Hi-tech in Israel
Israel is a country covering a small geographical area. The concentration of hi-tech firms across much of the country is recognized as one large cluster. Most activity is located in the densely populated coastal plain (Silicon Wadi) of metropolitan Tel Aviv, Haifa (Matam), and Jerusalem (Technology Park, Malha, Har Hotzvim and JVP Media Quarter. There is also additional activity around Beer Sheba and Kiryat Gat, and the Western Galilee, including Yokneam Illit. The total area is half that of California’s Silicon Valley.
VC and private equity
Israeli VC is focused on seed and early stage companies and on technology- companies in the fields of: communications and components; software; semiconductor chip design and manufacture; Internet and e-commerce; Bio-tech; Cleantech; medical devices.
Office of the Chief Scientist (OCS)
The OCS provides grants for research and development (R&D) programs. The grants are repaid with royalties from sales. The OCS sets limitations on the assignment out of Israel of ownership of IP rights to products developed from the grants from the OCS.
Types of company
In VC transactions, companies may be seed/pre-seed stage companies or later-stage companies. The companies may be registered in Israel or be corporations registered in Delaware with Israeli subsidiaries.
In recent years, foreign venture funds and venture lending companies have opened offices in Israel and have invested in local Israeli companies.
Foreign investors are generally exempt from Israeli capital gains tax on the realization of their investment in Israeli high-tech companies if the following conditions are met: the shares were purchased on or after 1 January 2009; the shares were not held through a permanent establishment maintained by the non-resident shareholder in Israel; the shares are not in a company whose assets consist primarily of real estate; the shares were not purchased from a related party.
The exemption does not apply to shares in publicly-traded companies.
VC Fund management
VC funds typically establish a management company in Israel, and pay an annual management fee of approximately 2.5% of total fund commitments. This fee may decrease after an investment
VC Fund – Limited Partnership
VC funds are not regulated and do not require a license. VC funds are usually limited partnerships and are subject to securities legislation restricting the offering of limited partnership units to no more than 35 persons, excluding certain qualified investors consisting primarily of financial institutions.
The VC fund’s limited partnership agreement governs the relationship between investors and the fund. Investors usually seek: confirmation of limited liability; restrictions on the use of proceeds; Employee Retirement Security Act 1974 (ERISA) restrictions; restrictions on recourse borrowing; financial reporting; key man provisions; non-competition restrictions preventing promoters from setting up a competing fund until certain time periods have passed; conflicts of interest provisions.
Long term capital appreciation from high growth, technology companies.
VC funds generally have a 7-10-year term with the ability to extend this term by a number of one-year periods (usually two to three extensions). VC funds usually aim to complete their investment period (deploy capital in new portfolio investments) within 3-4 years of the fund’s initial closing (while retaining capital for management fees and follow-on investments until exit) and to exit most of its investments within 3-5 years of investment.
Since 2001, VC funds in Israel now usually extend their investment periods (sometimes to 6-7 years). The average period between investment and exit has lengthened.
VC funds generally invest in equity in the form of preferred shares. The use of convertible debt is also very common before an investment round, both as bridge financing for immediate use and as a means to circumvent the need to set a company valuation when no third party investors are available to set a valuation.
Venture lending, where lenders provide secured loans to portfolio companies and receive an equity component in the form of warrants or an option to invest in the next round, has increased over the last few years.
The valuation of companies is one of the most secretive and sensitive matters. Regarding seed and early stage companies, the investee company’s valuation is set based on a sensitivity analysis that takes into account some or all of the following: the percentage holding in the company the fund aims to hold following the investment; the percentage holding the fund aims to hold at exit; the amount of capital the company is projected to require until the next round of financing; the amount of capital the company is projected to require until the exit; the reasonable (or possibly, conservative) expectation for an exit valuation. The result of the sensitivity analysis should provide for a projected internal rate of return greater than the minimal internal rate of return theVC fund has set for itself. Market comparables are also often used, whether in the public markets or, where available, in the private markets. Discounted cash flow and price to earnings ratios are rarely effective for valuing start-up companies except in the case of established, expansion-stage companies with substantial revenue and a broad customer base.
Valuations are effected by competition among funds for high quality deals. Additional factors that may affect valuation include the amount of capital the VC fund must deploy before the end of its investment period and the size of the investing fund, with both factors causing the funds to deploy larger amounts of capital, causing an inflation of valuations.
Investigations prior to investment
On a business level, before investing in potential portfolio companies, VC funds typically conduct a thorough investigation of the company’s proposed business including, calls with customers and of the potential market, particularly with respect to the size of the market, potential for dynamic growth and barriers to entry.
VC funds also typically evaluate and size up the entrepreneurs and the potential portfolio company’s management team. Some VC funds carry out preliminary legal due diligence at the term sheet stage to find any obvious fundamental problems from a legal perspective. Once VC funds have resolved to invest in a company, as part of the investment process they usually conduct a legal due diligence review in which they examine: the company’s capital structure; commercial relationships; employment relationships; other legal rights and obligations.
For companies with an operating history and a stronger technology portfolio, VC funds often retain an accounting firm to investigate the company’s financial condition and a law firm to investigate the company’s intellectual property portfolio. Major issues that arise in legal due diligence in relation to the company’s capital structure or its intellectual property rights may be deal breakers. Legal due diligence serves primarily as an opportunity for reorganization in the company particularly in relation to capital structure and keeping proper corporate records.
VC Legal Documents
Share purchase agreement – the commercial agreement of the parties, including the amount of investment and valuation of the target company, as well as the representations and warranties of the parties, the closing conditions and certain post-closing covenants.
Articles of association
Sets down the rights of the preferred shares, including dividend and liquidation preferences, anti-dilution protection and protective provisions.
Investor rights agreement. This contains those rights which may be of more general, on-going application to shareholders of the company, including registration and information rights, and sometimes composition of the board of directors.
Some investments also include additional documentation, including shareholders’ agreements, and a large number of ancillary documents such as indemnification agreements, management rights letters, IP assignments and so on.
Funds investing in a company typically receive the following protections: dividend and liquidation preferences; anti-dilution protection; pre-emptive rights to participate in subsequent financing rounds; rights of first refusal and co-sale; information rights, including rights to financial information and visitation and inspection rights; registration rights; representation on the board of directors; protective voting provisions (veto rights); restrictions on the use of proceeds; directors’ and officers’ and key man insurance.
Funds always take preferred shares. Angel investors may take ordinary shares.
Holders of preferred shares typically have the following rights:
Dividend – the right to receive a dividend in priority to the payment of a dividend to any other class of shares. Although this right is very common, most high-tech companies in practice do not pay dividends.
Liquidation preference – The right to a liquidation preference, typically a participating preference entitling the holder to some kind of preferred return (in Israeli companies, with an annual interest component, typically 6% to 8%), followed by the right to participate with the holders of ordinary shares on an “as converted” basis in any remaining proceeds. The liquidation preference applies both to actual liquidation of the company and to most exit events including a sale of all or substantially all of the assets of the company.
Anti-dilution protection, typically implemented by adjustments to the conversion rate under which the preferred shares may be converted into ordinary shares. The protection ranges from full ratchet to broad-based weighted average.
The right to representation on the board of directors. Protective voting provisions, requiring fund approval for various actions including the creation of a class of shares with rights superior to those held by the VC Fund, as well as other corporate activities.
Typically, funds receive representation on the board of directors and/or the right to appoint a non-voting observer to the board. This right may be conditional on the fund maintaining a certain level of ownership in the investee company.
As holders of preferred shares, the fund also benefits from protective provisions, requiring the approval of the fund (occasionally of a director appointed by the fund, and occasionally of a specified majority of all holders of preferred shares) for a variety of actions, often including: creation or issuance of a class of securities equal or senior to those held by the fund; approval of exit events (mergers and acquisitions and initial public offerings; the payment of dividends; the repurchase of ordinary shares; adverse changes to the rights of the shares; increasing the size of the board of directors; incurring indebtedness in excess of a specified amount; material changes in the business of the company; management type activities including, hiring and firing of key executives; bank signature rights; establishment of an annual operational budget.
Management rights letter
Funds that require a management rights letter for ERISA purposes typically receive one providing them with certain information and consultation rights in the event that they have not appointed a board member, and sometimes even if they have appointed a board member.
Funds also commonly obtain information rights which allow them to obtain information about the company so as to enable the fund to prepare financial reports to the fund’s limited investors as well as to facilitate an intelligent exercise of veto rights. Information rights usually include the right to: audited annual financial statements; reviewed quarterly financials and monthly reports; inspection and visitation rights.
Right of first refusal.
Investors usually have a right of first refusal in relation to the sale of shares by other shareholders. Sometimes this right is limited to the holders of a certain minimum number of shares (for example, 2% of the outstanding share capital) and is exercised on a pro rata basis. This right is usually not reciprocal, that is, the holders of ordinary shares do not have a right of first refusal in relation to sales of shares by the fund.
Exercise of the right of first refusal is often conditional on the purchase by the shareholders of all the shares being offered. There are exceptions for transfers of shares for estate planning purposes.
Often founders are completely barred from, or severely limited in, selling their shares for a specific period of time (often at least three years, but occasionally until exit). Typically, exceptions are made for transfers of shares to family members or for other bona fide estate planning purposes. These restrictions are intended to ensure that the founders recognize their economic interests as being linked with the success of the company.
Transfers of shares are also governed by applicable securities laws, and the investment documents typically contain provisions ensuring that such laws are followed (for example, by marking share certificates).
Minority Shareholder Protection
Investors have the right to sell shares together with the founders (or other holders of ordinary shares), if and when the founders sell shares to third parties. This right (tag-along right or right of co-sale) may be exercised if the investor elects not to exercise its right of first refusal. The rationale is that the investors are investing in the founders, and if the founders decrease their shareholdings, the investors require the right to exit with the founders.
Tag-along rights also serve to make it more difficult for founders to sell their shares and, in practice, force any such sale to be made in full coordination with the investors. It is very uncommon for founders to have tag-along rights in relation to sales of shares by VC funds.
Drag-along (bring-along) rights
Drag-along rights (also referred to as bring-along rights) facilitate the sale of the company in the face of opposition from minority shareholders. The articles of association often provide that where a specific percentage of shareholders (often including the holders of a specific percentage of preferred shares) agree to a bona fide third party purchase offer, all shareholders must then sell.
The Companies Law 1999, provides that if the holders of 80% (90% in the case of companies established before 1999) of shares wish to sell, then all shareholders can be forced to sell.
“Deep pocket” strategic investors often attempt to impose restrictions on the exercise of these clauses to ensure that they do not find themselves providing representations, warranties and indemnities that expose them to excessive liability.
Investors almost invariably require pre-emptive rights to participate in future financing rounds. Sometimes the right is limited to participation on a pro rata basis; other times the investor obtains a right of over allotment to take up shares that other participating shareholders elect not to purchase. Companies typically attempt to resist the request for over-allotment rights. These rights are generally subject to certain standard exclusions, such as: issuances on exercise of employee share options; issuance on conversion of preferred shares; and also certain issuances of warrants to strategic partners in transactions not primarily intended as financing transactions.
Approval by the company’s shareholders and board of directors is required to complete the investment. In addition, if the company has already raised funds in an earlier investment round, approval by the earlier investor is also likely to be required. If the company has received tax incentives or a grant from the Ministry of Trade and Industry, consent from the department providing the tax incentives or grant is also required.
VC Funds Costs
Investment agreements typically provide that, on closing, the portfolio company covers the VC fund’s costs in connection with the investment, up to a certain agreed cap. These costs usually include legal costs arising from the legal due diligence, and drafting and negotiating the investment agreements and often also include financial and technical due diligence.
If the closing does not occur, the portfolio company does not cover the VC fund’s costs.
Israeli companies usually provide incentives to employees (including founders) by granting share options which subject to vesting over a number of years. Founders of Israeli companies sometimes receive shares that are subject to repurchase by the company at par value if the founder ceases to be employed by the company.
Employees typically receive share options, which are exercisable if the employee continues to be employed during the relevant vesting period.
Section 102 of the Tax Ordinance provides a mechanism for ensuring that these options are only taxed (at capital gains rates) on the sale of the underlying security (that is, the shares obtained on exercise of the option). To benefit from the beneficial tax treatment, the share option plan must comply with the requirements of section 102, including holding the options in trust for two years.
Founders’ Long Term Commitment
Investors typically use a combination of methods to ensure the founders’ long-term commitment to the company. Investors may prohibit the founders from selling any of their shares for a period ranging from a number of years (at the earliest) to the closing of a sale of the company or its IPO (at the latest). The investors typically require that the founders’ shares are subject to a reverse-vesting mechanism, so that if the founder ceases to be employed by the company, the founder loses a portion of his shares Investors often require that founders enter into non-competition undertakings, restricting competition with the business of the company for some period of time following the termination of the founder’s employment. The enforceability of these undertakings under Israeli law is uncertain.
The no-sale and reverse-vesting provisions tend to be heavily negotiated in transactions, with founders often taking the position that they are entitled to all of their shares if their employment is terminated by the company without cause or if the company closes an IPO or M&A transaction.
Redemption rights are designed to enable a VC fund to recover its investment in an unsuccessful company. These rights allow the VC fund to require the portfolio company to repurchase the fund’s shares if the company has not closed an M&A transaction or IPO within a specific number of years following the investment. It is uncommon to find redemption rights provisions in investments due to Israeli corporate law limiting the ability of an Israeli company to repurchase its own shares.
The typical forms of exit of a successful portfolio company, and the relative advantages and disadvantages, are: sale of the portfolio company’s shares by all shareholders of the portfolio company’s shareholders. Depending on the sales price, this is the most efficient and perhaps the most successful exit for a VC fund, in that it involves a sale of all of the fund’s shares in the company, typically in return for cash or tradable securities. A potential disadvantage is that approval of the transaction may require class votes, giving certain shareholders the ability to frustrate the transaction.
Sale of the portfolio company’s assets. While a sale of the company’s assets has the advantage of not requiring shareholder approval, it is inefficient from a tax perspective. On a sale of its assets, the portfolio company is subject to capital gains tax, and when the resulting proceeds are distributed by the company to its shareholders, the distribution is often subject to a dividend tax.
Flotation of a company’s shares on a recognized stock exchange brings liquidity to the VC fund enabling it to begin selling its shares on the public market.
Sales of shares on certain stock exchanges are subject to time and quantity restrictions, which limit a VC fund’s ability to sell all of its shares simultaneously. The share price is also subject to volatility.
A VC fund may sell its shares in a portfolio company to a third party. Sales are often subject to a right of first refusal of other shareholders in the company. The price to be received by the VC fund is likely to reflect a discount since the third party is purchasing a minority interest in the company, and such sales are relatively uncommon.
The VC fund’s exit strategy is built into the investment documents by the inclusion of tag-along and drag-along rights as well as registration rights (the right to force the listing of the VC fund’s shares on the exchange where an IPO has taken place) and sometimes the inclusion of redemption rights.
Dardik Gross & Co., Ramat Gan, Israel
We are a boutique commercial law firm specializing in mergers and acquisitions and VC financing. Our Office is conveniently located in the heart of the Diamond Exchange District. We represent international VC funds and welcome inquiries from funds and investors looking to invest in Israeli technology and enterprises.
 Wadi – dry river bed