Is the Israeli Start-Up Nation era coming to an end?

SOS is a Morse code maritime distress signal (dot-dot-dot-dash-dash-dash-dot-dot-dot), first used in 1909. It has been translated as “Save our souls” or “Save our ship” and has become a universal call for help.

In Israel, SOS takes on a new meaning: Save our start-ups! Start-ups in Israel are in decline. It leads us to ask: Has the Israeli Start-Up Nation era come to an end?

Here are the data.

Why are start-ups leaving Israel?

A study published by the Start-Up Nation Policy Institute (SNPI) found that since 2017 there has been an average annual decline of 11.3% in new start-ups founded, a problem that “can no longer be disregarded.”

In 2014, some 1,400 start-ups were launched. Within five years, the number of new start-ups established in Israel decreased from 1,400 to about 850 in 2019, and it is estimated that only 520 new start-ups were established in Israel during 2020.

And today? According to the SNPI, “only 417 new start-ups were founded in Israel in 2021,” and 162 start-ups were established in the first nine months of 2022 and 143 in the first quarter of 2023, according to the Israel Venture Center (IVC).

IVC data show there are currently 9,484 active hi-tech companies in Israel, of which more than half are in the stage of initial revenues and revenue growth (annual revenues of over $10 million).

These 4,700 fledgling start-ups are like tiny acorns. Whether they take root in Israel or abroad, and whether they grow to be huge oaks or wither and die, is highly uncertain.

Studies conducted by the SNPI and the IVC with LeumiTech show only $1.7 billion was invested during the first quarter of 2023 in Israeli tech companies compared to $6.7 billion in the first quarter of 2022. This worrisome decline occurs at a time when abroad, after a brief decline, venture funding has largely recovered.

Our son Noam Maital, now in venture capital, recounts a recent exchange of emails with a promising start-up. He posed a question: “Are you based in Israel or the US?”

The reply he received carried a revelation: “I call Israel home, but fear not, dear interlocutor, for my corporate domicile lies in the hallowed realm of Delaware.” The Shakespearean language hides a serious problem – an attractive suitor abroad for Israeli start-ups.

Israeli entrepreneurs have a choice. They can incorporate in Israel. Or elsewhere – say, in Delaware. And this is what many are now doing.

Does this make Bezalel Smotrich, Israel’s finance minister, weigh a change of course? Apparently not.

In late June, he blamed the current economic crisis on global ills and, not surprisingly, on the previous Lapid-Bennett government: “In just a year and a half, the previous government managed to make difficult moves that severely hurt the citizens of Israel. When you add to that the global crisis that plagues all the economies of the world, you get the result we are dealing with now.”

Currently, cabinet ministers who should know better are in denial. This includes Economy and Industry Minister Nir Barkat, a legendary former entrepreneur who in 1988 launched BRM, a software start-up that pioneered anti-virus software. He used some of the proceeds from his exit to be the first investor in Check Point, in 1993. Barkat, a former Jerusalem mayor, denies the impact of his government’s folly on start-up decline and the flight of start-ups.

Politics trumps truth. And ignores the peril of capital flight.

Capital flight is the rapid exodus of money from a country due to unfavorable economic or political events. Today, money travels from country to country at warp speed. Jittery investors can move their money to safe havens in the blink of an eye, by wire transfer.

Usually, capital flight begins with locals who have inside knowledge. Foreigners follow suit very quickly.

Capital flight can be disastrous. Consider the Asian contagion, 1997. The Thai baht rapidly fell from 26 to the dollar to 53 by the end of 1997, when locals and then foreigners bailed out. The South Korean won fell from 900 to the dollar to 1,695 as money fled both those countries. The resulting Asian contagion created a global crisis.

A survey of hi-tech entrepreneurs and executives conducted by Michal Tsur – co-founder of Kaltura, a software firm – and Adam Fisher – partner in the VC Bessemer Venture Partners – highlighted the impending dangers. They found that in the wake of the proposed judicial reforms, 90% of Israeli entrepreneurs and executives of hi-tech companies said they would incorporate outside of Israel if they had to start their companies today. And some 80% of the large companies (employing over 100 people) said they had discussed corporate inversion.

Corporate inversion is an operation that registers a domestic company abroad, making its activity in Israel a wholly-owned subsidiary. This is a kind of capital flight that lowers Israel’s tax revenues and employment.

Surveys have shown that 71% of VC fund managers in Israel (both Israeli and international) now say they would prefer to invest in a company not registered in Israel.

Israeli start-ups once did incorporate abroad, mainly in Delaware. In 2016, Israel changed its tax laws, causing many start-ups to register in Israel. This brought a tax boom to Israel that lasted through 2021. The forces that once beckoned start-ups home now propel their departure, casting uncertainty on the future.

On February 22, the shekel fell to its lowest level in three years against the dollar, 3.88. It has since recovered somewhat but is still shaky; and by making imports expensive, it is worsening inflation.

Fully half of Israel’s growth – one-third of income tax from all employees, and nearly two-thirds of total individual taxation – have their source in hi-tech. This is why flight of hi-tech capital and brainpower can be devastating for the Israeli economy. One worker in every eight is employed in Israeli hi-tech – the highest proportion in the world. It is the goose that laid golden eggs.

The impact of capital flight already reverberates across Israel. The government’s budget deficit doubled in just one month, surging from NIS 4.9 billion in April to NIS 10.7 billion in May. Projections for the remainder of the year foretell a mounting budget deficit, painting a worrisome picture.

None of this is new. A 1995 IMF study revealed that among heavily indebted nations, nearly half of the burden arose from capital flight, resulting in reliance on high-interest borrowing. Experts at the Bank of Israel warn of an impending crisis as the coalition government seeks ways to corrupt the BI’s hard-fought independence.

Israeli entrepreneurs, architects of innovation, will persist in their quest to change the world. However, they are already relocating country residence and capital elsewhere.

The swift departure of money instills a sense of fear, leaving behind a trail of economic consequences. Reversing this exodus demands persistent efforts and a clear signal that the Israeli judicial system will remain independent. Money hesitates to migrate to countries where it is not fully protected by the rule of law independent of political influence.

The July 2 front-page headline of the business daily The Marker tells it all: “Hi-tech investments abroad have recovered – and fell by 68% in Israel [year-to-year].”

Capital outflow happens fast. Luring it back home will be a long, hard road. Repairing the massive damage done to our start-ups by the cabal of far-right politicians now running our affairs will take years.  ■

Destination Delaware

Israeli start-ups are again incorporating in Delaware, almost daily. Why?

• Delaware is known worldwide as the most business-friendly US state in which to incorporate. Some two-thirds of all Fortune 500 companies and over half of all US publicly traded companies are incorporated in Delaware. 
• Delaware’s corporation laws and statues are exemplary and are used to model business laws in other states. These protections for shareholders and businesses are simply incomparable to what is offered by any other state in the US. And, more importantly, far beyond what Israel offers in the wake of the proposed judicial reforms.
• Delaware offers huge tax savings. There is no state income tax for Delaware corporations that conduct business out of state; no inheritance tax on stock held by non-Delaware residents; no state sales tax on intangible personal property (such as royalty payments); and shares of stock owned by non-resident aliens are not subject to Delaware taxes. In addition, Delaware corporations not operating in the state of Delaware do not need to acquire a business license in Delaware. 
• No other state in the US has a corporate court system as powerful, as experienced, and as respected as Delaware’s Court of Chancery. You do not have to live in Delaware in order to incorporate a company there. And the cost to form a corporation in Delaware is one of the lowest in the world.
• Venture capitalists, angel investors, and other investors prefer investing in Delaware companies rather than corporations formed in other states.

The writer heads the Zvi Griliches Research Data Center at S. Neaman Institute, Technion and blogs at www.timnovate.wordpress.com.