Israeli tech rebound hinges on judicial reform
Al-Monitor Pro Members
Israeli reporter specializing in business, economics and politics
Feb. 27, 2023
The downturn in Israeli high-tech is likely to deepen this year as start-up funding continues to decline. The sector’s strong human-resource assets, looser monetary policy and a renewed global appetite for innovative technology should lead to a recovery perhaps as early as the second half of 2023. However, the government’s judicial reforms and hardline Palestinian policies and a resulting upsurge in violence may delay or weigh down on the rebound by undermining business sentiment.
- Israel’s start-up-focused tech sector suffered a 40% decline in funding to $15.5 billion last year from a record $25.8 billion in 2021, according to figures from industry tracker IVC Research. However, the 2022 total was the second-highest ever and the decline to a degree reflected a return to the sector’s long-term average.
- The fall in Israeli fundraising has paralleled a global start-up funding downturn (in the United States funding also declined 40% in 2022 to $67.3 billion, according to PitchBook Data). Behind the drop were rising interest rates and fears of a recession, which prompted a global sell-off of tech stocks. The tech-heavy Nasdaq Composite index dropped 33% last year.
- Early indications point to a further decline in Israeli start-up fundraising in 2023, with data based on media reports of announced funding rounds showing that about $550 million was raised in the first eight weeks of the year. That compares with about $600 million to $960 million in each of the final four months of 2022, according to IVC data.
- The short-term impact of the downturn has had the positive effect of winnowing out poorly performing companies bringing start-up valuations to more reasonable levels and (due to layoffs) easing a chronic labor shortage that had worsened during 2021. Laststart.com, which collects data on announced layoffs, puts staffing cuts since last April at about 10,350. The real total is almost certainly higher.
- A recent rally in Nasdaq stocks isn’t widely believed to be sustainable, as analysts see further US interest rate rises until mid-year, thus rate relief for the stock market and the tech sector may not emerge until later in 2023.
- Plans unveiled on Jan. 4 by Israeli Prime Minister Benjamin Netanyahu’s government to weaken the courts by, among other things, reducing their ability to overturn legislation and giving politicians control over judicial appointments, have encountered unusually strong opposition from the tech sector.
- High-tech’s concerns about the judicial overhaul have been expressed in street protests and public statements by industry leaders. Companies like cybersecurity company Wiz and the venture capital funds Papaya and Disruptive have announced they are pulling capital out of the country. An investigation by the Calcalist financial daily estimated that as of mid-February about $780 million held in local bank accounts had been transferred abroad. Another $2.2 billion in funds originally slated to be brought to Israel is remaining abroad.
- Meanwhile, security officials warn that the Netanyahu government’s hardline Palestinian policies and encouragement of settlements are further inflaming the already elevated level of Palestinian violence of the past year and risking a new intifada. On Feb. 22, an unusually large number of 11 Palestinians were killed in a firefight with Israeli troops in the West Bank city of Nablus.
- Foreign capital accounts for about 75% of all Israeli start-up fundraising. In addition, exits via initial public offerings and merger and acquisition deals almost always involve either a foreign stock market listing or a foreign buyer. Thus, political quiet and a positive global image for Israel are critical for the industry.
- The tech industry’s success or failure will reverberate across the Israeli economy. High-tech has long been the driver of economic growth and accounts for 15% of gross domestic product, 54% of exports and 11% of employment, according to the Israel Innovation Authority. High-tech employees, who enjoy very high pay, account for 24% of all personal income tax revenues collected by the government.
Scenario 1: Sector rebounds amid compromise on judicial reform
The government compromises on enough provisions in its judicial plan to assuage the tech sector’s most serious concerns. However, hardline policies in the West Bank inflame tensions and violence continues to grow, short of an intifada. Netanyahu has signaled a willingness to back down on judicial changes in the face of opposition from high-tech and other business sectors. Under US pressure, he may also moderate West Bank policies, reducing the risk of widespread violence. The US Federal Reserve’s monetary-tightening policy is expected to wind up by mid-year. Under these conditions, foreigners shouldn’t be deterred from investing in Israel and local business sentiment should remain positive. The Israeli tech sector will thus follow global trends and begin enjoying a rebound late in the second half of 2023.
Scenario 2: Unfavorable domestic conditions hamper tech recovery
The government pursues its judicial overhaul unchanged. The consequences will take time to manifest themselves in terms of politically tainted courts and government corruption, but passage of the measures is enough to cause high-tech investors and entrepreneurs to hesitate about entering into deals and starting companies. More capital, start-ups and (in the worst-case scenario) engineers and entrepreneurs leave the country as the business environment deteriorates. An upsurge in Palestinian violence exacerbates the situation. The Israeli industry shows some recovery, but even with interest rates heading lower and global stock markets recovering, Israel lags behind the global rebound. Netanyahu is well aware of the threat to the tech industry and therefore is unlikely to insist on the judicial overhaul being enacted in its current form.
Scenario 3: Upsurge in Palestinian violence
The government abandons the legal reform plan, at least for now, but the retreat forces Netanyahu to adopt a harder line on the Palestinians and settlements to ensure the loyalty of his far-right partners, exacerbating violence in the West Bank. The tech sector weathers such conditions, as it has in the past, and the industry recovery proceeds in tandem with a global one. However, if the violence grows, reaching inside Israel and provoking a strong Israeli crackdown, the sector will struggle to ride a global recovery, even if conditions worldwide turn favorable. This scenario is less likely to happen because the government is too invested in the judicial overhaul to jettison it.
Netanyahu recognizes the importance of the high-tech industry not only to Israel’s economy but to national security, as tech plays an increasingly important role in the country’s military capabilities (drones, cyberwarfare, intelligence). Despite his reputation as a hardliner, Netanyahu has traditionally acted cautiously vis a vis the Palestinians. The question is whether he can prevail over his far-right coalition partners both vis a vis the judicial overall and Palestinian/settlement policy. If he succeeds, the fundamental strength of the Israeli tech industry in terms of human capital and infrastructure, as well as a more favorable global environment as the monetary-tightening cycle winds down, should enable it to rebound in tandem with a global tech recovery late in 2023.
David Rosenberg has more than 30 years experience reporting, commenting and speaking on business, economics and politics in Israel and the Middle East. He has worked for Reuters, The Jerusalem Post and Dow Jones, and was bureau chief for Israel for Bloomberg News. He is the author of two books (Cloning Silicon Valley, 2001, and Israel’s Technology Economy, 2018) and has been published in The Wall Street Journal and Foreign Policy. He now writes commentary for the Haaretz daily.
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