Recent Developments in Israeli Hi-Tech

IEFF EVENT- June 1, 2011

Dr. Ayal Shenhav

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Topics

• General Overview of the current state of Israeli Hi-Tech and VC Market.

• The new  Angel Investment Law. • The Government Safety Net for Institutional

investment in Venture Capital funds• The Reform in the Encouragement of Investment

Law.

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Topics (Cont.)

 • The Israeli Chief Scientist – New Developments

- Pros and Cons.• The Returning Resident and Returning

Researcher tax benefits. • Key Issues in Operating as an Israeli – US

company

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State of the Market Mid 2010 Required Immediate Action

• VC Investments were declining rapidly.• No new funds raised by Israeli VCs .• Israeli Institutional Investors refrain from investments in

venture capital.• Exits continue but very limited amount of IPOs.• The result – the Ministry of Finance came up with a

package of measures to assist the hi-tech industry. • This package became effective on 1.1.2011

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Looking Back at the Past 10 Years

• Average annual VC Investment in Israel 2001 – 2008 was $1184MM.

• 2008 figure was $1398MM• 2009 Investment level – $735MM• 2010 Investment level – $880MM• In short – a deep decline in 2009 – 2010.(Source PWC Money Tree)

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Amounts Raised by Israeli VCs. 2000 - 2010

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Analysis and Trends of Israeli VC Market

• Almost no fund raising. Only $200M new funds raised in 2009 (Sequoia Capital). No new funds raised in 2010.

• The leading Israeli VCs have not raised a new fund since 2008.

• Many leading funds not investing, reducing staff size and even dissolving (Evergreen).

• US VCs playing a key (even dominant) role in the market (Battery, Benchmark, Bessemer, Caanan, Greylock, LightSpeed, NVP, Sequoia and others).

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Analysis and Trends of Current VC Market (cont.)

• New “Micro Funds” ($10 – 15MM funds) being formed to invest $500K – $1MM in seed rounds and target M&A of portfolio company in range of $10-20MM. Such M&A could yield 3-4X returns.

• Private Equity Funds supporting late stage companies [for example Cadent (Fortissimo), Primesense (Silverlake)].

• Q1 2011 quite strong ($342MM invested compared to $170MM in Q1 2010).

• Tough times for seed / first round companies.

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Analysis and Trends of Current VC Market (cont.)

• Super angels joining the market in organized manner (e.g. Mori Arkin Accelmed) or increased ad-hoc investing activity.

• Increased awareness of Venture Lending benefits but Venture Lending funds are cautious and seeking later stage companies.

• Recent exits (such as Provigent $350MM, Wintegra $250MM) have improved returns of VCs but overall returns are still low and most funds have not returned the capital commitments.

• Israeli VCs look to invest outside of Israel (for example JVP QLIK exit, Sequoia Jajah exit).

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Analysis of Current VC Market (cont.)

• M&A market is strong but exits typically in $10 -100MM range.

• IPOs rare and relatively small (Only 2 Hi-Tech IPOs in US markets in 2010 - MediaMind ($62MM) and Veringo $11MM).

• Very few (if any) $1Billion companies formed in Israel in last decade…New trend to try and go for the Billion Dollar Company.

• Critical time for the Israeli VC Industry – 2011 fund raising will determine future of industry.

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Recent Controversy re Future of Israeli VC Industry

• “Israel’s venture capital and startup industry is heading for collapse…the industry, which is the economy’s growth engine, is liable to be irreversibly damaged.” (Zeev Holtzman, May27, 2011 http://www.pehub.com/107025/vcj-report-retooling-the-mideast-venture-scene/).

• Michael Eizenberg, “An Open Letter To Zeev Holtzman - The Sky is not falling in Israel. It is Getting Brighter” (May 31, 2011) http://sixkidsandafulltimejob.blogspot.com/2011/05/open-letter-to-zeev-holtzman-sky-is-not.html

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Government Action to Bring New Investors to the VC Market

• Adopting the Angel Investment Law.

• Providing a “Safety Net” Israeli Pension Funds.

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Angel Investment Law

• Came into effect 1.1.2011• Investments by an individual in a “Target Company” are

allowed as a deduction against income from any source. • The result - an investment in a “Target Company” allows

a reduction in taxes (from compensation, services, etc.) and a saving of up to $45 for each $100 invested.

• The reduction is over a three year period (i.e., up to $15 per annum).

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Angel Investment Law (cont.)

• Deduction for each individual is limited to 5 Million NIS per company (including investments by related parties).

• Deduction is only for investments in equity and issuance of new shares.

• Investment has to take place between 1.1.2011 and 31.12.2015.

• The individual has to hold the shares during all the “benefit period” – i.e., three years.

• Upon sale of the shares the basis does not include amounts allowed as a deduction.

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Angel Investment Law (cont.)• Target Company has to meet all of the following:

– Incorporated in Israel.– Managed from Israel.– Is not publicly traded during the benefit period.– 75% of the investment is used for R&D.– 75% of R&D expenses are used in Israel.– Income of the Company in year of investment and in subsequent

year does not exceed 50% of R&D.– R&D expenses are used to advance a “factory” owned by the

company (not outsourcing).– R&D expenses constitute 70% of the Company’s income.

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Angel Investment Law – Open Issues

• Is deduction allowed for investments made through partnerships?

• What happens if there is a forced sale during the three year period?

• How to prove company complied with the requirements for deduction?

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Assessment of Angel Law • Too early to tell.• Not fully known to the investors community

and/or founders. • Usually the tax benefit is not sufficient to induce

investment (but may result in increased investment).

• Induces Founders to form their companies as Israeli companies.

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Safety Net to Israeli Pension Funds• Program initiated by Ministry of Finance and Ministry of

Trade. • Guarantee of a minimum return of 15% over the life of

the fund (7 years).• Participation will not exceed 25% of investment (for

example if fund returns 70% the participation brings investor to 95%).

• Overall commitment (to all funds) 200MM NIS.• Participating funds have to meet certain investment

requirements (e.g., 85% of portfolio in Israel).• Not attractive enough to institutional investors.

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Encouragement of Capital Investment Law

• Major reform in 2011. • Repeal of tax exemptions and implementing in lieu of an

exemption a low tax regime.• 2011 – 2012 10% in Approved Zone and 15% in Rest of Country.• 2013 – 2014 - 7% in Approved Zone and 12.5% in rest of country.• 2015 and onward – 6% in Approved Zone and 12% in rest of

country. • Dividend withholding tax of 15%.• Overall Israeli corporate tax rates are significantly lower than US

tax rates.

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Israeli OCS Funding• The Israeli OCS funds participates in the cost of

“approved programs”.• OCS funding replaces equity investment (or venture

debt). • OCS funding in non dilutive.• OCS funding has very favorable repayment terms (3%

of sales of products developed in the approved program).

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OCS Funding – Restrictions on Sale of IP

• Until 2005 IP developed with OCS funding could not be taken out of Israel.

• Acquisition of shares of an Israeli company is not “taking out” of IP (the corporate entity remains intact and IP belongs to such entity).

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OCS Funding – Restrictions on Sale of IP (cont.)

• Commencing in 2005 taking IP out of Israel is allowed but triggers a payment to the OCS.

• Payment is based on following formula (following 2010 amendment):

Payment = Sale Price X OCS Grants R&D Expenses

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OCS Funding – Restrictions on Sale of IP (cont.)

• For example: Company raised $18MM from VCs and $2MM from OCS. Overall R&D over life of company $10MM (other $10MM sales marketing, G&A etc).

• Company is sold for $20MM – OCS gets $4MM (20% of sale proceeds).

• OCS got a 2x multiple while VC got less than 1X.

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OCS Funding• Could save the company during tough times

and/or allow achievement of R&D progress.• However - Complicates Exit Event.• Unresolved debate (According to PWC 43% of

funded companies were supported by OCS). • Most major VCs add covenants restricting

OCS funding.

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Returning Resident Regime

• The goal – encourage OLIM and Israeli Expatriates to move to Israel.

• Offers extensive tax exemptions.

• No reporting requirements.

• Enacted in 2008 (60th anniversary).

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Returning Resident Regime (cont.)

• “Ordinary Returning Resident” – An Individual who returns to Israel after six years.

• “Special Returning Resident” – An Individual who returns to Israel after ten years (in 2007 – 2009 five years).

• Special Returning Resident treated like a new immigrant (“Oleh”)

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Returning Resident Regime (cont.)• When did the individual cease to be an Israeli resident?

– The main test “center of interests”.– Tax presumptions (425 days in three years test, 183 yearly

test).– New amendment provides a 4 year test (two years of 183

days outside of Israel + 2 years of center of interests outside of Israel) renders individual a “non resident” from day 1.

– Tax treaties may allow to establish non residency within one year or less.

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Returning Resident Regime (cont.)• When did the individual return to be an Israeli

resident?– ITA Circular – Date of Return is date in which home is used

permanently by any family member – One year “adaptation” (שנת הסתגלות) rule allows individual

to be treated as foreign resident during first year (but this year counts if thereafter becomes a returning resident).

– No official Government approval of “Returning Resident Status” is provided – rely on tax opinions.

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Returning Resident Regime – Taxation of Passive Income

• For Special Returning Resident / Oleh: 10 year exemption on passive income from non Israeli assets held prior to coming to Israel.

• For Regular Returning Resident five year exemption.• New rules allow exemption for assets which replaced

original non Israeli assets (more narrow “replacement rule for Regular Returning Resident).

• Passive Income includes dividends, interest, royalties, rent.

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Returning Resident Regime – Taxation of Capital Gains

• 10 year exemption for assets held outside of Israel.

• Partial exemption for sales after 10 years (10/11, 10/12 etc.).

• For Special Returning Residents replacement rules apply.

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Returning Residents – Compensation Income

• For Special Returning Residents 10 year exemption for income from services rendered outside of Israel.

• For services rendered partially in Israel and partially outside of Israel allocation of income is required.

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Returning Residents – Operation Through Companies

• In general a company managed and controlled from Israel is viewed as an Israeli resident for tax purposes and subject to Israeli tax.

• A company managed and controlled (from Israel) by an Oleh / Special Returning Resident is deemed not controlled from Israel and is not subject to Israeli tax (for 10 years).

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Returning Residents – Getting Ready to Come Back

• Make sure you hold shares in a non Israeli company (the exemption applies only to non Israeli assets!).

• Unvested Options – Consider Moving unvested options into Section 102 Capital Gains Track (Reducing Israeli Tax).

• Vested Options – Consider exercising US options and holding shares which will qualify for capital gains exemption (and US capital gains tax).

• Consider US tax liability following the move to Israel (due to Green Card or Citizenship) including State Tax issues, 911 foreign income exemption, social security and more.

• Move assets to “stable” investment mode (bonds, hedge funds, mutual funds) to avoid a sale which “ends” the exemption..

• Plan the date of your return to maximize Israeli tax benefits.

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Returning Researchers Law• Mr. X has been living in California for 15 years. He is a

Professor at Stanford.• In 2010 Mr. X moves to Israel and joins Weitzman

Institute. Mr. X discovers a new drug and is paid over the next 5 years $1,000,000 as his share of royalties.

• Since Mr. X’s income is from Israeli sources he is subject to Israeli tax (even though he is a Special Returning Resident).

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Returning Researchers Law (cont.)• A new exemption came into effect on 1.1.2011 and

applies to academic researchers.• A qualified researcher will be exempt from Israeli tax

on payments from an Israeli research implementation company ("חברת יישום").

• A “qualified researcher” is an individual who becomes and Israeli resident from 1.1.2011 until 2015 and which was a non resident during the six prior years.

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Returning Researchers Law (cont.)

• The exemption applies to income attributable to non Israeli payments received by the Implementation Company.

• The exemption is for five years from the first year in which payments were received by the Implementation Company.

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Where to Form Your Company Israel or Delaware?

Key Considerations:• Raising Money from VCs – Advantage Delaware.• Raising Money from Angels – Advantage Israel.• Tax Regime – Advantage Israel.• Sale of Company – Advantage Delaware (TBD).• Going Public – Advantage Israel (Foreign Private Issuer).• Look and Feel – Advantage Delaware. • Due to Angel Law growing trend to incorporate in Israel.

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Issues for Delaware Parent with Israeli Sub

• Location of IP (Israel or US?)

• Inter – Company Agreement.

• Unified Option Plan.

• Establishing Management & Control outside of Israel.

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Dr. Ayal Shenhav

Shenhav & Co., Law Offices

+972-3-611-0760

ayal@shehavlaw.co.il

www.shenhavlaw.co.il