War affects all things: Israeli tech sector beginning to lag behind

Foreign investors reluctant to invest in Israeli startups due to the ongoing war while, their international counterparts are witnessing a resurgence after weathering a challenging year and a half
Sophie Shulman|
What is the actual condition of the high-tech sector in Israel? Understanding this is essential not only for the sector itself but also for the whole Israeli economy, which relies on it for 50% of its exports and 25% of its tax revenue. The data gathered from the industry presents a mixed picture. On one side, there are sporadic instances of hefty capital raises, like Vast's recent $9 billion funding, Next Insurance's $265 million funding, or AI21's fund expansion from $53 million to $208 million, with significant and influential investors like Intel Capital and Comcast being involved.
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On the flip side, a recent exit report by PWC Israel, an accounting firm, unveiled a significant downturn in the sales and public offerings of Israeli companies. A decline of over 50% compared to 2022 was noted, marking a ten-year low that's never been seen before. The recent shutdown of the real estate unicorn, VEEV, doesn't inspire much confidence either. The once vibrant and transparent local high-tech sector now resembles a bunker. In every company, regardless of size, approximately one-fifth of the workforce operates in 8-hour shifts, and the timeline for returning to normalcy remains uncertain. Consequently, the industry has retreated into a sort of hibernation: everyone is putting in extra effort to fulfill commitments to customers, while simultaneously striving to maintain a low profile to avoid unsettling existing and potential future customers and investors.
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סטארט-אפ
סטארט-אפ
Israeli startups are on a decline
(Photo: shutterstock)
"The current capital raises are an aberration, not the norm," says a high-ranking individual in the Israeli venture capital sector. He notes that the 'Israeli discount,' a phenomenon we had almost forgotten, has resurfaced. Investors, primarily those from overseas without a consistent local presence, are concerned that they might need to draft more employees from these companies for reserve duty. Consequently, they're diverting their investments to American and European startups, which are already showing signs of recovery after a challenging one and a half years.
"It's disheartening that Israeli high-tech could have been in a much better position, even amid the October 7th Hamas attack. We braced ourselves for a tough 2023 due to the political climate, but we had the potential to be the best. The 2022 crash primarily impacted consumer applications, while Israeli high-tech, known for its deep tech specialization, continued to secure investments and deals. We could have retained our unique standing, but the coup and subsequent war delivered a double blow to the industry," he explains.
The growing disparity with the US and even Europe, in terms of both value and overall activity, is currently one of the industry's major worries. This trend began mid-year when Israel slipped from fifth to tenth place in high-tech company fundraising, overtaken by countries like Germany and France. In the first half of 2023, Israel's capital raises plummeted by 75%. There was a slight stabilization in the third quarter, but the fourth quarter figures are something no one wants to confront.
Any attempts to gather such data are met with resistance, suggesting that all information collection entities prefer to wait until the quarter's end. However, there's a likelihood that the fourth quarter in Israel won't be disastrous, given its seasonal strength and the fact that two large funding rounds - those of Next and VFast, totaling $400 million - have already taken place. Furthermore, 2023 is essentially a 'lost year' for both global and Israeli high-tech, primarily due to the political upheaval. Many overseas investors indicate that they perceive the risk of regime change in Israel as more threatening than war, suggesting that a decrease in interest could potentially alleviate the fundraising logjam here.
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The world moves on while Israel lags due to war
The world moves on while Israel lags due to war
The world moves on while Israel lags due to war
(Photo: shutterstock)
The focus is now shifting toward 2024, which is anticipated to be a recovery year for the global high-tech sector, given that NASDAQ is already trading at levels seen in 2021. The moment investment funds perceive the IPO window as opening, the hesitation to invest in more established companies is likely to diminish. Consequently, the large funding rounds that birth new unicorns are expected to make a comeback, albeit possibly not with the same vigor as in 2021. The year 2024 also holds promise for Israeli high-tech, as it is set to be characterized by advancements in deep technologies that will propel the realms of artificial intelligence. In this context, Israel has significant contributions to make, particularly in the hardware sector.
"High-tech investments in the US are already experiencing a revival, with a sense of optimism for 2024 that began when the Fed indicated we're at the desired inflation level," an entrepreneur from a startup that recently completed a fundraising round told Calcalist. "Investors are no longer fearful and aren't questioning what will happen with the interest rate, which has an impact," he added. "To understand what Israel could potentially lose out on, one can look at the fundraising activities for startups in the chip sector, a unique area of expertise within the local ecosystem. The technological advancements in all aspects related to artificial intelligence have spurred the demand for chips, leading to fundraisings that totaled $5.2 billion in the US in the third quarter. This figure represents a 68% annual increase, marking a return to the record-breaking fundraising levels of 2021."
"Currently, a significant shift is being discussed in the industry, with the spotlight moving from foreign funds to Israeli ones - the latter will need to significantly ramp up their activity. During the prosperous times, they lamented that the 'gorillas' from abroad were 'grabbing' the promising companies with substantial funding, leaving little room for them to operate. The present situation seemingly presents new opportunities for Israeli capital, although they are naturally more constrained in terms of amounts. "70% of the funding for early-stage companies came from foreign funds, and that's where the major challenge will lie in the near future," a high-ranking executive at an Israeli venture capital fund states. "As Israeli funds, we will strive to do as much as we can to ensure the industry continues at full throttle, but a gap leading up to 2024 is unavoidable. The upcoming two years will be challenging."
In total, local venture capital funds still have a considerable amount of money left from the prosperous years, and some, like Qumra and TLV, for instance, managed to secure fundraising for new funds exceeding $200 million just last summer. Viola Credit successfully closed a fundraising round of $200 million for a debt fund.
Gal Gitter, a partner at IBEX Investors based in the U.S., suggests that the issue isn't the readiness of funds to invest, but rather the declining performance of a significant number of companies. Currently, IBEX is investing from its second fund, a $100 million fund specifically for Israel, which was fully raised by the end of 2020. Its portfolio includes companies like Cobwebs, which was sold this year for $200 million, and Glassbox, which is listed on the Tel Aviv stock exchange. "Companies that are fundraising, like Vast for instance, are companies that are growing and demonstrating efficient growth. However, the problem is that there are too many companies that were previously hot prospects but are now simply not performing well enough. There's a willingness to invest in such companies, but they are not yet ready for a fundraising round at a lower valuation," explains Gitter.
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Gaza war
Gaza war
Gaza war affects Israeli tech sector
(Photo: Courtesy)
He adds an unexpected remark: "At the moment, it's less expensive to invest in American companies than Israeli ones, because the American ones have already 'fallen from the tree,' while the Israeli ones have not. We always follow what's happening in the U.S., and that's still the case." He says, "We continue to invest as usual and also see among other investors that the risk is perceived as short-term, and perhaps even with a longer view, there is a hope that Israel will become more politically and geopolitically stable," Gitter continues. "We see the lack of impact in the acquisitions of two cyber companies by Palo Alto deep into the war, and this is due to them having a large Israeli team here that is familiar with the terrain. This is also true for companies like Cisco or Microsoft that have been operating here for a long time. For those who are not here regularly, it's harder to price the risk, so they would prefer to delay deals in Israel until after the war."
Gitter points out another factor impacting investors, especially those from abroad, which are concerns about the ongoing business operations of smaller tech companies. These concerns are heightened due to a significant number of employees being absent because of reserve duty. "Investors and clients are beginning to question these companies. While most of them confidently assure that there's no threat to their future, the emergence of these questions, particularly from clients, is a risk. At present, the business level isn't affected and the impact is primarily felt in development, where the bulk of the workforce of Israeli startups is located," he explains.
Another worry that has been growing throughout 2023, and is now intensifying, is the creation of new startups. Since the coup, there's been a dramatic decline in the number of new companies being established in Israel, with the majority of those that were established being registered in the U.S. Over the past two months, for understandable reasons, hardly any new startups have been founded and many investors express that, unlike before, there isn't a sufficiently large pool of new ventures in Israel.
In response to this concern, there's a wide consensus among all those interviewed: while fewer new startups were founded this year, those that were are significantly superior to those founded in 2021. "Those who chose to start a company in the past year are entrepreneurs with a burning idea who felt they had no other choice, while the rest remained in their comfortable salaried positions. Startups that are driven by burning ideas and entrepreneurs who feel compelled to develop them are the ones that ultimately succeed and are the ones that funds are more willing to invest in and put more money into," he says.
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