The Israeli Tech Industry Is too Dependent on U.S. Economy, Says Israeli Finance Ministry

Israel’s venture capital sector depends greatly on the U.S. economy, with an almost direct correlation between the growth of Nasdaq and the scope of investments in Israel, according to the weekly review published Monday by the chief economist of the Israeli Ministry of Finance.

The result is a significant risk of exposure to a global financial crisis, as the large presence of non-Israeli investors in the local industry will mean the country will be quite impacted by any long-term venture capital-related issues. According to the report, U.S. venture capital investors accounted for 35% of all investors in Israeli tech in 2018, while Israeli investors accounted for 30%. Furthermore, “estimates are that the measure of Israeli money invested in Israeli companies is lower.”

The report also describes two main reasons for the longevity of venture capital crises. The first is that while fund managers are privy to information about its returns, limited partners receive that information only near the end of a fund’s life cycle. This, in turn, affects their investment decisions regarding future funds. The second is that an existing crisis limits the ability of new funds to raise commitments, in turn increasing the financial distress of startups, which are usually characterized by a lack of tangible assets, a negative cash flow, and a lack of access to traditional debt financing sources.

The venture capital industry became important to countries before the burst of the dot.com bubble, thanks to its contribution to innovation, employment, and economic growth. At the same time, lack of venture capital diversity limits the chances of startups to survive the “death valley” of the early stages. The report, however, emphasizes that venture capital funds bring more to the table than just funding: they assist with strategic and operational planning, connect companies with potential clients, and improve company performance by bringing in professional expertise.

The second part of the report focuses on the funding model of the Israel Innovation Authority, the tech investment arm of the Israeli government. The report points out a potential flaw here as well. Research and development centers are responsible for the creation of new knowledge, which then finds its way to the general ecosystem and generates economic growth. However, the report cautions that while the public sector derives many benefits from such influences, the business sector only looks at the potential profit and therefore tends to underinvest in such projects where a bigger investment will result in a bigger social impact. It is the responsibility of government players such as the Israel Innovation Authority to manage that potential flaw, according to the report.

Private funding for innovation in Israel—just like in the U.S.—tends to rise sharply during peak periods and fall sharply during recessions. During periods of slower growth, lack of funding has in the past led to the closure of startups and increased demand for government funding. The report points out that historical data shows that the authority’s budget structure means its ability to increase funding is rather inflexible. The authority’s budget is a conditional expenditure model, meaning startup royalties are reinvested in new companies. Peak market periods, which experience more exits, are therefore characterized by a bigger budget.

The report took a deeper look at the relationship between financial crises and startup demand for government support by looking at the Herfindahl–Hirschman Index (HHI), which measures competition and market concentration. The conclusion was that in times of recession, the share of startups among applicants rises sharply, leading the HHI to fall. In 2001-2002 and 2009-2010, for example, 450 more research and development projects were rejected than in non-crisis years, valued at a total of NIS 1.7 billion.

The report concluded that the lack of synergy between the governmental research and development policy and the demand for it will result in the closure of startup companies during crises due to temporary financing problems, while during peak periods there may be an inefficient excess of public funding available. The authors, therefore, recommend that the Innovation Authority’s budget will be reconsidered according to criteria that are predefined based on the availability of private funding in the market.