The Israeli hi-tech sector has long been a powerhouse of innovation and growth, fueling the country’s economy and earning a reputation as a global leader in technology. However, as 2023 progresses, the sector is facing a number of challenges that threaten its core DNA.
Looming risk of brain drain
The government’s planned judicial overhaul poses a fundamental threat to the hi-tech sector, according to a wide array of local and global experts. They claim that the weakening of Israel’s checks and balances will result in increased investment risk for Israeli tech, more hesitance from foreign investors, and a subsequent “brain drain” as entrepreneurs move their businesses to other countries with higher investment potential.
Joeri Kreisberg, the hi-tech partner at Arnon, Tadmor-Levy Law, advised that in order to avoid that predicted hi-tech flight, ”the Israeli government must take immediate action to address the concerns of the hi-tech industry. This includes ending the uncertainty and reassuring the industry that the Israeli legal system remains robust and reliable.”
Kriesberg added that the government should offer tax benefits and incentives to start-ups, investors and employees to make operating in Israel more appealing. “The Israel Innovation Authority’s funding for start-ups should also be increased, and the terms of such funding should be improved,” he said.
According to Amir Zolty, a partner and head of hi-tech practice at Lipa Meir & Co, some relocation is already occurring, even before the actual enactment of the judicial overhaul.
“The two prevailing trends that we have witnessed are the almost complete shift to incorporating new hi-tech companies abroad, and corporate inversions transferring all holdings in existing Israeli hi-tech companies to a foreign entity, thus turning the Israeli company into a fully-owned subsidiary,” Zolty said.
“Many of these ‘flipping’ companies also transfer their intellectual property to the foreign parent companies and waive governmental funding. Such steps are highly likely to divert business activities, employees and taxable revenues from Israel. In the short term, it may be a field day for lawyers, accountants and tax planners. In the long run, we may end up with a ‘Silicon-free’ wadi, and memories of a once-thriving hi-tech industry,” Zolty added.
Budget constraints could lead to more outsourcing
Besides the overhaul’s looming presence, the hi-tech sector also needs to grapple with the current global recession that has affected hi-tech industries around the world. That recession has led investors to spend more carefully, which in turn has led to tighter budget sheets for companies of all sizes, both young and mature.
“A new start-up today must show two things now more than ever,”
Nogah Miloslavsky Hendler
“A new start-up today must show two things now more than ever,” said Nogah Miloslavsky Hendler, vice-president of product at Commit. “The first is efficiency: Start-ups need to explain their burn rate and make very sure that every dollar spent is allocated to push the business forward.
“The second is sustainability: If 2021 was a year in which any entrepreneur with a dream could potentially raise money, 2022 and 2023 are characterized by investors seeking a start-up’s ability to achieve a market fit and grow in the competitive landscape.”
One notable example of an area in which start-ups need to become particularly frugal is in the rental of real estate for their operations. With office space in many of Israel’s tech hubs among the most expensive in the world, companies are finding it more important than ever to carefully evaluate their real estate needs.
“Office space is usually the third-largest expense for a tech company – after salaries and R&D,” noted Ziv Shor, JLL Israel’s country manager, adding that it was an expense that until now wasn’t a major concern for start-ups.
“Immense areas were taken by companies and start-ups without proper understanding of their actual needs or implications of a long-term commitment – a decision that is now backfiring on companies due to the current economic situation and the need to control their cash-burn rate,” he said.
Adi Heinisch, general manager at CloudZone, suggested that another common budgetary issue is the cost of cloud infrastructure, which is also among the highest expenses for the average start-up.
”Start-ups that have built their solution on cloud-based technologies are facing a serious cost challenge in the midst of the economic crisis,” he said. “Board of directors are pushing to save costs, which creates two main challenges for CFOs: How to analyze the actual cost per user/license, and how to make their infrastructure incredibly cost-utilized and efficient.”
Heinisch suggested a solution that rings true for both cloud infrastructure and real estate cost-reduction: outsourcing. “Don’t do it yourself! Doing it by yourself will waste a lot of time and money, and will remove your focus from growing and stabilizing your business,” he said.
By hiring external service providers for cloud DevOps tasks and utilizing outsourced Cloud cost experts, start-ups are likely to maintain their productivity levels while cutting down on unnecessary bulk.
Scaling will be a lot harder
As the tech sector has matured and thrived, there has been a lot of discussions about whether Israel is ready to make the transition from Start-Up Nation to Scale-Up Nation, with established, profitable companies operating on a global scale. But that transition may need to be seriously reevaluated, or even shelved for a while.
“Now, more than ever, rapid growth is a double-edged sword for start-ups. While scaling presents immense opportunities, it also introduces a host of challenges that can strain the organization,” said Dorel Ishai, co-founder and co-CEO of the consulting company StartPlan.
“Start-ups must focus on maintaining product or service quality, investing in scalable infrastructure, and managing the complexities of a larger workforce. To ensure quality, it’s crucial to invest in robust quality assurance systems and continuous employee training. Scalable infrastructure requires careful planning, adoption of cloud-based services and efficient project management tools,” he said.
Shirona Partem, vice-president of corporate development at Kape, echoed Ishai’s sentiment, noting that growth may no longer be the end-all, be-all for a start-up hoping to find success.
“As the investment market shifts its focus toward profitability, Israeli tech companies will need to move away from the growth-at-any-price mentality that has dominated the industry in the past and instead focus on building profitable businesses,” Partem said.
“In the past, many Israeli tech companies have relied on selling their technology to larger, established companies. However, with the changing investment landscape, start-ups and tech companies will need to find alternative strategies for growth and exit,” she said. “Those who will rise to the challenge will exit it stronger and healthier than ever before, but there will be some casualties on the way.”
End of the tunnel
Faced with these challenges, will the Start-Up Nation be able to overcome these challenges and the bevy of others that 2023 presents? Head of DLA Piper Israel group, Jeremy Lustman, for one, remains confident that it will.
“Disruption and unease usually create opportunities. There are many funds flush with cash that closed before the unease started, and they are looking for deals. Investors will spend more time and attention on their existing portfolio companies and help them navigate through more challenging times, and the cycle will rebound,”
Jeremy Lustman
“Disruption and unease usually create opportunities. There are many funds flush with cash that closed before the unease started, and they are looking for deals. Investors will spend more time and attention on their existing portfolio companies and help them navigate through more challenging times, and the cycle will rebound,” he said.
“Israel has always shown its resilience, and I don’t anticipate this period to be any different.”
Given the sector’s tenacity, it’s likely that it will indeed emerge on the other side of the current rough period – but it may become an entirely new beast in the process.