Two weeks ago, for the first time in 18 months, the shekel-dollar exchange rate fell below NIS 3.50/$, following a 7% gain for the shekel against the dollar this year. There are many and varied reason for the strong shekel, relating to the strength and attributes of the Israeli economy, but the cut in the US interest rate also played a role. The US Federal Reserve Board recently raised the interest rate, but last month, for the first time since 2008, it reversed direction.
Israel's tech sector has been experiencing an unprecedented boom in recent years due to developments that have brought about a digital revolution including the Internet of Things. The low interest rate, however, also made a significant contribution. "The low interest rate, which will probably continue to fall in Israel and throughout the world, is diverting money and resources to higher-risk investments that can generate a higher return, and the technology industry will probably benefit from this," says Deloitte Israel TMT Corporate Finance Advisory head Tal Chen, CPA. Furthermore, the many investments and the intense competition by investors for the startups themselves have boosted valuations and generated many unicorns (private companies with valuations of over $1 billion).
Natalie Refuah, a partner in the Viola Growth venture capital fund, predicts that the presence of financial institutions in technology investments will increase in the near future. She also comments on Israeli investment institutions, which invest in the tech sector much less than their counterparts elsewhere in the world. "The Israeli investment institutions have more personnel today, because they manage a great deal of money that comes in shekels, which can be used to make bigger investments in dollars," Refuah says.
If we pay attention only to the low interest rate, the boom seems likely to continue. Incidentally, given interest rate hikes, no one thought that money for the tech sector was going to dry up all of a sudden - gradually, over a number of years, it would be likely to have an effect. The interest rate, however, is not the only variable; uncertainty concerning the entire global economic situation is also part of the equation.
"We are in a period in which economists and economic figures say that the laws of economics are beginning to fray before our eyes. The rules don't fully work, and there are many vectors playing a role today that are pulling in different directions, says PwC Israel partner and technology leader Guy Preminger.
"Trade and currency wars are now taking place between the blocs. It's not just between China and the US; it's also the US and Turkey, Iran, and Russia. There are also such centers in Europe and the UK. It's a rather special period in which anything can happen. It can end with all of the leaders shaking hands and reverting to the situation as it was a year or two ago, but it can also end with aggressive measures leading to a steep fall in world trade," Preminger adds.
Refuah, on the other hand, is more encouraging: "Some people are talking about an imminent colossal crisis; others believe that everything can go on rising. When people have been managing money for a great many years, we know that the market eventually reached equilibrium. The numbers and data in the market don't show that people think there's going to be a crisis in the dynamic of the markets. People are still investing, the markets continue going up, and everything is just rising almost everywhere in the world."
Israel is becoming less attractive
If the low interest rate is supposed to boost the entire global technology industry, the effect of the strong shekel on Israeli industry is not necessarily positive. Actually, various players in the industry are affected differently by the appreciating shekel. Development centers are affected in a different way than startups, and have different considerations than those of venture capital funds.
"The Israeli consumer will think that the strong shekel is good, because it makes it possible to travel overseas more cheaply and import goods more cheaply (good for importers), and therefore to buy more cheaply in Israel. But it's not necessarily good for the Israeli economy and the Israeli tech sector," says Roundforest VP finance Zvi Noy. "Israeli technology mainly appeals to foreign markets (US, Europe, Asia), because the Israeli market is too small to build a strong and stable business model. Every startup therefore turns to foreign markets, and is immediately exposed to foreign currency risk. In the simplest way, as soon as you put in foreign currency and get shekels out, your 'purchasing power' weakens as the shekel strengthens. This results, for example, in personnel costs in Israel being more expensive for the company.
"A basic condition today for a company entering some of the tracks in the Law for the Encouragement of Capital Investments is substantial export activity. This means that the state has the same interest as startups in increasing exports, and therefore has to foster them - and this also means a monetary policy that will weaken the shekel when necessary," Noy adds.
"Today, from the very outset, one of the major decisions by startups is where to establish a development center: in Israel or overseas. An overseas development center costs much less but a local center means management is close by and much more control. Everything has advantages and disadvantages, but the exchange rate has a very great effect on this dilemma, and the more that the shekel strengthens, the more significant this factor becomes," Noy explains.
The higher cost of personnel affects not only Israeli startups, but also Israel's attractiveness as a target for establishing international development centers. "As the shekel-dollar exchange rate falls, the salaries of programmers in dollars rises, and this can lead to a situation in which international companies operating in Israel reduce their activity here. There is no doubt that if the shekel continues to strengthen, it will generate a lot of pressure on the industry," says Deloitte head of valuation practice Dov Kacowicz.
"The Israeli tech sector has become more expensive in recent years. Salaries have been rising to US levels - less only than in Silicon Valley, but substantially more expensive than in other regions in the world competing with us," Chen adds. "Where R&D centers and activity of foreign companies are concerned, most of them work in Israel with profit margins of 7-12%, and in recent months, as the shekel continues to strengthen, they are having to increase their budget in order to maintain this level of profit."
"Startups - Not forex traders"
The effect of the low shekel-dollar exchange rate on the technology sector is extensive, but various people we spoke with believe that there is an especially significant effect on financing rounds by startups in the early stages - those that do not yet have overseas development centers and have not yet begun sales, in addition to the general effect of the strong shekel on the Israeli economy.
For example, an industry source who asked to remain anonymous told us, "With a strong shekel, growth companies whose revenue is in dollars will simply add to their international offices and transfer activity out of Israel. It's no problem for them to do this, but it will cause irreversible damage to the economy. Early stage startups, on the other hand, don't have this flexibility, and every investment they get in dollars will be worth fewer employees, fewer development years, and less maturity. No one will return to them the time and money that they lose because of the strong shekel. It's simply a disaster for the economy."
"Companies in the early stages raise money in dollars and spend money in shekels. When we invest in a company, we tell the founders to look at their spending in shekels and in dollars, and to convert all of the money to shekels as long in advance as possible. We tell them, "Neither we nor you are forex traders. You have so many things to worry about; don't get involved in that, too,'" says StageOne Ventures managing partner Tal Slobodkin. "Companies that already have a CFO will start trying to manage this with more complicated financial tricks, but not the small companies."
Slobodkin says that among funds specializing in investments in young Israeli startups, the usual practice is to direct portfolio companies to convert money from their financing rounds to shekels, or to use hedging tools (preserving a fixed value for the same amount of foreign currency). At the same time, he says, "Today, banks in Israel give better interest rates on dollar deposits than on shekel deposits. It's stupid, and reinforces the lack of sophistication among young startups, because if they deposit money from their financing rounds in dollars, they may get 2% interest, but they lose 10% when the shekel-dollar exchange rate goes down."
Cheap debt does not necessarily help
Israeli technology companies are likely to benefit from the indirect effect of lowering the interest rate in the form of new investors with available capital and increased consumption of technological products. At the same time, the financing methods prevailing in the industry are unsuitable for the new economic situation. "Technology companies, and certainly companies that do not yet have revenue, are not companies that finance themselves through debt - certainly not bank debt - and they therefore do not benefit from an interest rate cut," Chen says. "They finance themselves by raising capital, and a lower interest rate detracts from the already minimal interest on their deposits."
In a financing round, especially in the early stages, large stakes in the company's ownership are given to investors in exchange for the high risk. Raising debt, on the other hand, becomes especially attractive when the interest rate is low. Therefore, Noy says, "There is today a trend among companies that have reached a slightly later stage to raise debt from funds and banks at more attractive interest rates. The technology departments at banks are now offering technology companies loans on the basis of current revenue and prospective future revenue. The fund backing the company can also affect the decision whether or not to take a loan."
On the other hand, the debt-raising tool is still limited. Chen stresses, "The debt alternatives for startups today are not significant in Israel. While we see that industrial companies have been successful in raising debt at very low interest rates in the past year, the interest rates on debt for the technology sectors, especially for startups, are not going down to the same level. A substantial proportion of the companies have no access to debt raising, because they are not in the relevant stages."
Published by Globes, Israel business news - en.globes.co.il - on August 13, 2019
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