A correction, not a burst bubble: Israeli tech sector grapples with market realities

The global tech industry has seen better days. In recent months, private and public companies, including US tech giants, have put in motion thousands of layoffs and hiring freezes as the sector hunkers down amid a market downturn that took off this past spring.

Israel’s celebrated tech sector has been no exception to the slump. Here too, layoffs are in the headlines nearly every day as companies look to cut operating costs and gain more “runway” during this period. Raising money is much more difficult in a jittery market and companies are hoping to stretch the cash they have for a longer period to ensure their survival.

In the first six months of 2022, Israeli companies raised $9.8 billion, a 30% drop compared to the second half of 2021 — a year in which Israeli companies nabbed $25.6 billion in private investments, according to the latest tech report by research center IVC and LeumiTech.

But 2021 was an unprecedented funding year and a record year for global tech IPOs and M&As, unlikely to be repeated any time soon.

Investment firms and financial institutions have been warning of a tough road ahead.

The current squeeze is part of a “much-expected” market correction, according to Jon Medved, founder of investment firm OurCrowd.

“The reality now isn’t the ‘go-go-go’ bull market of six months ago. 2021 was a record year like no other — IPOs, investments, growth. The market has come down and that is normal,” Medved told The Times of Israel.

Uri Gabai, CEO of Start-Up Nation Central’s Start-Up Nation Policy Institute, said the past 18 months or so have been a “hyped period in high-tech. We see that in VC investments and fundraising as they go hand-in-hand. As investments go up, demand for talent goes up and you have rapid growth.”

“What we are seeing now is a turning of the tide, and we are possibly headed toward a recession,” added Gabai.

Amid rising inflation and interest rates, a battering for stocks, a global economic slowdown, an energy crisis sparked by the Russian war on Ukraine, and ongoing supply challenges, whispers of a recession — a prolonged downturn in economic activity — have grown louder.

The International Monetary Fund (IMF) last month downgraded its global growth outlook and warned of “gloomy, more uncertain” times.

“The world may soon be teetering on the edge of a global recession, only two years after the last one,” said IMF chief economist Pierre-Olivier Gourinchas in late July.

The IMF downgraded growth forecasts for most countries, including big revisions for the United States and China, cutting more than a point off the prior forecasts to 2.3% and 3.3% respectively.

In Israel, the central bank last month cut its economic growth forecast for 2022 to 5%, and 3.5% in 2023, down from its February projections for 5.5% for 2022 and 5% for 2023.

The tech sector is a vital part of the Israeli economy, with tech exports accounting for almost half of all Israeli exports of goods and services in 2021.

Was it a bubble?

There’s been much speculation about whether the current period can be compared to the “dot-com” era of the late 1990s and early 2000s, marked by investors pouring money into new and promising internet-based businesses as internet use and access exploded.

These investments led to a rapid rise in US technology stock valuations, with the tech-dominated Nasdaq Composite Index rising some 400% between 1995 and 2000. But things started to turn in 2001 as it became clear that many of these companies, while exciting, were just not profitable and were burning through their venture capital or capital raised through IPOs. Amid rising interest rates in 2000, the bubble burst in 2002 with the Nasdaq dropping almost 77%, tanking valuations and wiping out many dot-com companies. Famous survivors include Amazon and eBay.

While there are similarities between the two periods — mainly regarding speculation-driven investments and the free flow of cash — there are also key differences.

In a nutshell, the global tech industry has many more high-quality businesses now than in the late 1990s. Today’s big tech companies, like Amazon, Apple, Google, Microsoft and Meta (Facebook), are huge and bring in massive profits that are in line with their stock prices.

And although the Nasdaq Composite Index has gone down by about 20% since last year, there’s still huge demand for tech, emphasized by the effects of the COVID-19 pandemic.

“The need for innovation to solve huge issues has only increased,” said Medved, pointing to growth in food tech, water and energy tech, and health tech — all looking to address crises or core challenges.

Sagi Dagan, vice president and head of strategy at the Israel Innovation Authority, told The Times of Israel that while the downturn is part of expected cycles in the global economy, “nothing has changed in the macro demand for tech.”

And the boom or bust, and everything in between, depends on the sub-sector.

“Defense tech is booming, demand for cybersecurity will keep increasing, cleantech or climate tech growth is not big but demand is up, and demand for health tech is long-term,” said Dagan, adding that there are sectors that are “growing rapidly.”

Gabai noted that companies in the fintech space and the enterprise software sector were among those that became overvalued in 2021 and are likely to experience a “bumpy road ahead.”

In a report last week on the stability of the Israeli tech sector, the Bank of Israel said that while the global slowdown is expected to continue, the current crisis, at least for the local industry, was unlike the dot-com bubble.

The tech sector is currently “more mature and more diverse” than it was 20 years ago, the bank said.

Israeli tech sector employees account for just under 10% of the workforce, or roughly 350,000 people.

But there are areas of concern. Thousands of people have lost their jobs, and some “11 percent of those currently employed in the sector work for startup companies that are at the greatest risk of a hit to their operations due to a slowdown in capital raising.”

In the short term, the bank said, the downturn’s impact will include a decline in state revenue from taxes (mainly on income from the realization of capital gains), a halt to salary increases due to a slowdown in hiring, and possibly more startup closures due to cash difficulties.

Also, the declines in the market are expected to reduce foreign exchange conversions by local tech companies by about $700 million, or 0.16 percent of nominal GDP, according to the central bank’s estimates (compared to if the Nasdaq had remained at its peak in late 2021).

In the medium term, insofar as the global economy continues to slow, the Israeli tech sector could see a decline in demand for its goods and services as well as a growth slowdown due to less capital being available, the Bank of Israel noted.

The local tech sector relies heavily on foreign capital, largely American. In the first half of 2022, 64% of investment funds that flowed into Israeli companies was foreign, according to the IVC-LeumiTech report. In 2021, when Israeli companies raised a record total of investments, 69% was from non-Israeli investors.

“When Wall Street and Silicon Valley catch a cold, Israel is going to sneeze,” Medved said wryly.

The good, the bad, and the mixed

There is some good news. The big foreign funds that set up a presence in Israel “show no signs of packing up and going back home,” Medved pointed out.

“There are still plenty of opportunities for startups to raise money. Israel is a global player in tech. And Israeli companies are inherently better at making do with less; they are capital-efficient, flexible, quick, and good at pivoting,” he said.

“There are startups that are still growing and doing well, despite market conditions,” added Medved, noting that investments in early-stage or growth-stage companies remain strong.

The so-called “mega-rounds” of $50 million or more in Israeli startups dropped by almost 50% between the fourth quarter of 2021 (a record quarter) and the second quarter of 2022 (Q2 2022), according to the IVC report, but funding below $50 million remained stable.

“The strength in early rounds could… signal a shift in investors interest to more potentially lucrative investments than the hyper-growth companies, which are now considered overvalued,” the report said.

The silver lining here, according to LeumiTech CEO Timor Arbel-Sadras, is that the crunch “will eventually lead to healthy economic conduct of the high-tech industry,” making it focus on growth, operational efficiency, and established business models. Mature companies that “act in accordance with these principles will overcome the challenges and run successful funding rounds,” she said.

For investors, there is still “tremendous dry powder [committed but unallocated capital in VC firms] funds available, and people don’t get paid for sitting on it. There are lots of exciting opportunities out there and this is a good time to invest in companies, as their valuations have come back to Earth.”

“Moneywise, this is a great time to make an investment,” he said. “Strategic acquirers will also start making smart acquisitions.”

“We are also likely to see consolidation. Startups will join forces and leverage each other’s strengths,” he added.

Medved, like other top investors, emphasizes the cyclical nature of markets and the need for perspective.

“This world [of stock markets investments] is cyclical. There were many good years — we’ve had an incredible run of 14 unbroken years of growth, since 2008 following the global recession,” Medved said.

Now, “there’s a course correction” and Israel’s tech sector will “come out stronger, it has a proven ability to survive crises. Israeli companies tend to move fast, and they are good at making do with less,” said Medved.

Eze Vidra, a co-founder and managing partner at Remagine Ventures, an early-stage fund investing in Israel and Europe, wrote in a post last month that “startups can take advantage of their nimble size and ability to move fast and take risks.”

“Every industry is being transformed with tech. Innovation never stops and the potential to reach people/clients is bigger than ever,” wrote Vidra, a former general partner at Google Ventures.

Medved said that if we take a long view of history, “many great companies were forged in difficult times.” Notable examples include Amazon and Salesforce.

It is in hard times “that the great entrepreneurs shine,” wrote Alan Feld, founder and managing partner of Vintage Investment Partners, in a LinkedIn post last week. “The great entrepreneurs care (and always cared) about bringing value to their customers, product-market fit, unit economics, proving the model before raising too much money, sales efficiency and raising at a valuation that was reasonable and that would not force them to raise in a downround subsequently,” he added.

But the market shift is painful. Companies are contracting, cutting spending, and laying off staff.

“There’s a focus on runway. The easiest money to raise is the money you already have. It’s not easy to cut costs but it’s also not easy to raise money,” Medved noted. OurCrowd is advising its portfolio companies to “stay close to customers and focus on their areas of growth,” he added.

Tech talent shortage

The layoffs are also not necessarily across the board. They vary by industry and description.

“Let’s just say that there won’t be any unemployed software engineers,” said Dagan.

Demand for such roles has been rising amid a chronic shortage of tech talent (engineers, developers, and computer science professionals), in Israel and globally.

According to the latest Human Capital in Tech 2021-2022 report by the Start-Up Nation Policy Institute and the Israel Innovation Authority released last month, there were 33,000 vacant positions in the Israeli tech industry as of March-May 2022. Many of these — about 12,000 — were for non-tech positions that may have since been cut, according to the report.

The number of vacant positions for tech-heavy roles has risen slightly compared to July 2019, at about 20,000, the report noted.

The shortage of deep tech talent, where desired candidates usually have backgrounds in engineering and development or are fresh out of elite intelligence units in the Israel Defense Forces, connects to a lack of diversity.

The tech workforce has been dominated by a Jewish male majority for years, and the lack of diversity and inclusivity has been marked as a risk to the tech sector and its growth potential.

“High-tech is preserving its homogeneity as a Jewish industry: less than 20% of its salaried employees are Arab, most of its employees are non-ultra-Orthodox men, women comprise less than a third of all the industry’s salaried employees, and ultra-Orthodox men and women comprise only 3%,” read the report.

The government has been looking to address this shortage by encouraging members of underrepresented communities to join the tech scene through specialized programs and plans, but in a downturn, those with rich tech background have the upper hand, Gabai noted.

Many of the layoffs are occurring outside core tech roles.

“There’s optimism for tech employees; there’s also concern for new hires, juniors [developers with 1-3 years of experience], sales, people without a rich background in tech. Those with more education are in stronger positions,” he said.

Dagan estimated that we are likely to see a “reallocation of talent from different sectors, as some sectors are booming, some are not.”

The Bank of Israel report on the sector noted that “since Israeli high-tech in recent years has featured high demand for employees and a lack of skilled labor, it is likely that an adverse impact to employment among some firms in the sector would mainly be reflected in the transfer of employees to more stable firms, with less prolonged unemployment.”

“The high-tech sector is diverse; we won’t see the same behaviors across the board,” said Gabai. “B2C [business-to-consumer companies] are more affected, B2B [business-to-business] too.”

“There are lots of good companies out there. We’re not worried for the long-term. We are worried about the next five weeks, the next five months,” Gabai said.