A Q&A guide to venture capital law in Israel.
The Q&A gives a high level overview of the venture capital market; tax incentives; fund structures; fund formation and regulation; investor protection; founder and employee incentivisation and exits.
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This Q&A is part of the PLC multi-jurisdictional guide to venture capital. For a full list of jurisdictional Q&As visit www.practicallaw.com/venturecapital-mjg.
Israel has a thriving venture capital industry. There are about 70 venture funds operating in Israel, of which over a dozen are Israeli branches of foreign-based venture capital funds. In addition, numerous foreign funds without offices in Israel have made investments in Israeli companies. The robust size of the venture capital market is correlated with the relatively large number of start-up companies in Israel. According to PricewaterhouseCoopers’ MoneyTree report, in the third quarter of 2011, US$198 million (as at 1 November 2011, US$1 was about EUR0.7) was invested in 44 Israeli start-ups.
Private equity funds, both domestic Israeli and foreign-based, have made significant investments in Israeli companies. Foreign funds that have invested in Israel include Apax, York Capital and Goldman Sachs. In addition, there are a number of Israel-based private equity funds.
While technically venture capital is a subset of private equity, traditionally venture capital funds tended to focus on early-stage companies, particularly in the technology area, and private equity funds on more mature businesses. There is some overlap, as venture funds have invested in mature technology companies, and private equity funds have looked to earlier stage companies.
Early stage companies in Israel have a variety of potential sources of funding. As in other countries, many such companies look to “friends and family” or outside angels to supply the initial round (seed stage) of financing. In addition, there are a variety of Israeli government-sponsored funds for research and development (R&D). The Israeli Office of the Chief Scientist of the Ministry of Industry and Trade has a budget to make US$300 million in R&D grants annually, which pay for up to 50% of R&D costs. These grants are repayable with royalties on sales. In addition, there are a number of government-subsidised technological incubators that house start-up companies.
While all technology sectors receive venture capital funding, software, communications and life sciences have historically accounted for 60% to 70% of venture capital investments. Internet and semi-conductor companies are also large components of the total. In the past few years, clean-tech companies have been receiving an increasing share of venture capital funds.
In the third quarter of 2011, venture capital investments started to decline, following a steady increase from the beginning of 2010 until the second quarter of 2011. The decline in global M&A activities, the downgrading of the US credit rating and the European financial crisis are all major factors contributing to the recent decrease in investments.
While there has recently been no significant change to Israeli law affecting the venture capital industry specifically, the following changes to Israeli tax law are worth noting:
There is a new tax incentive scheme for individual investors in start-up companies, allowing “angel” investors to deduct qualifying investments against income from any source.
Corporate tax rates, which had been scheduled to be reduced to 23%, will instead increase to 25% from the current 24%.
Capital gains tax will be increased to 25% from the current 20%. For major shareholders the tax would rise to 30%, compared to the current 25%.
To encourage foreign investment in venture capital funds, the Israeli Income Tax Authority issues private rulings to funds operating in Israel to provide tax relief to non-Israeli investors. Foreign investors in venture capital that invest in high-tech companies in Israel may be exempt from tax on their share of capital income that the fund derives from its investments in companies either:
Located in Israel.
Incorporated outside Israel, most of the assets of which are located in Israel.
For a venture capital fund to qualify for the tax exemption, a number of conditions must be met, including:
The total sum raised by the fund must exceed US$10 million, of which at least 50% must be from foreign investors.
The fund must invest at least 50% of the funds raised in companies located in or associated with Israel, the main business of which involves the establishment or expansion in the fields of:
medical technology and biotechnology; or
In November 2010, the government announced a new proposal to provide a safety net for Israeli institutional investors investing in Israeli venture capital funds. Under this new proposal, the state will absorb a percentage of any losses that the institutional investors might suffer from such investments.
Venture capital funds have traditionally received funding from institutional investors, corporate investors and high net-worth individuals. Many investors in Israeli venture capital funds have been foreign-based (particularly US) pension funds, funds of funds, corporate investors and individuals. Recently, US pension funds and corporate investors have been less active in investments in venture capital funds, including Israeli ones.
Venture capital funds are usually structured as limited partnerships. Many venture capital funds investing in Israel have foreign, usually US, institutional investors as limited partners. As such, the funds are often required to abide by certain US regulations, such as Venture Capital Operating Company rules, to which US funds are subject.
In addition, because limited partnerships usually pass through profits and losses to their limited partners, and for other reasons, the funds generally invest in corporations, rather than partnerships or limited liability companies (LLCs) that might themselves be pass-through entities for tax purposes.
The prevalence of more than one venture capital fund in a round of financing depends on the funds and the status of the portfolio company. In the earliest round of venture financing, it is not unusual to see a single fund supply the entire round of investment. In later rounds, existing funds often seek to include new venture capital fund investors to join the investment.
The vast majority of venture capital funds are structured as limited partnerships. The jurisdiction of formation is usually:
Israel, for Israeli limited partners.
Delaware, for US investors.
The Cayman Islands, for offshore investors.
The structure of the venture funds operating in Israel generally follows the models that are well known in the US. Limited partners supply 95% or more of the capital, through capital commitments on subscription, which are then called by the fund as and when needed for an investment. A general partner manages the fund, and receives (directly or through a management company under common control) a fraction (often 2%, though such amounts vary) of the total committed capital as an annual management fee, as well as carried interest (often 20% of the net profits above the return of capital to investors).
The typical life of a venture capital fund operating in Israel is ten years. The term may be extended under certain circumstances, which may include a decision by the general partner to extend for up to one or two years, with limited partner approval required for additional extensions.
Extensions have become more common, as funds have experienced a need for a longer amount of time for gains to be realised on their investments. This delay can be attributed to a virtual collapse in the market for initial public offerings (IPOs) of technology companies in the US, which remains the target market for Israeli technology companies.
Generally, if the activity of the promoter, manager and principals is limited to the venture capital fund itself, they do not require licences in Israel.
While the fund itself is generally not subject to specific regulation as an investment company, there are restrictions on how a venture capital fund can be marketed or advertised. For example, Israeli securities law limits the number of offerees that can be approached in Israel as potential investors, unless the offerees meet a specific definition of “qualified investor”, which generally is limited to institutional-type investors.
The relationship between the investors and the fund is governed by a limited partnership agreement, and ancillary agreements, such as a management agreement. Protections sought by investors vary by fund, but typically include:
Term of the life of the fund.
Rules on distributions.
Limitations on self-dealing by the managers, as well as compensation for the general partner.
Clawback of overpayments to the general partner.
Time commitment of key persons of general partner.
Mechanism for liquidation if certain key persons are no longer managing the fund or are convicted of certain acts.
Limitations on certain types of investments, co-investment by the general partner, and investments in a single portfolio company.
Financial reporting requirements.
Venture capital funds in Israel generally invest in equity, usually by using preferred shares.
There are entities that provide venture debt financing, which usually involves debt plus warrants to give the investor a share in the upside of the company’s growth.
Venture capital funds in Israel use valuation methodologies that are familiar to US venture capital investors. Since the portfolio companies tend to be in a relatively early stage, the potential investors generally do not use methods such as discounted cash flow to analyse the potential value of the investment. Instead, the venture capital funds tend to rely on an analysis of:
The founders and management team, particularly whether they have had prior success in another company.
The potential market for the proposed products.
The intellectual property estate of the company, and the barriers to entry that it could have against potential competitors, as well as the risk of infringement on the intellectual property rights of others.
The time to market of the proposed products, including any regulatory approvals that may be required.
How much additional capital will be required to get a product to market or to an exit.
Expected exit scenarios for the company.
Venture capital funds typically conduct extensive business and legal due diligence investigations of the potential investee company. These investigations include:
Reference checks on the founders/management.
Intellectual property review.
Review of financial history of the company (for companies that have such a history).
Discussions with customers and suppliers.
Legal due diligence of:
the company’s corporate records (including capitalisation history);
customers and supplier contracts;
Review of the company’s projections and business model.
A venture capital investment typically begins with a non-binding term sheet that sets out the principal business understandings between the venture capital fund and the investee company. Following execution of the term sheet, the parties negotiate a series of documents:
A share purchase agreement, which contains the:
representations and warranties of the company;
number of shares to be issued;
consideration to be paid; and
conditions to closing of the transaction.
Articles of association (if the company is organised in Israel) or a certificate of incorporation (for companies organised in Delaware, which is a commonly used location for organising companies, even if much of the activity is through an Israeli subsidiary). This document typically contains the:
terms of the preferred shares (such as liquidation and dividend preference);
conversion mechanisms; and
In an Israeli company, the articles of association may also contain the:
right to appoint directors;
rights of first refusal; and
In a non-Israeli entity, these matters may be contained in a separate agreement.
Investor rights agreement, which typically contains:
information rights; and
other requirements, such as maintenance of directors and officer’s insurance.
In addition to representations and warranties of the company contained in the share purchase agreement, venture capital investors in early rounds of financing often require representations and warranties by the founders. In addition, the venture capital investors may demand indemnification by the founders for any breaches of the company’s or the founders’ representations and warranties.
Venture capital investors also typically require the following:
Pre-emptive rights to participate in future financings.
Co-sale rights, such as tag-along (the right to sell when other shareholders sell shares) and drag-along (the right to force others to sell if holders of a specified percentage of shares agree to sell).
Anti-dilution protection, which adjusts the conversion price of the preferred shares if the company sells shares at a lower price than the price paid by the venture capital fund.
Veto rights over specified actions of the company.
The typical form of investment is preferred shares. Funds do often advance bridge loans to potential or existing portfolio companies, which are intended to convert into preferred shares at the next subsequent equity financing, usually at a discount to the price in that later round.
The typical structure of a venture capital investment calls for preferred shares, which are entitled to a preference on liquidation and dividends. The rate of preference varies, but an 8% annual return is common. Usually, the preferred shares are expected to participate along with the ordinary shares after the preferred receive their preferred return. Subject to negotiation is whether the preferred will be forced to give up the preferred return if treatment as an ordinary share would give the preferred shares a certain multiple of the initial purchase price.
Board representation and veto rights over certain decisions are the typical mechanisms for management control. In addition, venture capital funds typically require information rights.
Typically, preferred shares are not subject to any restrictions on re-sale (other than those required by applicable law). Venture capital investors do usually require the ordinary shareholders (or at least the founders) to subject their shares to restrictions such as:
No-sale for a specified period of time.
Reverse vesting, in which a portion of the founder’s shares can be repurchased by the company if the founder’s service to the company does not continue beyond specified milestones.
Tag-along rights (the right to sell when the founder sells shares).
Rights of first refusal (the right to purchase any shares that the founder is selling).
Typical protections include:
Tag-along rights (the right to sell when other shareholders sell shares, though this right often applies only to sales by founders).
Drag-along rights (the right to force others to sell if holders of a specified percentage of shares agree to sell).
Veto rights over specified actions, such as mergers.
Pre-emption rights are found in virtually all companies in which a venture capital fund has invested.
The consents required vary by company. At a minimum, board approval is required for share issuances. In addition, the articles of association will likely require amendments to accommodate the new series of shares to be issued, which would require shareholder approval. Existing shareholders may have specific veto rights, which may require a class vote.
Some companies, which received government grants, may also be required to notify or get approval from the relevant government agency.
Legal expenses of the venture capital fund related to the investment are usually covered, at least in part, by the investee company.
Founders generally have shares in the company. These may be subject to reverse vesting schedules, under which the shares can be repurchased by the company or by one or more investors if the founder does not complete service to the company of a specified duration. Other employees generally receive options, which are also subject to vesting over time based on service to the company.
Israeli tax law treats options favourably, if the options are held in trust for two years before sale of the underlying shares, with the employee paying tax on capital gains rather than as ordinary income.
Founders’ shares are usually subject to reverse vesting provisions (see Question 25). In addition, the founders’ shares may be subject to a no-sale provision, at least for a specified period of time (see Question 20). Employment agreements also typically contain non-competition covenants, though enforceability in Israel may be limited in scope and duration.
Exit alternatives from an unsuccessful company are limited. There may be a sale of assets (such as the intellectual property) to a strategic buyer, or to a patent buyer. In some cases there is a sale of the entire company at a low valuation. Contractual obligations of the company to repurchase the shares owned by the venture capital fund (put option) are highly unusual in Israeli early-stage companies.
Venture capital funds generally look to sell the entire company or have the company go public through an IPO.
A sale can be structured as a merger or a sale of shares, or as a sale of assets of the company. A sale of shares may require the use of a drag-along provision in the case of a company with more than a few shareholders. A merger requires some corporate law formalities, which may complicate the transaction. The consideration may be in cash or shares, or a combination of both. There are tax and other matters to consider in deciding which type of consideration is advantageous to the venture capital fund.
With the recent financial crisis, IPOs have become less common in the past few years, particularly on the US markets that had been the main forum for IPOs in the past decade. An IPO has certain disadvantages, such as the inability of the fund to sell all of its holdings immediately. In addition, the process is lengthy and expensive. On the other hand, if the company is successful, the fund could realise additional gains in the future if the value of the company rises.
There are a number of mechanisms that a venture capital fund should demand at the outset, to maximise the ability to achieve a favourable exit. These include:
Registration rights (see Question 15).
Liquidation provisions that are activated on a transaction that is defined as a deemed liquidation, and which ensures that the fund receives its preferred return, regardless of the form of the exit.
Qualified. New York, 1995; Israel 2002
Areas of practice. Venture capital; mergers and acquisitions; capital markets.