Israeli entrepreneurs seen incorporating startups in the US amid judicial overhaul

A 32-year-old Israeli entrepreneur set up his cybersecurity company in Israel in December. Now he regrets the move, he said in an interview with The Times of Israel, as the uncertainty regarding changes to the judiciary in Israel has made it difficult to get foreign investors on board. As a result, he has started a process of “flipping” his company — reincorporating it in the US state of Delaware.

“I found a good and known investor in Silicon Valley and very soon we realized we were a good fit,” said S, who declined to have his name and his company’s made public because of the sensitivity of the situation.

“But very soon, the investor made clear to us that he thinks it’s a strategic mistake for the company to be an Israeli firm and not to be a US one. He said he’s prepared to invest the money only if we reincorporate in the US.”

“Of course, some US investors have required this in the past as well,” S acknowledged. But this particular investor has invested in Israeli-incorporated firms in the past and is now requiring a US incorporation instead.

The investor didn’t specifically say it was because of the judicial upheaval undergoing in Israel, S noted, but it was implied. “He said something like ‘we prefer the stability of the US business climate.”

The entrepreneur said that had it not been for the investor’s request, he wouldn’t have flipped the company into a US one. “We would have probably eventually opened up a subsidiary in the US,” he said.

Yair Geva, head of the tech division at Tel Aviv-based law firm Herzog Fox & Neeman. (Moshik Brin)

Almost all new startups set up by Israeli entrepreneurs are incorporating their businesses outside of the country, mainly in the US, as a direct consequence of the judicial reform that is being spearheaded by Prime Minister Benjamin Netanyahu’s coalition government, two Israeli lawyers told The Times of Israel. Others, like S, are reincorporating their firms in the US at the request of new investors, the lawyers said.

This is set to have an impact on the economy, translating into less tax for the country’s coffers and damaging Israel’s position as a tech powerhouse. Even worse, experts say, the new trend is pushing the tech industry back by decades to its early days when Israeli firms would register in the US to be closer to their investors and market.

“Since the start of the judicial overhaul, we are seeing almost 100% of new startups incorporating in the US as opposed to Israel, whereas before, the vast majority was setting up in Israel,” said Yair Geva, head of the tech division at Tel Aviv-based law firm Herzog Fox & Neeman.

“People are losing trust in Israeli democracy, in the independence of the judiciary, and more broadly the damages to stable professional unbiased institutions such as the Bank of Israel.

“This means that over time Israeli companies won’t be identified as such. They’ll be able to quickly liquidate activities here and go elsewhere, resulting in job losses, intellectual property (IP) loss and tax losses. All of this will compromise the Israeli tech brand,” Geva said.

The proposed changes would grant the government total control over the appointment of judges, including High Court justices, and severely limit the High Court’s ability to strike down legislation. Some lawmakers have also challenged the independence of the central bank and the impact of interest rates on mortgages.

The plans have triggered mass rallies around the country and opposition from leading economic voices, former policymakers and technology leaders who say a strong democracy and a system of checks and balances are essential for the economy and its thriving tech sector, which is the nation’s growth engine.

Israelis wave a placard as they protest against the government’s controversial justice overhaul plans in Tel Aviv on March 4, 2023. (JACK GUEZ / AFP)

Moody’s rating agency cautioned Tuesday that the government’s plans to curb the judiciary could weaken the country’s institutional strength and negatively affect its economic outlook. Earlier this month, Fitch Ratings affirmed Israel’s A+ credit rating with a stable outlook, citing the country’s “diversified, resilient” economy, but warned that the planned judicial changes could have a “negative impact” on the country’s credit profile.

Israel’s economy expanded 6.4% in 2022, with the tech sector accounting for some 50% of exports and 15% of the nation’s GDP.

The uncertainty about the legal overhaul is creating “a lot of ambiguity” in the tech industry, said Itay Frishman, a partner at Tel Aviv-based Meitar Law Offices, one of the largest law firms in Israel.

“New startups are being formed as Delaware corporations, and existing Israeli startups and companies are doing re-incorporations or what we call a ‘flip’ – where you flip from being an Israeli company into a Delaware corporation,” he said.

When a company is flipped, the structure of the firm is changed so that the parent company becomes a Delaware corporation and the Israeli entity, which is still needed because of its local employees, becomes a subsidiary of the US firm.

“The flip comes in most cases because of a request by investors,” explained Frishman. “It is generally new investors who are demanding that the company flip into a Delaware corporation.”

Itay Frishman, partner at Tel Aviv-based Meitar Law Offices. (Courtesy)

Because of the global economic downturn and a drop in global venture capital, Frishman said, startups have no choice but to comply. If an investor says “I’m willing to put money in right now but I demand that you do a flip, there is not much a company can do. It’s not like you have dozens of opportunities out there.”

Still, investors “don’t really care about the details” of Israel’s judicial reform, said Frishman. “They hear what the experts are saying, and if the experts are saying this is not good…and there is enough instability, that is enough to cause them to say, Hey, I want a different structure.”

Frishman said that while before the judicial overhaul push, 15% to 20% of new startups were incorporated in Delaware, today he sees some 80% of new companies incorporating there. And some 50% to 75% of new investors are demanding existing Israeli incorporated companies reincorporate elsewhere, he said.

“I don’t have all of the numbers, but I wouldn’t be surprised if we are talking about hundreds that are doing it or seriously considering it,” he added.

According to preliminary data compiled by IVC Research Center, which tracks the Israeli tech industry, there were over 394 new startups set up in 2022, including incorporations in Israel and in the US.

Lower tax revenues and intellectual property loss

The main concerns of this trend, explained the attorneys, are lower tax revenues for Israel and the possible flight of workers and intellectual property to foreign shores in the longer term.

When a company is incorporated abroad, said Geva, “you lose taxes from the profits of shareholders that sell (their shares) when the companies are sold.”

Tech workers protest Israel’s right-wing government in Tel Aviv, Tuesday, Israel, Jan. 24, 2023. The Hebrew on the blue sign reads: ‘No democracy, no high tech; and the yellow sign reads: “No to the coup d’etat.’ (AP/ Maya Alleruzzo)

In addition, if the company is incorporated in the US, Israel loses revenues on dividend payments made to foreign investors. If the company is incorporated in Israel, then foreign investors are not exempt from taxes on dividend payments. “So you are losing taxes on all the dividends from profits to foreign investors,” he said.

Intellectual property rights are another important issue to consider, Geva said. When entrepreneurs set up their companies in Israel the intellectual property on the technology is generally registered locally as well, and taxes can be imposed on the generated revenues.

But in the long term, he said, if a company is US-incorporated, it will eventually escape the Israeli tax regime.

Intellectual property changes over time, Geva said, and what is relevant today can be irrelevant in two years, with companies constantly upgrading their technologies.

“These companies over time can gradually or quickly decide simply to develop the new IP in other jurisdictions,” triggering a revenue loss for Israel. “If the company is Israeli you’d never lose it.”

Tech ecosystem in jeopardy

In the nineties, when Israel’s tech industry was in its infancy, almost all of the startups were registered in Delaware in order to be close to investors and the end market. Over the years, however, as the local ecosystem developed, Israeli entrepreneurs started registering their companies locally due to a more friendly tax regime and as US and other foreign investors slowly learned that their investments in Israeli firms were safe.

This evolution has enabled Israel to transition from being a startup nation, as it is often dubbed — a country with a plethora of startup entrepreneurs selling their business to the highest bidder for a quick, albeit smaller, return — to a scale-up nation, where entrepreneurs hold on to their companies for longer and develop them into large, often billion-dollar unicorn companies.

The shift has triggered a whole ecosystem of complementary businesses that have developed around these firms – including a network of local and international accountants and lawyers and bankers who service them.

Tel Aviv’s financial business district skyline June 2022 (Elijah Lovkoff via iStock by Getty Images)

“The tech ecosystem includes many unicorns, some of them selling in billions of dollars,” said Niron Hashai, dean of the Arison School of Business at Reichman University in written comments. “Such firms are ‘complete firms’ which not only enroll programmers or engineers, but many other employees that support the business side of technology (marketing, product management, support, design). The center of these firms’ business is in Israel and importantly most of their intellectual property. This means that a large share of the revenues from tech is channeled to Israel.”

“If more and more firms revert to being incorporated in the US none of this will continue,” Hashai said.

“Once startups will grow, they will move their center of activity to the US. IP and related revenues won’t be assigned to Israel. This does not only mean loss of revenues and potential employment (that of non-tech employees), but also places a glass ceiling on the future growth of the tech ecosystem in Israel.”

Aware of the threat to their activities, Israeli tech leaders have taken to the streets to protest the judicial overhaul and some have started to pull assets out of the country, often at the request of their foreign investors. Tech unicorn Riskified said Wednesday that it would be transferring $500 million out of the country, citing concerns that the government may begin to place restrictions on cash transfers. Additionally, the company is offering a limited number of relocation packages to interested staff members.

Israeli cybersecurity startup Wiz, which raised $300 million at a $10 billion valuation in its latest private funding round, said last month that the capital will not be invested in Israel given the uncertainty around the country’s judiciary system.

One of the major investors in the Israeli tech sector, Bessemer Venture Partners, in February called on its companies in Israel to consider moving assets out of the nation’s banking system.

“It seems like the path we are walking on right now will lead to a wiping out of 30 years of educating investors and building a legal system to support the Israeli tech industry,” said Meitav’s Frishman.

Investors are willing to take a risk on Israeli technologies, he said. But they will not be prepared to take a risk on Israel’s legal system.

Brain drain fears

Over time, Frishman said, not only will we see companies reincorporating in the US but also an “actual relocation of the best brains in Israel outside of the country.”

S, the entrepreneur who is in the process of reincorporating his startup, said that it took decades of hard work to make Israel a place in which US investors felt comfortable investing. Now, he said, their concern is “palpable,” due to the “uncertainty and “noise” arising from the judicial overhaul.

“If investors are concerned and they don’t want to take a risk, they won’t take it. They are not interested in politics or other things,” S said.

At the moment, he is not moving the company’s IP out of Israel, he said, because that step is far more drastic and more complicated to do — unless he has to. “There is a chance that the investor will demand that too,” he said.

When he set up the cybersecurity firm in December, S debated whether to set it up as an Israeli or US entity.

“It was a mistake to set up in Israel,” he said. “Going forward, my advice to new startups will be to set up in the US.”