Yigal Arnon - Tadmor Levy: Tech ecosystem should brace for difficult times

"Obviously, we will see flat rounds, down rounds and more internal rounds. For good companies that can not obtain financing we will see small exits and unfortunately, when a small exit is not an option, we will also see scaling down and liquidations," explained the tech experts of Israeli law firm Yigal Arnon - Tadmor Levy.

Yigal Arnon - Tadmor Levy is one of the top Israeli law firms participating in CTech’s Most Important Gateways to Israeli Tech series. The heads of the firm's tech department answered a series of questions asked by CTech about their involvement in the Israeli ecosystem and how they expect the current crisis to affect the tech market.

Elie Sprung (from right), Nimrod Vromen, Kobi Ben Chitrit, and Yarom Romem.

Name of firm: Yigal Arnon - Tadmor Levy

Tech sectors of expertise: Software, Internet, Life sciences (biotech, medical devices, healthcare and pharma), Cybersecurity, Data privacy and data protection (including database regulations), Fintech, Blockchain, and cryptocurrency, Automotive and smart mobility, FoodTech, Aggrotech and more.

Number of lawyers in the tech and VC departments: 90

Heads of department: Yarom Romem, Kobi Ben Chitrit, Nimrod Vromen

Notable clients (startups, growth companies, VCs, angels): Appsflyer, ConnecTeam, Overwolf, Cye, NucleAI, Variantyx, Adaptive Shield, ScadaFence, Agritask, Flytrex, GK8, Scopio Labs, BRM, Lightspeed Venture Partners, Glilot Capital Partners, Viola Ventures, Oak HC/FT, Ibex, Providence Strategic Growth, Norwest Venture Partners, Vintage Investment Partners, Susquehanna Growth Equity, OurCrowd

Notable deals: As part of our extended relationship with our clients, we can mention several deals during these past years:

• Represented Providence Strategic Growth in leading a $160,000,000 round in Pixellot (May 2022)
• Represented ConnecTeam in its raising of $120,000,000 (March 2022)
• Represented Run:ai in its raising of $75,000,000 funding round (March 2022)
• Represented first in its acquisition by fireblocks for $100,000,000 (February 2022)
• Represented Overwolf in its raising of $75,000,000 (January 2022)
• Represented Providence Strategic Growth in leading a $65,000,000 round in Ironscales (November 2021)
• Represented Scopio in its raising of over $50,000,000 (November 2021)
• Represented GK8 in its acquisition by Celsius for $115,000,000 (November 2021)
• Represented Lightspeed in leading a $75,000,000 round in FeeX (November 2021)
• Represented Lightspeed in leading a $200,000,000 round in Cato Networks (October 2021)
• Represented Providence Strategic Growth in leading a $200,000,000 round in Lusha (September 2021)
• Represented Lightspeed in co-leading a $185,000,000 round in At Bay (August 2021)
• Represented Lightspeed in leading a $60,000,000 round in Elementor (April 2021)
• Represented PayPal in its acquisition of Curve for $200,000,000 (March 2021)
• Represented Palo Alto in its acquisition of Bridgecrew for $200,000,000 (February 2021)
• Represented Intel in its acquisition of Moovit for $1,000,000,000 (May 2020)

Following the SPAC and IPO boom in 2021 - What trends are you expecting for the upcoming short and medium-term?

Kobi Ben Chitrit: Obviously, we will see flat rounds, down rounds and more internal rounds. For good companies that can not obtain financing we will see small exits and unfortunately, when a small exit is not an option, we will also see scaling down and liquidations. Companies that raised in 2020 - 2021 at "unicorn" valuations, need more money now and can not raise at or above previous post money valuation will be reluctant to raise money at down rounds and one of the alternatives that we see now often is raising money through debt and similar instruments \[e.g., redeemable shares\] which will allow companies to raise money without going into "valuation" issues, avoid a "down rounds" and avoid a painful triggering anti dilution protections. We will also see more preferred shares that are accompanied with "stronger" down side protections - e,g, better liquidation preference, redemption feature etc. so as to give the new investors more measures to to maintain high IRR even if the market continues to be difficult. Another "instrument" that we see now is "performance options" that trigger and give the investors more equity if the company fails to achieve commercial milestones. These "performance options" are also a good tool to bridge on valuation gaps between the investors and the company. Also, we will see "management carve out" plans, repricing of options and structures and measures that will allow the companies to be able to continue to attract superstar managers and key employees. On the other hand, and on the optimistic side of things, history tells us that we are now looking at investors that will make a fortune on their investments. Never to forget that difficult markets create great opportunities!

Will we continue to see funding rounds at the fantastic valuations we saw last year? Why?

Nimrod Vromen: To answer this question one needs to understand what valuations are driven from when startups raise money, and the answer is actually counter-intuitive. The parameter which affects valuations the most, is actually the amounts raised. The reason is that investors normally don’t fight for stakes that are two high, so as to not over-dilute and disincentivize the team. So if a company raises $10m, investors want to get to a certain percentage (say 25%, for the sake of example), which in turn drives the valuation (so in this example, pre-money valuation would be $30m, post-money $40m). If there's less money available to be raised (say, $5m), it's still important for investors to strive for a similar position in the company (maybe not 25% in this example, but no less than 20%), so the valuations go down together with the reduction in available money (in this case pre-money valuation of $20m, post of $25m). Since liquidity opportunities are more scarce (public company valuations are dropping, which leads to large private companies understanding that they won't IPO this year), this in turn leads to their VCs reallocating funds to their existing portfolio and ready to invest less in new companies, which means rounds are smaller, and therefore valuations are smaller. This is compounded by the reason that public company stocks are plummeting – which is in part general fear, but also no less because they were genuinely over-valued with high-multipliers. This further fuels investors to negotiate the valuation more responsibly with new targets. So bottom line – no, we will not see as many companies achieve fantastic valuations as in the past, at least for the time being.

What is the most important process Israeli high-tech has experienced over the past two years and where does it leave the industry?

Yarom Romem: An important trend that we have seen over the last two years, which in my view is the most important, is that Israeli entrepreneurs are, as a group, no longer exiting early and are no longer expected to cash out early. Entrepreneurs and venture capitalists want to build bigger companies that will last. This is the result of the convergence of a number of factors. More money was invested into Israeli companies by international venture capital funds, which are looking for returns on larger investments, which require companies to build big and prepare for an IPO and not for a trade sale; numerous and often large secondary sales by founders have allowed founders to “hedge their bets” and de-risk and also gave these founders the space to double down on their startups and continuing to build bigger businesses. Israeli companies have also been encouraged by their investors, particularly international growth and private equity funds, not least by the provision of sufficient capital, to make acquisitions to further fuel growth, a relatively new occurrence in Israel. Thus we have seen startups flush with cash following newly raised mega-rounds acquiring other companies in the US, the UK and elsewhere as well as acquiring other startups in Israel. We expect this process to accelerate in the coming years as some startups, unable to obtain investment, opt to get sold on one hand, while other companies that raised sufficient capital and need to continue to show rapid growth attempt to spike that growth by acquiring good companies in distress. Overall, this development shows a maturing of the startup industry and bodes well for the hi-tech industry and the Israeli economy as a whole.

What are the business/cultural/economic differences between Israeli and foreign VC investors?

Elie Sprung: When comparing Israeli to foreign VCs, we would refer as foreign VCs with a local presence as Israeli VCs. Israel is a small place where most people in the VC community know each other, which makes it easier for local investors to both make themselves known to the entrepreneurs and to know the entrepreneurs themselves, which makes the process much quicker. Israeli VCs could overlook certain issues that may arise with the business if they have confidence in the entrepreneurs themselves, which is obviously much easier when the investor knows the entrepreneur. The market terms for investments in Israel as opposed to investments in the valley are also different – valuations and investment amounts are lower and the preferences that many investors request are often more aggressive in Israel than in the valley.

Why aren’t there enough Israeli institutional investors in tech? How should they be encouraged?

Nimrod Vromen: I actually think that while one can state this as a fact, the trend is that institutions will invest more. We recently co-authored a report with IVC, Arnon Segev & Co. Law Offices (which represents institutions) and Consiglieri on the increase in the amounts of institutional funds invested in the private sector. I think that one doesn’t see the full results of this process, the trajectory is that institutions are investing much more in tech, and both the absolute amounts invested and their share of the investor market will grow further in 2022. There are regulations incentivizing this, and there's a culture evolving around this among the institutions.

What are some basic mistakes made by entrepreneurs?

Kobi Ben Chitrit: Not agreeing with their fellow entrepreneurs on the basic items for moving forward (e.g., reverse vesting) and then going into discussion around these issues in the midst of the financing and wasting time and effort on these items instead of concentrating on the closing of the financing. Not making sure that all IP related issues are covered (i.e., rights to the IP are not necessarily and clearly owned by the Company). These are things that it is much easier to agree or remedy when the Company is in stealth mode than when the Company is a unicorn..... Taking money from the investor who offered the highest pre-money and not from the investor who can bring real value to the company. Agreeing on a long no-shop on the basis of an LOI that doesn't say much and then fighting over basic LOI things while being in no-shop and without the ability to walk away and look for alternative deals. Neglecting tax exposure items and then facing higher tax rates (e.g., paying ~50% income tax instead of ~25% capital gain tax is like giving your acquirer a ~33% discount on the exit valuation...). Not getting their company ready for the due diligence process and then wasting valuable time (and money) on VDR preparation instead of focusing on the deal and moving the deal to closing. Going to "cheap" service providers and contractors for advice (as I always tell my clients - you pay "peanuts" you get monkeys...)

What are the most important parameters for a law firm when deciding to represent an entrepreneur in a deal (product, paying customers, entrepreneur’s previous experience), and what would be a reason to turn down an entrepreneur (if any at all)?

Elie Sprung: First off, as a law firm you are always looking for returning clients. This makes life much easier with respect to the expectations of both parties as well as cuts down any learning curve. To make things even easier, if the entrepreneur is a returning client, this likely means that he or she had a successful exit, which means the chances of the startup being successful in raising funds are increased.

If the entrepreneur is not a returning client, then you look to his or her experience as well as to the business itself. Obviously, if the business has revenue, then it is an easier decision to take on the client as you know that you will be paid. Many times, however, we are willing to take a chance on entrepreneurs and their startups if we think it can be successful.

In the end, the lawyer / client relationship is based on trust and therefore only if the parties trust each other will it be a successful relationship.

What are the most crucial stages of a deal?

Kobi Ben Chitrit: I am always telling founders that it is not over until the fat lady sings.... (or in Hebrew: "Sofrim Ba'Madregot") so most crucial is to close.... but seriously, for financings - agreeing on a comprehensive TS with a reputable investor, together with a pre and post cap table, is the most crucial point of the deal. Statistically, once a TS and cap table are agreed, and unless there are skeletons in the Company's closet, there is a very good likelihood that the deal will be closed. For M&A, I think most crucial point is also LOI but here you should also look for the sign off by the shareholders and making sure that all or substantially all of of the shareholders are aligned, not because you need it from a legal perspective but also in order to avoid disruption and delays in the deal due to shareholders disputes. We mentioned skeletons so important to say that in both financing and M&A, a crucial "stage" is the preliminary stage of "getting your company ready" for the DD examinations that the investor and acquirer will preform. Poor preparation for the DD process, and even worse - "red flag" DD items that the acquirer discovers in the course of your DD - will delay your deal and can even kill your deal, so better to get prepared...