Keeping Start-Up Nation alive: Financing scale-ups by reinventing Israeli capital markets
This piece will appear in Hebrew in Globes Magazine on Dec. 7.
Tel Aviv Stock Exchange Liquidity
The historic 2010 dual graduation of Israel to developed country status both within the OECD and MSCI country indexes should have opened its markets to a much larger pool of foreign investors. Instead, there has been a real decrease in foreign portfolio investment and an increase in local portfolio outflows, reducing the future of the local capital investments and overall economic growth.
In the wake of the global economic crisis, Israel’s capital markets have suffered a decline in liquidity threatening its economic security and future growth. Without capital market liquidity, Israel will never reach its growth potential to move from a start-up to a scale-up nation and global leader in new technologies that will contribute to global and, thereby, domestic growth. The liquidity in the Tel-Aviv Stock Exchange has declined by over 50 percent in the past year, ranking a low 30th among exchange turnover ratios.
The IPO market has collapsed. Currently, IPOs are not an option for most Israeli firms because of the high regulatory costs in the NASDAQ and their very low valuations in the Tel-Aviv Stock Exchange (TASE). From 2002 to 2012, only 9% percent of Israeli exits with an average IPO size of $32 million occurred through IPOs, versus over 20 % percent in United States with an average IPO size of $237 million. According to the Israel Securities Authority, 95 percent of the country’s startups are sold through mergers or acquisitions to foreign entities. Fewer firms are listing in the Tel-Aviv Stock Exchange (TASE). Regular delistings are costing the markets billions of shekels in investment opportunities that could drive growth.
Israel’s capital markets are chronically underperforming. For example, earnings per share for the TA 100 has had growth of 2.0 versus 8.4 for the S&P 500; PE (price to earnings ) ratios run seriously behind comparable benchmark indexes and on an aggregate basis as well. Israel capital markets are failing to attract and retain foreign investors in its capital markets, and as a result, they lack breadth (diffusion of foreign investors) and depth (amount of portfolio and foreign direct investment flows).
It’s time to reinvent Israel’s capital markets. Time is short to accomplish the following: increasing transparency and accessibility to foreign investors, creating new financial products such as Exchange Traded Funds to enable more exposure to foreign investors, fixed-income products that support economic expansion in Israel’s regions and new technologies, expanding private equity through public markets such as venture trusts and business development corporations for underfinanced firms, and build a technology bridge to institutional investors for pre-IPO companies through new trading platforms. In taking these measures, Israel can relaunch its capital market for its own expansion in disruptive technologies that will serve the world and also finance other nations’ start-up firms that seek to emulate Israel’s rise as the first start-up nation.
Israel now captures only a small portion—often limited to high-end R&D—of the global technology value chain. And while the country is known for its R&D, its startups have not been as successful commercializing the products and discoveries that would build more businesses, new sectors, and secondary markets, and gain for Israel a greater share of the product value chain. This hampers long-term growth. If Israel could resolve the market-related financing gaps so that startups could overcome capital constraints, this would also strengthen the country’s position as a global incubator for companies at home and abroad.
How can Israel’s capital markets become active partners in the launch of new technologies to increase portfolio and foreign direct investment? Can instruments be designed that allow institutional investors access to the latest technologies without forcing companies into premature M&A activity or low IPO valuations? What are the regulatory, institutional, legal, tax, and market infrastructure requirements for building a sustainable financial services landscape to support new technologies?
Too many of the innovations and intellectual property created by Israeli R&D are expatriated. Despite high levels of patent productivity relative to R&D spending, the transition from patent productivity to long-term value through capital formation and job creation isn’t occurring. In short, an Israeli company develops an innovative technological product or process, but it can’t yet commercialize that technological product or process and apply it to new sectors to repeat its success in information and communication technology in new sectors of food, health, water and energy. That economic benefit is enjoyed by companies elsewhere in the global value chain and technological mojo moves on.
To build a global nation, it is not enough to incubate startups. Israeli venture capital and private equity are highly concentrated in the seed and early stages of business development (80 percent versus 52 percent in the United States), but little is available for later-stage growth. Late-stage investing comprises only 20 percent of invested capital, compared to 52 percent in the United States. Yet late stage is when the impact of a company’s development is most crucial—when the company should start monetizing its product to ensure sustainability.
The sold startups also have low value-at-exit. Research on exit ratios, which measure pre-money valuation (prior to financing) divided by the total VC investment price (prior to exit) suggests that Israeli exit ratios are below those in the United States and Europe. Israeli companies are going to market too fast—without the opportunity to accumulate the value that would attract higher valuations. And they cannot accumulate that value because they cannot obtain later-stage venture or private equity capital, and they are not allowed to access the public markets for growth capital. When companies are forced to make premature exits, they lose the opportunity to realize full potential for economic growth.
In short, the lack of late-stage financing, along with human capital constraints, is leading Israeli startups to premature exits through mergers and acquisitions. Knowledge-based capital firms and their exports, the heart of Israel’s competitive advantage, require a longer financial runway to takeoff in building global companies.
Israel can increase the value of its capital markets by adopting financial policies that increase liquidity, and encouraging firms, through regulatory and tax regimes, to pursue more transparent disclosure policies and thereby attract new capital.
Prof. Glenn Yago is a Senior Fellow at the Milken Institute and Senior Director at its Israel Center where he leads its Fellows program of research and training for young Israeli economists. He is also a visiting professor at the Hebrew University of Jerusalem Graduate School of Business Administration.