The coming months will be ‘critical’ for the Israeli high-tech sector, report warns

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While Israel’s high-tech sector continues to be the largest and fastest growth engine in the Israeli economy over the past decade, the coming months will be “critical” for the industry, the Israel Innovation Authority (IIA) cautioned in a report released Tuesday.

In its State of the High-Tech Industry in Israel 2023 report, the Israel Innovation Authority, in charge of directing the nation’s tech policies, set out the serious challenges that Israel’s tech ecosystem faces that could threaten its position as a global leader of innovation, and a major contributor to the country’s economy.

One of the central questions raised in the report is whether the Israeli high-tech industry will fall in line with the signs of recovery that can already be seen in the US technology sector’s bounce-back this year, or whether there is cause for concern of a deep ongoing crisis with uniquely local characteristics.

“The global macroeconomic slowdown, the war in Europe, the tension between China and the US, the inflation and interest rate environment — all of those have changed dramatically in the last 18 months, resulting in a sharp decline in venture fund investments,” Israel Innovation Authority CEO Dror Bin told The Times of Israel. “When you have such a high degree of uncertainty, investors tend to put their money in safer places than a risky startup, and we see this decline in all global tech hubs, but in the last quarter the Israeli tech hub is a little bit more affected.”

Last year was rough for Israel’s tech industry, as the uncertainty surrounding borrowing costs and high valuations pushed entrepreneurs and investors into a wait-and-see mode. The financial environment and a slowing global economy saw tech shares take a battering in global markets in the second half of 2022, pushing company valuations down both in the public and private sectors. The market downturn has seen thousands of workers laid off, triggering funding pullbacks and creating a bear market for new tech offerings. In total, in 2022, investments in startups in Israel dropped by almost half compared to the previous year, amounting to $15.9 billion.

The negative trend in the Israeli high-tech industry has intensified in recent months amid growing uncertainty surrounding the government’s proposed judicial overhaul and a slowdown in foreign investment.

Dror Bin, CEO of the Israel Innovation Authority. (Courtesy/Hanna Teib)

In the first quarter of this year, Israeli tech companies raised $1.7 billion in capital, down 70% from the $5.8 billion in the first three months of 2022, according to a report by IVC Research Center and LeumiTech. The quarter marked the lowest figure in four years. That compares with a decline of 55% in the US, it was noted in the report.

“The political situation in Israel is creating some additional uncertainty for entrepreneurs for investors,” said Bin. “We would like to see the political instability go away as fast as possible, as this is not a good situation.”

The Israeli high-tech industry is contributing 18% to local GDP, versus less than 10% in the US, and about 6% in the EU. About 14% of all employees work in the high-tech sector and in tech jobs in other sectors. The Israeli economy relies on high-tech products and exports, which make up about 50% of total exports, as well as high-tech taxes.

“The Israeli economy’s dependence on the high-tech sector has significantly grown in the past decade, therefore, we must do everything necessary to preserve the industry and continue nurturing its competitiveness in the global market,” Bin urged.

Bin noted that “91% of investments in Israeli high-tech are funded by the private sector — there is no parallel to this anywhere else in the world.”

Israel has the lowest percentage of government funding for R&D among OECD countries, with only 9% of national R&D expenditure funded by the government. In addition, about 80% of venture capital investments in high-tech were generated from foreign funds in the years 2021 and 2022, according to the report.

Tech workers protest against the government’s judicial overhaul ‘time is running out for Israeli high-tech,’ in Tel Aviv, on March 23, 2023. (Avshalom Sassoni/Flash90)

“The Israeli high-tech industry is unique and different, and such a model does not exist in any other market worldwide,” Bin remarked. “The entire Israeli economy is highly reliant on the behavior of this sector and the preservation and cultivation of trust from foreign investors in it.”

Since the start of the year, Israeli tech companies have shown negative returns compared to technology companies traded on the Nasdaq. In the first quarter of 2023, the return on the index of the top 100 technology companies traded on Nasdaq was close to 24% pointing to signs of the start of a recovery, while the Tel Aviv Technology Index fell 1% during the same period.

“The coming months will be critical for the Israeli high-tech sector,” the Israel Innovation Authority warned in the report.

“The past teaches us that, usually, two quarters after the recovery begins in the stock market, as reflected in the rise of the Nasdaq index, there is also an increase in capital-raising and employment in the Israeli high-tech industry,” said Bin. “Given the rise in the Nasdaq since the beginning of the year, under normal circumstances, one could expect an increase in fundraising and employment in Israel during the summer months.”

“We don’t want to see Israel getting out of correlation to other tech hubs in the world in terms of fundraising,” he said.

However, according to preliminary data for April and May data, “there is a genuine concern of a separation trend between the Israeli high-tech industry and global trends,” the report cautioned.

“These trends are worrisome, especially considering the significant dependence created on the high-tech sector in Israel as a central and growing industry that contributes to the economy, and in light of this sector’s substantial dependence on foreign investors – more than other innovation hubs,” it was added.

Tech hubs

As of April 2023, there were 9,093 tech companies, ranking Israel’s startup ecosystem as the third largest globally after San Francisco and New York, according to the report.

“We are facing a different situation to the one that we saw a decade ago when most of the startups were formed either in the Silicon Valley or in Israel,” noted Bin. “Today we’re looking at multiple tech hubs rising across the world with which we are competing for the same resources.”

“Venture funds are moving very fast, from one tech hub to the other, tech hubs are competing for workforce and entrepreneurs are becoming more selective about where they want to form their startup and what is the optimal ecosystem for them to do so,” he added.

In this global environment and amid heightened competition from other tech hubs, the Israel Innovation Authority recommended a strategic plan to develop a number of areas to sustain and improve the competitiveness of the country’s tech ecosystem.

First, the Israeli government needs to identify new growth engines and channel resources and financial investment to new markets in which there will be demand for new technologies, such as climate tech and health tech. In these areas, Israel could become an exporter of global solutions helped by removing regulatory barriers.

“A lot of the innovation that we saw in the last decade was riding the wave of the digital economy but humanity’s challenges are different today,” said Bin. “The digital economy will not help feed the planet’s population; it will not help in producing enough clean energy, or smart transportation.”

A row of solar panels on display at the first Climate Prize Solutions Festival, a climate tech gathering honoring Israeli innovation, October 26, 2022. (Studio Thomas)

“A lot of human challenges are now residing in places where software alone is not enough. You need a combination of some tangible product or electronics together with software and artificial intelligence,” he said.

There are about 516 climate tech companies in Israel out of which about 24% operate in the energy sector, and 37% are involved in agriculture, food, and water. The pace of fundraising for climate tech companies has grown threefold from less than half a billion dollars in 2018-2019 to over $2.5 billion in 2021, according to the report.

Second, Israel needs to strive to increase the demographic and geographic diversification of its high-tech industry from the center of the country to other areas around the country and promote the integration of significantly underrepresented groups of the population.

Third, the government needs to create incentives to encourage Israeli entrepreneurs to form new startups, which have been declining in recent years, by providing a supportive framework for them to grow as Israeli companies and to succeed globally.

“Innovation is intensifying exponentially and will determine which countries lead in national and economic resilience,” Israel Innovation Authority chairman Ami Appelbaum stated. “We are at the threshold of a period in which three domains of innovation are poised to transform the world as we know it: Generative AI, quantum computing and communication, and innovation in climate-related fields.”

“The need to preserve Israel’s national resilience does not allow the country to slow down innovation in any of these areas and lag behind. It is a period of deep economic and social crisis, but also a period that presents opportunities if we can navigate wisely,” Appelbaum remarked.

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