Government agency warns judicial uncertainty will damage tech ecosystem

Israel Innovation Authority predicts Israeli startups will struggle to raise capital, forcing them to shut their operations or move to other countries if uncertainty is not lifted

Sharon Wrobel is a tech reporter for The Times of Israel.

Tech workers march in Tel Aviv to protest against the government's planned overhaul of the judicial system, January 31, 2023. (Tomer Neuberg/Flash90)
Tech workers march in Tel Aviv to protest against the government's planned overhaul of the judicial system, January 31, 2023. (Tomer Neuberg/Flash90)

The debate over the government’s controversial plans to shake up the judicial system is fueling uncertainty among investors, prompting Israeli high-tech entrepreneurs and firms to relocate abroad, a government agency responsible for the local tech ecosystem warned on Monday.

In a report presented to the Innovation, Science and Technology Ministry, the Israel Innovation Authority (IIA) raised serious concern about the growing risk that Israeli high-tech companies and funds will find themselves decoupled from the global tech market that it is depending on for most of its capital raising.

“The instability [of the judicial authority] creates a perception of uncertainty that reduces the viability of investing in Israel,” IIA researchers wrote in the report. “There is a substantial concern that Israel will disconnect in the near future from global capital trends and that its share of the global venture capital investment pie will decrease.”

The government entity that provides the majority of state grants to local early-stage startups to support disruptive technologies cited a “significant negative gap” between returns of tech stocks traded on the Tel Aviv Stock Exchange and on the Nasdaq in recent weeks.

Since the beginning of 2023, Israel’s tech index generated zero return, while the Nasdaq 100 index rose by about 20 percent during the same period, according to the report. Past studies have shown a correlation between the growth of the Nasdaq and the total volume of investments in Israel, it was added.

“This gap is increasing the fear that we are on the verge of a situation in which there will be a ‘splitting’ between the global and Israeli markets,” IIA researchers cautioned in the report. “If this is the case, many Israeli hi-tech companies will find it very hard to raise investment and will be forced to close or move to other countries.”

Dror Bin, CEO of the Israel Innovation Authority. (Courtesy/Hanna Teib)

There is already a growing trend of Israeli startups being established outside of the country, which started in February and accelerated in March. Between 50% and
80% of the of Israeli startups that were opened in March incorporated through a foreign company.

“In a very short time, we may face a situation where there will be an absolute
majority of start-up companies that will be incorporated through a foreign company, probably in volumes of over 80%,” the IIA warned in the report. “This phenomenon could have far-reaching consequences on the Israeli economy in the medium and long term.”

Many Israeli startups and firms register abroad mainly for technical reasons, but the findings show that many of them now also intend to register their future intellectual property overseas.

“As a result, companies that aren’t located in Israel will pay significantly fewer taxes, resulting in severe harm to the state’s income,” according to the IIA report.

The tech industry, touted as the main growth engine of the economy, generates about 18% of GDP and is responsible for over 50% of exports and about 30% of payroll taxes, according to the IIA. In addition, Israel’s high tech sector employs about 11% of the country’s workforce.

The prospect of the judiciary system being weakened has been fueling uncertainty threatening to undermine Israel’s standing as a stable hub for investments from abroad, on which the local high-tech ecosystem largely relies on for its existence.

File: Workers from tech sector protest against the government’s planned judicial overhaul, in Tel Aviv, on March 9, 2023. (Tomer Neuberg/Flash90)

Following large-scale demonstrations and massive protests against the government’s contentious judicial plans — that would grant the government total control over the appointment of judges, including to the High Court, and severely limit the High Court’s ability to strike down legislation — their advancement has been paused to allow for dialogue and in effort to reach a broad compromise between opponents and proponents.

“We are today in the middle of a global crisis, and it is still too early to know when and how it will end. Added to this is a local crisis that has created additional uncertainty,” stated Israel Innovation Authority CEO Dror Bin. “Even if the legal-judicial crisis is solved, it will take time to reach a solution, and even after this, it will take time to build confidence with investors once more.”

“Therefore, we must act efficiently and take the necessary steps to deal with the challenges [and] with the uncertainty that has been created,” Bin urged.

Commending the IIA for coming out with “hard data and putting the writing on the wall,” Mati Gill , CEO of AION Labs said that the worrisome figures and trends presented are hard for the government to ignore. Rehovot-based AION Labs is a collaboration between pharmaceutical heavyweights Pfizer, AstraZeneca, Merck, and Teva Pharmaceuticals, together with Amazon’s AWS and the Israel Biotech Fund.

The current financial environment of high interest rates and a slowing global economy has seen tech shares taking a battering on global markets in the second half of 2022, pushing company valuations down both in the public and private sectors. The market downturn has seen thousands of workers laid off, triggering funding pullbacks and creating a bear market for new tech offerings.

“The current [internal] challenges are only adding more logs on the fire and if there is one thing investors don’t like, it is a lack of judicial stability,” said Gill.

In the first quarter of this year, Israeli tech companies raised $1.7 billion, down 70% from the $5.8 billion in the first three months of 2022, according to a report by IVC Research Center and LeumiTech. The quarter marked the lowest figure in four years. That is after private investments in the local hi-tech sector peaked in 2021 with investments of a staggering $26 billion slumping to around $15 billion in 2022.

“The decline in investments is without doubt a global phenomenon. Despite this, there are some elements that are unique to Israel, and these cannot be disentangled from the current uncertainty in the Israeli market and its implications,” according to the IAA report.

The state-backed agency said that removing the uncertainty soon is the most important step that the government needs to take in light of the issues that have been detected and the damage that has already been inflicted.

“It is preferable that this will be done as quickly and decisively as possible in a way that will allay the fears of investors and entrepreneurs in the medium-long term and will create long-term certainty and stability,” the IIA urged in the report.

In parallel, the IIA made a number of recommendations to the government such as easing the regulatory environment, introducing incentives to encourage investments and registration of intellectual property in Israel, as well as, steps to help meet the growing funding needs of Israeli startups.

“The findings of the study require the government to take rapid action in order
to reverse the worrying trends it highlights,” said Innovation, Science and Technology Minister Ofir Akunis.

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