual for entrepreneurs, prompting crucial questions: What criteria are investors prioritizing in the current landscape? What opportunities have arisen, and how can entrepreneurs capitalize on governmental initiatives aimed at supporting them?

What are investors looking for in the current environment?

When we assess the current state of the technology sector, investors are seeking much the same as they were during the boom of 2021. Even now, their focus remains on backing solid companies poised for growth. However, there’s a notable shift in their approach, driven by a desire to mitigate risks. To achieve this, investors have narrowed down the scope of their investments significantly. This serves a dual purpose: it reduces financial exposure and allows for more selective choices among companies. Essentially, they’re opting for quality over quantity. It’s far easier to assess and invest in, say, two low-risk companies from a pool of options than it is to spread investments across ten similar-risk ventures.

These adjustments ripple out, further minimizing risk. With demand for investment outweighing supply, investors now have the luxury of time to conduct thorough due diligence. This contrasts sharply with the frenzy of late 2021, where investors were under pressure to sign fast or else lose out on deals entirely. Time allows for a clearer understanding of potential pitfalls and advantages in an investment. Finally, investments are being made at lower valuations. While this might seem counterintuitive, it sets the stage for potentially higher returns. Lower initial valuations mean there’s more room for growth, increasing the return on investment.

What opportunities were created?

As discussed, the current landscape offers many opportunities primarily favoring investors, stemming from the disparity between investment supply and demand. This setting empowers investors to be discerning and conduct more thorough evaluations of potential investment targets. It’s important to note that while prices have declined, the primary opportunity arises from decreased investment risk. If a company boasts a strong team and product, returns are likely. In essence, the risk of investing in an unsuccessful venture, resulting in a write-off, is more serious than the risk of investing in a successful company at too high a price, which typically yields lower returns.

Undoubtedly, this scenario isn’t ideal for companies; however, it also presents opportunities for successful ones. With fewer investments available, successful companies can anticipate reduced competition. Furthermore, a pivotal shift in the technology sector is the move from a growth-centric approach to prioritizing rapid transition to profitability. While this transition was anticipated by the end of 2021, its realization occurred approximately a year later than expected.

How to take advantage of concessions given by the authorities?

As a response to the adverse impacts of the “Swords of Iron” war on the local economy, the government has initiated measures to bolster the technology sector. One of these initiatives involves the launch of new pathways by the Innovation Authority, aimed at incentivizing investment in companies while mitigating risk for investors. A notable addition is the introduction of a rapid grant avenue, totaling NIS 400 million, tailored for companies facing imminent financial difficulties. Operating within the framework of the R&D fund, this channel targets innovative technology firms with a runway of up to six months, providing financial support of up to $7.5 million until the next funding round.

The effects of warfare on the cyber domain

Cybersecurity has long been prominent within the technology sector, predating the onset of the recent conflict. As technology becomes important in more industries – a trend that has persisted for years with no signs of abating – the need to safeguard new software becomes increasingly critical. This includes software employed in diverse sectors such as public transportation, automotive computing, and business management. Since the outbreak of the conflict, the significance of cybersecurity has surged to unprecedented levels.

Recent research conducted by S Cube, which specializes in high-tech company valuations, underscores the heightened importance of cybersecurity. Among the key findings of S Cube’s latest study is that cybersecurity emerged as one of the top three areas for fundraising rounds in 2023. Following a slight decline in 2022 to approximately 14% of fundraising rounds, cybersecurity rebounded in 2023 to constitute roughly 19% of fundraising activities. Although there has not yet been a formal study tracking transaction rates in the field since the beginning of the year, there’s been a noticeable uptick in cybersecurity transactions of late, suggesting a continued strengthening trend in the field.

The scope of SAFE and down round agreements

When a company finds itself at a critical juncture, teetering between survival and closure, entrepreneurs often entertain proposals they might otherwise dismiss. Meanwhile, investors aim to secure the most favorable terms to maximize their value. Against the backdrop of the current global crisis affecting the technology sector – unrelated to the difficult situation in Israel – the popularity of SAFEs (Simple Agreement for Future Equity) has increased. The issue of valuation caps in these agreements has also garnered heightened attention.

In the past, entrepreneurs frequently disagreed with the valuation cap stated in their SAFE, viewing it as much higher than the company’s true value. However, nowadays, it’s increasingly common for entrepreneurs to accept the valuation cap as reflective of their company’s value.

Despite the uptick in down rounds – defined here solely in economic terms as capital raised at a reduced valuation, or with improved terms for investors such as increased interest, investment multipliers, warrant additions, etc. – the phenomenon hasn’t become ubiquitous. While the prevalence of down rounds has increased compared to previous years, companies that do secure funding often do so at slightly higher valuations than in their previous rounds. This suggests that widespread down rounds have yet to materialize.

The bottom line

During crises, companies find themselves compelled to explore more creative financing avenues and embrace a broader range of investors – a sentiment echoed among those entrenched in the venture capital scene. The landscape has shifted. Money used to flow freely, but now it comes with a price tag. This shift is a key driver behind the downturn in the global technology sector.

In the past, when money was abundant and interest rates hovered near zero, entrepreneurs wielded significant power, and investors vied for their favor. Today, the tables have turned, with investors holding sway and entrepreneurs needing to court them. However, amidst these challenges, investors’ primary focus remains unchanged: identifying companies with strong teams and promising products. Therefore, if you have the right team and a product with potential, investment prospects are still favorable, even in these trying times.

What is said in this article is provided for informational and general purposes only. The aforementioned does not constitute “investment consulting” and/or “investment marketing” as defined in the Law on the Regulation of the Practice of Investment Consulting, Investment Marketing and Investment Portfolio Management, 1995 and/or a substitute for the above and/or a substitute for legal, financial, taxation advice, financial or any professional and personal advice. The S-CUBE company and/or the IBI group and/or any of the group companies will not be responsible for any loss or damage caused to any third party due to reliance on the above information.

The performance of the domestic sector was good relative to the US, despite unprecedented geopolitical crises; the medical and cyber sectors have eaten into the market share of information technology companies; and a change for the better is expected at the end of the second half of 2024

In 2023, the local technology sector exhibited resilience amidst challenges faced by foreign investors, garnering renewed confidence. However, the deep global tech crisis also impacted Israeli tech firms, compounding the economic damage from what proved to be one of Israel’s most difficult years. New research from S Cube, which specializes in the valuation of high-tech companies, sheds light on the capital-raising landscape for Israeli tech firms and those affiliated. Despite a notable reduction in overall investment, top-tier companies defied odds by increasing their median investment volume compared to last year. Furthermore, the fields that received the highest number of fundraising rounds last year remained the same as last year, when the demand for investments in the fields of medicine and cyber ate into the market share of information technology companies.

Despite the national trauma, Israeli high-tech remains strong

Based on extensive data from thousands of valuations conducted by S Cube for its clients since 2013, the study identifies the magnitude of the impacts of geopolitical events on the Israeli economy and the prevailing crisis within the global tech sector over the past year. This translated into a notable decline in the frequency of fundraising rounds. Among the rounds that did occur, there was an approximate 15% decrease in the median valuation of companies in the more advanced fundraising tiers (D and above) compared to the previous year, alongside a marginal 2% dip in median valuation for companies raising C rounds. However, fundraising rounds for companies in their initial stages displayed a mixed pattern: a remarkable 73% surge in the median valuation for B rounds contrasted with a slight 4% decrease in valuations for A rounds. This variance suggests a discerning approach by investors, shown by a 40% reduction in the number of B rounds. Investors appear to favor companies demonstrating early-stage promise and significant growth potential, contributing to the increased valuations observed in certain fundraising tiers.

Regarding the challenging economic climate faced by Israel, especially within the technology sector, Israeli tech companies demonstrated relatively robust performance compared to their US counterparts. In the first three quarters of 2023, the US witnessed a substantial 54% decline in median valuations for companies in advanced fundraising stages (C rounds and above), whereas Israel experienced a more modest 24% decrease in the same category. Similarly, while the US saw a significant 66% decline in median valuation for B rounds, Israel saw a noteworthy 73% increase. In the initial stages of fundraising, the US experienced a 9% decrease compared to Israel’s 4% decline. It’s important to note that during peak periods, Israel’s value escalations were more tempered, and historically, the impact of crises on Israel’s tech sector performance has been less severe than that on US companies.

The leading companies managed to increase the investment amounts

Analyzing last year’s investment rounds reveals a surprisingly positive trend in advanced stages (D and above), with a notable 4% uptick in median investment volume received by companies, reaching approximately $42.7 million compared to $41 million the previous year. This figure stands only 15% less than the median investment volume recorded in 2021, which hovered around $50 million – in a year often characterized as a bubble. While this phenomenon isn’t representative of the entire sector’s performance over the past year, it underscores a fundamental truth: promising companies continue advancing even amidst crisis. Conversely, the broader sector trended negatively in terms of investment volumes, witnessing a 63% decline in median investment volume for C rounds to approximately $10 million, compared to roughly $27 million in the previous year. Similarly, there was a 36% dip in median investment volume for B rounds, totaling about $8.3 million compared to $13 million in the prior year, alongside a slight 3% decrease in median investment volume for initial fundraising rounds to approximately $7 million, down from about $7.2 million the preceding year.

The fields of medicine and cyber have taken a bite out of information technology’s market share

Amidst the upheaval, the momentum of the technological revolution remains unabated. The demand for technology continues to increase across industries. The key sectors dominating the landscape in the past year remained largely the same. Leading the pack once again in 2023 were IT & Enterprise Software ventures, constituting roughly 24.6% of all investment rounds – a decline from the previous year’s 33.3%. This category encompasses technologies leveraging artificial intelligence to enhance the operational efficiency of businesses across different sectors. Following closely behind, Healthcare and Life Sciences secured a notable share, accounting for approximately 20.3% of rounds compared to 17% the preceding year. This sector spans a spectrum of fields including pharmaceuticals, medical devices, digital health, and biotechnology. Notably, Cybersecurity witnessed a resurgence in interest, rebounding to approximately 19% of investment rounds last year after experiencing a dip to 14% in 2022.

A change for the better is expected at the end of the second half of 2024

In 2024, the United States enters an election year, a period often marked by a conservative approach from investors who tend to prefer less risk until after the early November elections. However, historical trends suggest that the stock market typically rallies post-election, regardless of who wins. Consequently, while the current crisis is anticipated to persist through 2024, optimism prevails for an upturn in the latter half of the year. Israeli high-tech remains intertwined with the fluctuations of the American market, although the immediate future is dictated most significantly by the duration and outcome of the ongoing conflict.

What is said in this article is provided for informational and general purposes only. The aforementioned does not constitute “investment consulting” and/or “investment marketing” as defined in the Law on the Regulation of the Practice of Investment Consulting, Investment Marketing and Investment Portfolio Management, 1995 and/or a substitute for the above and/or a substitute for legal, financial, taxation advice, financial or any professional and personal advice. The S-CUBE company and/or the IBI group and/or any of the group companies will not be responsible for any loss or damage caused to any third party due to reliance on the above information.

A change for the better in the technology sector is expected at the end of the second half of 2024

The Nasdaq is once again at a record level while Israel is in an ongoing war, what does this mean for the local high-tech companies? The CEO and founder of S Cube of IBI Capital Group, the largest valuation company in the technology sector in Israel, sums up the past year and discusses the big trends to look out for in 2024

S Cube performs about 650 valuations per year, primarily for startups at all stages of growth. The vast majority of clients operate in the technology sector and in fact, S Cube performs most of the valuations for the technology sector in Israel, which provides an excellent perspective on the Israeli high-tech ecosystem. Reflecting on 2023, the local technology sector is resilient, allaying the fears of foreign investors and garnering confidence. However, the profound crisis in the global technology sector still impacts Israeli technology companies, on top of the economy-wide headwinds from one of the nation’s most challenging years. A change in global trends is anticipated by the end of 2024, yet the trajectory of the local sector also hinges on the evolving developments of the war.

The Nasdaq is once again at a record level and indeed above its level at the end of 2021. Back then, many saw this as a bubble. Is the situation different this time? How do you see the state of the technology sector on a global level?

The Nasdaq stands as the preeminent index for technology stocks globally; however, utilizing it as the sole reference for the entire sector is misleading. Over the past year, as indeed we’ve seen in the past few years, industry giants such as Apple, Microsoft, Alphabet (Google), and NVIDIA, benefiting from significant scale advantages, have continued to expand in absolute terms and also relative to the broader technology sector. When examining the situation at small and micro-cap companies, particularly the bulk of the private companies in the American market, the indications of a bubble dissipate entirely, revealing substantial declines of up to several dozen percent in company valuations over the past year.

And so, despite some leading companies maintaining valuations akin to those at the end of 2021, this does not accurately represent the broader sector. Excluding these outliers, the sector as a whole has experienced a profound crisis over the past year. Notably, the increase in the US interest rate, which was at zero at the end of 2021, has since risen significantly, experiencing an additional increase of 1% in 2023 to reach a range of 5.25-5.5%. Consequently, investors can now secure a favorable return on deposits with very low risk. This exerts a substantial negative influence on investments across all sectors, including the technology sector.

In Israel, the events of October 7 and the war, whose end date is unknown, came after difficult months that the technology sector went through due to the legal reform issues. How much did these events affect Israeli technology companies?

The current performance of technology companies in Israel mirrors that of their counterparts in the United States. However, it is important to acknowledge that during the peak period, the value increases in Israel were smaller (Historical data indicates that on the flip side, the impact of crises on the technology sector’s performance in Israel has been comparatively moderate relative to the impact on American companies). The prevailing factor behind these disappointing results in 2023 is the pervasive uncertainty characterizing the past year. Commencing with internal political strife surrounding legal reforms that dissuaded foreign investors, the uncertainty escalated even higher since October 7 due to an ongoing and indefinite war, with uncertainty surrounding its conclusion, potential additional fronts, and the ensuing consequences.

On one hand, the strengthening of the shekel implies investor confidence in Israel’s ability to manage the situation. On the other hand, the national trauma and daily updates on losses and injuries among military forces, some of whom will endure permanent disabilities, paints a much more somber picture. Despite hoping for and believing there will be a favorable outcome in the end, gloominess permeates daily life. Attempts to stimulate the economy and maintain a robust home front are challenging, given the significant portion of the population engaged in reserves and the disruption caused, at the very least, by missile threats and alarms on a regular basis. The resulting impact on productivity, coupled with the enormous government expenditure on the war, compounds the challenges, suggesting that the economic difficulties will likely persist into the year 2024.

In terms of raising capital in the local technology sector, how did the entrepreneurs deal with the challenges of the past year?

In the past year, there was a notable decrease in fundraising rounds, with only exceptional companies managing to sustain or increase their valuations, resulting in a generally lower valuation landscape compared to 2022. However, there are promising signs from November and December, with many successful funding rounds concluded. This resilience underscores the sector’s strength, which, in my view, emerged as a pivotal civilian force in terms of mobilization and contribution to the national effort during the ongoing war. While these tech companies may not be significantly impacted at the operational level, given their primarily international markets, they face challenges in capital raising. Investors, faced with the choice between an Israeli company and a foreign counterpart with similar technology, may lean toward the latter due to prevailing uncertainty in the broader Israeli economy.

The difficulty created in raising funds from foreign investors during the year led many entrepreneurs to express interest in corporate inversions. To what extent have these processes been completed in practice?

Over the past year, a significant shift occurred as a growing share of new companies opted to incorporate as foreign entities, after years of Israeli startups incorporating primarily in Israel. Moreover, particularly among early-stage businesses, some corporate inversions occurred, wherein the Israeli parent company transformed into a subsidiary of a foreign counterpart. The motivation behind these decisions was primarily driven by the challenges faced in fundraising as an Israeli entity. It’s worth noting, however, that the phenomenon is relatively uncommon. This is largely due to the complex and economically burdensome nature of the process, making it an impractical choice for well-established companies.

In the current environment, it is possible to see more investment mechanisms and different conditions that benefit the investors without lowering the pre-money valuation. How do you feel about the various down round avoidance mechanisms?

I believe that down rounds should not be categorically avoided. In situations where a company initially raised capital at an exceptionally high valuation, it might be more prudent, especially during a crisis, to consider a down round and then gradually recover, rather than navigating financial complexities solely to maintain an inflated share price. Modifying the terms of preferred shares, such as introducing a 200% investment multiplier for investors, may superficially maintain the share price on paper (even though economically it decreases), but it can lead to challenges and complications in subsequent funding rounds. Consequently, such manipulations are, in my view, short-term fixes that could potentially inflict long-term harm on the company.

After an almost complete absence of secondary transactions in 2022, are there any signs of a change in trend in the past year?

In the final quarter of the year, a notable resurgence of secondary transactions occurred among our clients, signaling a positive outlook. The reappearance of these transactions is particularly encouraging as it suggests optimism within the investor community. When an investor participates in a standard investment round, it serves as a capital infusion directly benefiting the company’s operations, enhancing its prospects for success. In contrast, secondary transactions involve the transfer of funds to entrepreneurs, employees, or investors from previous rounds. Secondary rounds really demonstrate investors’ belief in the intrinsic value and potential growth of the company, since the funds they invest don’t directly increase the capital or growth potential of the company.

What is expected of the global and local technology sector in 2024?

2024 marks an election year in the United States, and historical trends suggest that investors tend to reduce their risk exposure in the lead-up to the elections in early November. However, post-election periods typically witness improved stock market performance, with US markets historically rebounding strongly regardless of election outcomes. I anticipate that this year will follow the same pattern. The ongoing technology crisis is likely to persist throughout 2024, with signs of improvement expected in the latter half of the year. Domestically, our market is closely linked to the American market, though in the near future it is also contingent on the duration and outcome of the current war. In any event, I project a notably swifter recovery for the technology sector than for the rest of the Israeli economy.

What is said in this article is provided for informational and general purposes only. The aforementioned does not constitute “investment consulting” and/or “investment marketing” as defined in the Law on the Regulation of the Practice of Investment Consulting, Investment Marketing and Investment Portfolio Management, 1995 and/or a substitute for the above and/or a substitute for legal, financial, taxation advice, financial or any professional and personal advice. The S-CUBE company and/or the IBI group and/or any of the group companies will not be responsible for any loss or damage caused to any third party due to reliance on the above information.

We find ourselves in one of the most difficult periods Israel has ever known, following several months of wallowing in a political quagmire. Enormous uncertainty looms, with credit rating agencies threatening downgrades, increased discount rates, and the ominous specter of a US yield curve steepening, intensifying recession concerns. Now, more than ever, it’s imperative that the company’s leadership plays a pivotal role in the valuation process.

As we gear up for the 2023 financial statements, companies are already building cash flow forecasts to assess the decline in the goodwill value of previously acquired assets. This unfolds against the backdrop of one of the most challenging years to hit the Israeli economy, marked by a series of serious events that have negatively impacted company valuations.

The most daunting of these events transpired on October 7, which led the State of Israel to declare the ‘Iron Swords’ war, the repercussions and consequences of which remain unpredictable. This event unfolded after months of the local economy being mired in a political quagmire, sparked by sweeping legal reforms that prompted massive street protests. In response, international credit rating agencies are contemplating a downgrade of Israel’s credit rating. In parallel, the global macro environment is also challenging, in view of the continued increase in interest rates expected to increase the discount rates applied to companies’ activities, and the yield curve in the USA which inverted in October last year and remained inverted for the longest period in history.

The inversion of the yield curve is an indicator of a recession which will make it difficult to establish a substantial improvement in business results for the coming years, one that could otherwise offset the aforementioned headwinds. This inversion presents a significant obstacle to envisioning substantial business improvement in the coming years, which could offset the aforementioned challenges. The yield curve, a graphical representation of bond yields across different timeframes, typically exhibits higher yields for bonds with longer maturity dates during normal economic conditions. An inverted yield curve, where short-term bond yields surpass long-term ones, is anomalous, primarily associated with periods preceding recessions.

Can I delay the annual impairment test to a more convenient time?

Accounting guidelines stipulate that intangible assets with an indefinite lifespan necessitate at a minimum an annual impairment test, which can be conducted at any point during the year, provided it remains consistent each year. However, if an event or change in circumstances occurs that may reduce the value of the activity materially, the guidelines require that an impairment test be carried out even if a year has not yet elapsed.

To determine if there was likely to be a decrease in the value of an asset, one must consider if any material events that negatively impact the asset’s activity have transpired or are expected. In addition, any increase in interest rates or yields that may influence the discount rate must be examined. For publicly-traded companies, the market value of the asset compared to its book value must also be considered.

Since the start of the year, the Israeli economy has struggled with underperformance, experiencing a yield gap of approximately 30% between the Tel Aviv 125 index and the Nasdaq, in part due to months embroiled in a political quagmire centered around judicial reform. The gap further widened due to the ‘Iron Swords’ war that rattled the local capital market, exacerbating the uncertainty in which Israeli companies operate. Historically, combat situations have had a limited long-term impact on company valuations. However, the unparalleled level of uncertainty in the local economy has heightened the specific risk premium for Israeli companies.

Furthermore, in 2023, the trend of rising interest rates in the USA persisted, with an additional 1% increase so far. In September, the Federal Reserve even signaled the possibility of another interest rate hike within the year.

So although there is room for cautious optimism regarding the long-term consequences of the extraordinary events in Israel, companies must also be realistic. Disregarding the many indications of value decline due to the current uncertainty and the rising US interest rates, along with the subsequent escalation in discount rates, will be extremely difficult to justify and defend before the various auditing bodies.

Reliable valuations – based on Management’s forecasts

S Cube, the leading technology valuation company in Israel, conducts approximately 650 valuations annually. Despite our extensive experience spanning 14 years in valuations, including Purchase Price Allocation (PPA) works and impairment tests, we still believe that no one knows the companies better than the entrepreneurs themselves and the financiers who support them.

As a result, the cash flow forecasts underpinning our valuation assessments are not dictated by us; rather, they are grounded in normative industry data and, above all, evaluation from the companies’ management. Our seasoned team of analysts collaborates closely with company leadership to offer guidance and support in crafting forecasts that align with historical performance, industry-standard profitability benchmarks, and the prevailing and anticipated macroeconomic conditions.

Our objective is to ensure that our valuations, accepted by the Big Four and other major accounting firms, remain defensible, coherent, and ultimately represent a realistic assessment of value.

In the current challenging situation, it is even more important that the company’s management be an integral part of the valuation process. S Cube is at your disposal for the impairment test required for the 2023 financial statements, as well as for a wide range of other professional valuation services. For more details, please contact info@s-cube.co.il

Gidi Shalom Bendor is the CEO and founder of S Cube of IBI Capital, the largest provider of valuation services to technology companies in Israel.

 The above is provided for informational purposes only and should not be considered complete and/or exhaustive information of all aspects involved in the impairment test. The aforementioned does not constitute legal, financial, taxation, or economic advice or a substitute for any professional or personal advice. IBI Group and/or any of the Group’s companies will not be responsible for any loss or damage caused to any third party due to reliance on the above information.

Current multipliers in the technology sector are attractive for entrepreneurs who expect an exit; preparing for an M&A transaction may take months, during which the transaction may be canceled for various reasons; this is how you shorten the process

Israeli technology stocks traded on Nasdaq have demonstrated resilience in 2023, delivering a respectable return of approximately 20%, despite the backdrop of uncertainty stemming from the Israeli government’s proposed changes to the legal system. While this may appear lackluster compared to the Nasdaq index’s overall gain of around 30% during the same period, it underscores the robustness of Israel’s technology sector in the face of adversity. Amidst the prevailing gloom, it’s crucial to recognize that strategies to mitigate uncertainty exist (such as corporate inversions), even for investors not presently willing to invest in Israeli firms. Ultimately, investors seek technology with the potential for value creation and visionary entrepreneurs who can harness that potential. Therefore, if you possess a winning combination of a talented team and groundbreaking technology – investors will come.

Furthermore, the Nasdaq index presently stands just 13% shy of its all-time high, achieved at the close of November 2021. Many consider this level to be indicative of a bubble, or at the very least, the pinnacle of what has been a remarkably robust year for the technology sector in the past decade. Consequently, this market environment presents a good opportunity for entrepreneurs exploring exit strategies. However, in the realm of M&A transactions, success hinges on more than just possessing a winning product or technology. Several technical factors can tip the scales. Therefore, it’s prudent for startup companies to prepare and be well-versed in these critical elements in advance, ensuring that at the moment of truth, the transaction is executed successfully.

1. “Scheduling Is a Matter of Timing”

It’s essential to recognize that the M&A process is a lengthy endeavor because of the due diligence, where you’ll need to furnish a variety of documents, including board meeting minutes, investor presentations, valuations, and clean financial statements with an auditor’s unqualified opinion. It’s worth noting that, as with any transaction, until the purchase agreement is signed, there’s always a possibility of the deal falling through. The longer it takes to compile all the requisite documents for the M&A process, the greater the likelihood of the deal falling through for reasons unrelated to your product or technology. Potential factors include the acquiring company undergoing its own acquisition, key personnel overseeing the M&A process shifting roles, shifts in the capital market conditions, or alterations in financing options for the transaction.

Therefore, the company must be ready for a comprehensive due diligence long before any buyer arrives. This entails organization of all necessary documents into a dedicated M&A folder and leaving no gaps in your financial statements. For instance, failing to conduct valuations for expense allocation related to employee stock options can result in an auditor’s note or qualification on financial statements. Given that most investors shy away from acquiring companies with qualified financial statements (and a company with a qualified opinion cannot carry out an IPO at all), such matters must be addressed promptly. Retroactively performing valuations for several years is a complex task involving historical cap tables and option tables’ analysis, scrutiny of investment agreements, articles of association, warrant agreements, and convertible loan agreements.

Even with the appraiser working as fast as possible, the process can be lengthy, and the company may need weeks merely to gather all the requisite documents, before the appraiser can begin their work. The same goes for Purchase Price Allocation (PPA) reports following acquisitions of companies or technology. PPA execution, even when carried out close to the acquisition date, can take weeks. Delaying it until the last minute, after due diligence has commenced, adds further complexity, making it challenging to recall pertinent conditions leading to the transaction – not to mention the time needed for the accountant to review it. It’s crucial to remember that each passing day increases the likelihood of a transaction failing.

2. Due Diligence Is Not Necessarily One-Sided

It is very useful to conduct due diligence on the buyer – to know how much experience the buyer has in conducting M&A transactions and what their reputation is. Do they usually follow through with proposed transactions, or drop them because of unspecified difficulties? When an earnout mechanism is incorporated into the agreement, understanding the buyer’s profile becomes particularly important. This insight helps gauge the shareholders’ likelihood of receiving the payments stipulated in the earnout mechanism, a common component of M&A agreements that outlines additional payments by the buyer to the acquired company’s shareholders contingent upon future performance.

3. Are Some of the Shareholders Holding Out for More?

In order to carry out a standard M&A transaction under the Israeli Companies Law, the approval of 95% of the shareholders is required, and if the target company is public, obtaining approval becomes particularly complex. On the other hand, when it comes to a reverse triangular merger, the approval of just a simple majority – more than 50% – is required (Delaware law is broadly similar with this simple majority requirement.)

Now, what exactly is a reverse triangular merger? In this merger structure, the acquiring entity establishes a wholly owned subsidiary and transfers the designated purchase price to it. This newly formed subsidiary then merges with the target company, resulting in the proceeds being distributed to the shareholders of the target company. Upon the completion of this merger, the acquiring entity assumes full ownership of all the shares within the merged company.

That is, if some of the shareholders prefer not to carry out the merger for any reason, structuring the transaction as a reverse triangular merger type can allow the company’s management or the founders to force the sale on those holdout shareholders.

4. Prepare for the Challenge at the Administrative Level

In addition to the “headache” for the company’s finance team, which was detailed at the beginning of the discussion, it should be understood that the M&A process, from negotiations to due diligence, demands a substantial investment of time from the entire managerial hierarchy within the company. This becomes especially taxing for startup companies, where the majority of managers routinely put in double-digit workdays. The extra workload from the M&A process can rapidly deplete available time and disrupt the day-to-day management of the company’s operations. There are no quick-fix remedies for this predicament. Each company must find a tailored solution to address it. The key is proactive preparation, ensuring that potential solutions are identified in advance, sparing you the added burden of reaching for solutions when time is already in short supply.

5. A Professional, Skilled, and Experienced Team is Vital

A proficient and seasoned team of lawyers and accountants, with considerable prior experience in conducting M&A transactions, play a pivotal role in preventing potentially catastrophic mistakes that could inflict substantial harm on the future interests of the acquired company’s shareholders. Such blunders might also leave the managers that oversaw the process vulnerable to legal repercussions. Historical evidence underscores that in the event of a critical procedural error, the likelihood of shareholders accepting the outcome as-is is exceedingly slim, and such disputes typically end in lawsuits.

The Bottom Line

Despite the challenging economic landscape and political conflict in Israel today, technology continues to progress. A winning team with innovative technology holds the key to attracting investors, who excel at solving problems as they arise. Once you’ve demonstrated the economic viability of your product or technology and are poised for an M&A agreement, all that’s left is preparing the groundwork to make the most of the opportunity once it arrives. Awareness of the various requirements for executing the deal and integrating these considerations into your development and initial capital-raising stages can significantly enhance your prospects for a successful exit. This proactive approach not only bolsters your chances of a favorable exit but also molds the terms of the deal in your favor.

Gidi Shalom Bendor is the CEO and founder of S Cube of IBI Capital, the largest provider of valuation services to technology companies in Israel.

 The above is provided for informational purposes only and should not be considered complete and/or exhaustive information of all aspects involved in the corporate inversion process. The aforementioned does not constitute legal, financial, taxation, or economic advice or a substitute for any professional or personal advice. IBI Group and/or any of the Group’s companies will not be responsible for any loss or damage caused to any third party due to reliance on the above information.

Everything you need to know about intangible assets before transferring the IP out of Israel – how do you determine the value of a company’s IP? When is a valuation necessary? Which companies are expected to go through the process easily and when are difficulties to be expected?

The uncertainty surrounding Israel’s legal system due to the government’s proposed reforms poses challenges for private Israeli technology companies seeking funding. Investors are hesitant to invest in Israeli companies until there is clarity about the legal environment. In some cases, investors even condition their investment on transferring the company’s IP outside of Israel. This transfer can be achieved through a “corporate inversion”, but it is important to differentiate between old and new companies.

For new companies in the growth phase, a corporate inversion is relatively simple, involving minimal expenses and usually no actual tax payments. However, for older and profitable companies, the process is more complex and demanding, requiring significant time and resources, and often results in higher tax payments. Regardless of the company’s situation, transferring the IP is equivalent to selling it, necessitating a valuation to determine the applicable tax. By understanding these distinctions and navigating the process strategically, companies can make informed decisions about IP transfers and manage potential challenges.

What are intangible assets and IP?

Intangible assets, of which IP is a subset, are assets whose physical, and hence also legal, characteristics are different from those of tangible assets that are easier to perceive and define. Tangible assets such as a factory, tractor, or computer are by their very nature under the control of their owners and generate a benefit or profit for their owner in an easily identifiable way. In contrast, identifying intangible assets can be more challenging, although they share properties similar to tangible property, such as the possibility of being transferred, sold, or licensed. IP encompasses various types of assets, including technology, knowledge, brand, design, and trade secrets. Companies may also possess many other intangible assets such as customer relationships, non-competition agreements, backlog, and human resources.

Can a company have multiple intangible assets?

Yes. In fact, most companies have a range of intangible assets.  For example, a company can simultaneously hold IP such as a patent, technological knowledge that is not patentable, a trade secret, and a brand. Simultaneously it might have many other intangible assets such as a non-compete agreement with the engineer who developed the technology and a valuable customer list.

When is valuing the company’s IP necessary?

Companies are obligated to conduct IP valuations whenever intangible assets are transferred, whether through sales or transfers to other entities. For instance, during M&A transactions, the acquiring company must carry out a Purchase Price Allocation (PPA) to allocate the purchase price between tangible and intangible assets and determine the value of goodwill, which forms the basis for periodic impairment tests. Similarly, spin-off transactions, where a company grants the right to use its IP, necessitate a valuation to set transaction pricing. Additionally, when selling IP to another company in Israel, the Israeli Tax Authority often asserts that the value of the entire company, excluding tangible assets, equals the value of the IP, making a valuation crucial to reduce the tax liability. It is also important to be aware that simultaneous transfers, such as transferring employees to the receiving company alongside the IP transfer, may result in a higher tax liability as it is considered a transfer of activity by the Israeli Tax Authority.

IP valuation also plays a pivotal role in “technical” sales like corporate inversions, which have garnered substantial attention lately due to legal uncertainties in Israel. Such inversions involve transforming an Israeli company into a subsidiary of a foreign-registered entity. For companies that have received grants from the Israeli Innovation Authority, any IP removal from Israel is considered a sale, potentially leading to the imposition of fines or penalties. On the other hand, carrying out an inversion while leaving the IP with the new Israeli subsidiary is unlikely to result in penalties.

Why is IP valuation more complex than company valuation?

The valuation of intellectual property (IP) employs methods similar to those used for valuing companies. However, there is a fundamental difference between the two processes. While valuing a company requires estimating its entire enterprise value, IP valuation focuses solely on identifying the specific value attributed to the IP itself.

In the case of company valuation, we typically have access to comprehensive information about the entire entity, such as financial reports, management forecasts, and budgets. However, when valuing IP, additional analysis is needed. Apart from assessing the overall business performance of the company, the valuation process necessitates isolating and analyzing relevant data specifically related to the IP.

What is the difference between company value and IP value, and why is there usually a large gap between these values?

If a company has no business activities or assets other than IP, than the company value is simply the IP value plus the net cash in the company. However, this is rarely the case except in very early stage startups. Usually, a company’s business activity is the main value generator, especially in mature companies, and the IP only accounts for a small portion of the company’s value.

How is the IP value of a company determined?

The most accepted methods for IP valuation are the Relief from Royalties Method, the Multiple-Period Excess Earnings Method, the Net Asset Value Method, and the With or Without Method. The choice of valuation method is based on the particulars of the IP and the company’s circumstances, as detailed below.

Relief from Royalties

The Relief from Royalties method is based on the principle that if a company owns the valued IP, it is exempt from paying royalties for its usage. The main challenge with this approach lies in identifying the appropriate royalty rate prevailing in the market, which must align with factors such as similarity of the IP, the technology’s life stage, and the structure of the transaction.

Multiple-Period Excess Earnings Method (MEEM)

The main idea underlying the MEEM is that the value of the IP is derived by isolating and capitalizing the profit that the company derives from the use of the existing IP. The main challenge is to isolate the cash flow attributed only to the valued asset.

Net Asset Value (NAV)

This is essentially the cost approach, which is only used if there is no ability to predict cash flows derived from the IP. This method is considered inferior to the other options and is only used when the other methods are not viable. In this case, the value of the IP is estimated based on the amount invested so far in developing or obtaining the IP or alternatively as an amount for which the valued IP can be sold.

With or Without

Within this method, the value of the company is assessed twice – in the first scenario, the value of the company is assessed based on the forecasted cash flows, including the use of the IP. In the second scenario, the value of the company is estimated based on the projected cash flows if the company did not have the valued IP. The IP value is the difference between the two different scenarios.

The bottom line

When considering taking IP out of Israel and performing corporate inversions, it’s essential to distinguish between new companies in the growth phase and old, profitable ones. For new companies, corporate inversions are relatively straightforward, and they may choose this path to secure funding from foreign investors amid uncertainty about Israel’s legal system. However, for established companies, the process is complicated, time-consuming, and resource-intensive, often results in higher tax payments, and brings limited economic benefits.

Transferring IP outside of Israel and conducting corporate inversions is a complex matter, demanding a thorough assessment tailored to each company. Factors like recent transactions, planned future deals, and the perspectives of entrepreneurs, and local and foreign investors must be carefully considered. While challenges and obstacles can be expected throughout the process, both entrepreneurs and investors in the technology sector can overcome these with creativity and determination. By carefully evaluating the feasibility and potential outcomes, businesses can make informed choices regarding IP transfers and corporate inversions, optimizing their strategies to protect their assets and maintain competitiveness.

Daniel Guterman is the Head of IP & Economics of S Cube of IBI Capital, the largest provider of valuation services to technology companies in Israel.

 The above is provided for informational purposes only and should not be considered complete and/or exhaustive information of all aspects involved in the corporate inversion process. The aforementioned does not constitute legal, financial, taxation, or economic advice or a substitute for any professional or personal advice. IBI Group and/or any of the Group’s companies will not be responsible for any loss or damage caused to any third party due to reliance on the above information.

More challenging than ever: What are venture capital investors looking for in Israel in 2023? In the current period of uncertainty, many questions and doubts arise. What is the effect of political tensions on the market? What can be done nonetheless to increase the chances of receiving an investment? What is expected for the Israeli technology sector in the coming months?

Based on a Podcast with Yaron Elad, host Gidi Shalom Bendor

The current global macroeconomic landscape has cast a pall on technology companies, both within Israel and beyond. The confluence of factors, including rising interest rates, diminishing multiples in public markets, and a decrease in investment inflows, has created a complex operational environment. Compounded by the inherent risks associated with investing in technology firms, particularly at early stages, local tech enterprises now grapple with an additional layer of complexity – the potential fallout from the controversial changes to the legal system that loom overhead. Within this context, entrepreneurs striving to expand their investor base find themselves pondering a strategic shift. The concept of “corporate inversion” is gaining traction – a concept wherein the parent company is registered as a foreign entity, and the Israeli counterpart becomes a subsidiary. Entrepreneurs are likewise cautious about securing funding from the Israeli Chief Scientist, given the pervasive uncertainty around entanglement with the Israeli government. So how do things look from the investor’s point of view? What can be done nonetheless to increase the chances of receiving an investment? Will the situation improve in the coming months?

What are investors looking for today?

In the constantly changing world of technology companies in Israel, the current macro environment adds substantial challenges. Investment volumes have receded, while the competition for investor funds has intensified dramatically, driven by a major surge in deal flow. Unlike the past, where startups had the upper hand and could practically choose between investors, the present landscape demands concrete proof of viability. Advanced-stage enterprises must now establish their ‘go to market fitness,’ demonstrating robust marketing strategies, effective market penetration plans, and sustainable unit economics. Similarly, early-stage ventures face the imperative of demonstrating ‘product-market fit,’ proving alignment with market demands and solid customer volume and Annual Recurring Revenue (ARR) figures. This reshaped landscape requires companies to present a comprehensive and compelling showcase of their value proposition, market readiness, and potential for lasting growth.

Above all, investors are still looking for talented entrepreneurs

What hasn’t changed, and probably won’t in the future, is that investors are looking first and foremost for talented entrepreneurs with not only technological skills but even more importantly, a good understanding of their business environment. Furthermore, investors prefer ventures situated within markets they understand and that have strong growth potential. For entrepreneurs, the essential competency lies in their capacity to analyze the relevant market for the product they are developing. Key considerations involve identifying the precise niche the product can capture, discerning the initial and advanced-stage clientele, estimating potential revenue streams across customer segments, and gauging market demand through interactions with prospective customers. Essential market research includes broad outreach to potential customers confirming the product’s necessity and ascertaining the price potential customers would be willing to pay. This research should usually include big foreign markets like the US and Europe, rather than just the relatively small local Israeli market.

Equally crucial is the ability to manage the company post-development. This involves strategic planning for market penetration, including avoiding pitfalls like hasty over-recruitment of sales personnel in the US with the intention of firing all but the most successful ones. A judicious approach instead involves phased recruitment post-initial sales, a measured progression that aligns with reaching the product-market fit stage before scaling up sales efforts. Entrepreneurs embracing this careful growth strategy and minimizing cash burn significantly enhance their prospects of securing subsequent funding rounds and, by extension, bolstering the company’s overall likelihood of success.

The most common mistake – and how to avoid it

In the last year and a half, the VC space has flipped from an entrepreneur’s to an investor’s market, and accordingly, it’s more vital than ever to convey the right message when raising funds. One of the most common mistakes among entrepreneurs who come to meetings with potential investors is to focus on their needs and the needs of the company instead of focusing on the needs of the investor whose money they are asking for, such as return on investment and profit. In this regard, it is important to note whom the additional investors joining the investment round are and how the business plan was built in such a way as to allow for a sufficiently long runway, so that the investor will not be forced to continue pouring cash into the company before seeing a return on their investment.

US investors give higher valuations, so is it worthwhile to raise funds in Israel?

In recent years, the Israeli VC market has witnessed a surge in fundraising volume, narrowing the gap with the US. Nonetheless, there remains a significant disparity in terms of valuation between the two countries. The valuations received by technology companies in the US greatly surpass those in Israel. However, the allure of a high valuation from an American investor can sometimes be deceptive. While initially appealing due to the potential for lower dilution, entrepreneurs must scrutinize the investor’s track record carefully.

In particular, the American investment landscape operates in a rather binary manner, unlike in Israel. In the US, if a company fails to meet its key milestones, investors often move on swiftly, making it challenging to secure subsequent funding at the same valuation. This can prove detrimental, even leading to a down round or the failure of the company. Conversely, the prevailing ethos among Israeli VC funds is a supportive one. The tendency is to back and nurture companies, help them navigate critical stages, and ultimately guide them to the vital product-market fit phase. This dichotomy underscores the different philosophies at play, and entrepreneurs must weigh these factors carefully when considering investment offers.

The VC market in 2023: still full of opportunities

Despite the challenges in the global and local macro landscape, the need for technology still exists and is not going to disappear anytime soon. On the contrary, technology continues to enter more and more fields. With this ceaseless growth comes rising demand for cybersecurity – a resource perennially in short supply. While investors have indeed tempered their fervor compared to a year or two ago, there are still many excellent investment opportunities, and substantial pools of investor capital continue to seek these out.

Yaron Elad is the CEO of Elron Ventures, which invests in early-stage startups; Gidi Shalom Bendor is the founder and CEO of S-Cube of IBI Capital.

The current situation in Israel makes it difficult for private technology companies to raise funds and investors demand that Israeli companies become “American”; what does “corporate inversion” involve, for whom is it worthwhile and are we likely to see a massive loss of high-tech companies to the USA?

 The legal uncertainty in Israel has sparked an alarming trend of new high-tech companies registering as foreign entities, to the extent that according to estimates from the Israeli Innovation Authority, a staggering 50%-80% of high-tech companies established in the first quarter of 2023 chose to register abroad. On this ground, a spotlight has shone on the concept of “corporate inversion” within Israel’s technology sector and made it one of the hottest topics of the day. Corporate inversion involves transforming an Israeli company into an American one, and lately, many entrepreneurs are considering this move due to the uncertainty surrounding the legal system in Israel, particularly in light of the government’s planned reforms. Unfortunately, this situation is making it challenging for private Israeli technology companies to raise funds, as some investors are wary of investing in Israeli companies until the legal landscape becomes clearer.

What exactly is a “corporate inversion“?

A corporate inversion refers to a transaction where a company incorporated in Israel undergoes a change in its corporate structure, effectively placing a company incorporated in the state of Delaware, USA, “above” the Israeli entity. In this process, the shareholders of the Israeli company exchange their shares for shares of the American company, ultimately resulting in the American company becoming the parent company and the Israeli company becoming a wholly owned subsidiary of the American company.

It is crucial to understand that if one decides to transfer intellectual property (IP), a valuation becomes necessary. The Israeli Tax Authority views the transfer of IP out of Israel as a sale, which entails the obligation to pay taxes on it. Moreover, in cases where the transaction structure is more complex, such as inversions involving spin-offs or involving Israeli companies with foreign subsidiaries, a valuation of the transferred assets or the assets remaining in Israel is typically required to determine tax liabilities.

Will it be necessary to pay tax as part of the move?

A corporate inversion always triggers a taxable event. When shareholders of the Israeli company relinquish their shares, it is deemed a sale by the tax authorities. However, the liability to pay taxes may vary, and each case requires individual examination. Foreign investors are typically exempt from paying taxes when performing an inversion in an Israeli company. Local investors may also avoid tax liabilities if the inversion is conducted after a prolonged period of declining multipliers in the public markets, resulting in losses “on paper”. The primary challenge in most cases lies with the founders, as they typically did not pay for their shares. Consequently, no purchase cost is recorded and the entire value of their shares at the time of the inversion becomes taxable income for them.

Postponing tax payment until an exit

If there is a significant tax liability with no apparent solution, there is always the option to seek a pre-ruling approval from the Tax Authority for postponing the tax payment until the date the shares are sold. However, obtaining this approval comes with several limitations. The inversion process must be completed within 60 days from receiving the approval, and there will be a restriction on future dilution for a period of two years. Additionally, the sale of shares of the American company will be subject to limitations, and the shares must be deposited with a trustee.

For companies incorporated since January 2018, there is a faster and relatively simple alternative known as the ‘green route’. This route provides an expedited process for dealing with such tax liabilities.

The carrot and stick of the IRS

One of the primary incentives for American investors to invest in American companies is the qualified small business stock (QSBS) benefit. This provision grants American investors, who hold shares of the American company for at least 5 years, a tax exemption on profits of up to $10 million from the sale of their shares. On the other hand, when it comes to the Israeli company, the IRS imposes taxes on the parent company for the profits generated (whether distributed as dividends or not). Unfortunately, the IRS may sometimes not recognize the accumulated losses of the Israeli subsidiary for tax purposes.

IP – keep it in Israel or transfer it?

In most corporate inversions, companies tend to retain their intellectual property (IP) in Israel. The primary reason for this choice is that inversions typically occur before an investment round to meet the requirements of American investors seeking to benefit from the aforementioned QSBS exemption. The investment round often enhances the value of the company’s IP, leading to a considerable tax liability during the inversion process. This happens because the transfer of IP to the American company is viewed as a technical sale for the company and as a dividend for its shareholders, triggering a taxable event and resulting in significant tax liabilities.

Another motivating factor for companies to keep their IP in Israel is that, if the IP remains in Israel after the inversion, the change does not incur penalties from the Israeli Innovation Authority (formerly the Office of the Chief Scientist). Transferring the IP as part of the move incurs fines.

Leaving the IP in Israel means that not much has fundamentally changed in the view of the Israeli Tax Authority. If more than 50% of the total value of the consolidated company is attributed to the Israeli subsidiary, then the sale of shares of the foreign parent company is also considered an Israeli taxable event. Therefore, when the company reaches an exit point, all shareholders, including foreigners and foreign investors who invested after the inversion, will be obligated to deal with the Israeli Tax Authority.

Tax considerations usually favor Israel

Despite the growing interest among technology entrepreneurs in performing corporate inversions, the actual number of completed inversions remains relatively low for the time being. The primary reason for the limited uptake is the tax implications. The QSBS benefits notwithstanding, the effective tax rate paid by American companies is substantially higher in most cases. In addition, tax compliance costs for American companies are typically much higher than for Israeli companies.

The bottom line – is it worth it?

When it comes to inversions, a distinction should be made between new companies in the growth phase and established, profitable companies. For new companies, undergoing an inversion is generally a straightforward and relatively inexpensive process. Some of these startups willingly consider corporate inversion as a condition to secure funding from foreign investors, who are wary of current uncertainties in Israel’s legal system. On the other hand, for older and profitable companies, the inversion process is complex, lengthy and demanding, requiring the investment of significant time and resources, and often results in higher tax payments.

Performing a corporate inversion is a complex issue that demands a company-specific evaluation considering recent share capital transactions, planned future dealings, and input from entrepreneurs, local investors, and foreign investors. However, while obstacles and challenges are to be expected during the process, those who choose to proceed will find out that both the entrepreneurs and the investors in the Israeli technology sector can be very creative if necessary and eventually find solutions to every problem, benefiting entrepreneurs and investors alike.

Gidi Shalom Bendor is the CEO and founder of S Cube of IBI Capital, the largest provider of valuation services to technology companies in Israel.

The above is provided for informational purposes only and should not be considered complete and/or exhaustive information of all aspects involved in the corporate inversion process. The aforementioned does not constitute legal, financial, taxation, or economic advice or a substitute for any professional or personal advice. IBI Group and/or any of the Group’s companies will not be responsible for any loss or damage caused to any third party due to reliance on the above information.