Israel Israel

Exporting technology from the ‘start-up nation’

The Israeli government provides significant amounts of funding to the country’s start-ups via the Office of the Chief Scientist. But with the financing comes restrictions designed to ensure that the success stories will benefit the country as well as the entrepreneurs. Daniel Marcus and May-ad Katz explain how the system works.

n the two last decades, Israel has and implications of such restrictions? Israel's gross domestic product (in become a fertile ground for And how can they be dealt with comparison to an average of 2.33% in I technology and other start-up effectively? In addressing these OECD countries), while the Central companies. Extensive entrepreneur ship questions, we will open a window to the Bureau of Statistics reported that and a vibrant start-up industry have led Israeli companies received NIS 1.4 to the country being labeled the ‘start- Technology companies billion (approximately US$400 up nation’. Every year, Israeli start-ups million) from government resources. attract investors and buyers from in Israel may be subject This funding, granted through various around the world. The principal asset of to rather unique government entities and programmes, these start-up companies (and in including OCS programmes, is certain cases, their only asset) is their restrictions on the designed to support the research and intellectual property – the know-how export of their development of Israeli companies, and on which they are based. Consequently, intellectual property is recognition of the fundamental it is often the case that the main position of the high-tech industry as the objective of an acquirer of, or investor and the manufacture of main growth engine for Israel's in, these companies is to obtain direct their products outside economy. access to the intellectual property – in One of the governmental entities key order to transfer it to other countries. of Israel. to providing funding for the early stages With this in mind, foreign investors of technology companies (including the should be aware that technology relevant legislation and suggest seed and pre-seed stages), when such companies in Israel may be subject to solutions that may assist foreign investment is considered fairly risky, is rather unique restrictions on the export investors in exporting Israeli the OCS (see ‘OCS framework’, below). of their intellectual property and the intellectual property subject to OCS Receiving funding from the OCS has manufacture of their products outside restrictions. 1 several notable advantages for of Israel. The source of these companies: aside from the OCS’s restrictions is a governmental office OCS funding willingness to share the risk of the loss known as the Office of the Chief The start-up industry in Israel receives of its ‘investment’ in the company, the Scientist (the ‘OCS’), which serves as a extensive financial support from the OCS does not demand any equity in part of Israel's Ministry of Industry, government, which allocates significant return for its funding, nor does it Trade and Labor. yearly budgets to further develop and interfere with the company's day-to- In this article, we will try to provide strengthen it. For example, according to day management decisions. answers to the following principal the OECD, in 2010 the gross domestic OCS-funded companies are required, questions: What is the legal basis for expenditure on research and however, to repay the funding they these restrictions? What are the content development in Israel was 4.25% of receive by way of royalties from future

OCS framework spent in order to support the R&D additional money from the private projects run by hundreds of Israeli sector and operating on their own. The The Ministry of Industry, Trade and companies. Another programme OCS's MAGNET programme Labor’s Office of the Chief Scientist administrated by the OCS is the encourages collaboration among (the ‘OCS’) oversees a significant Technological Incubators Programme, industrial companies and between the portion of the Israeli government’s which was established in 1991. Since companies and researchers from support for research and then the programme has undergone academic institutions. development. It operates through a many revisions and it currently has 25 The OCS also operates other number of domestic and international technological incubators, with their domestic programmes such as TNUFA programmes, agreements and primary goal being to transform (assisting entrepreneurship and collaborations. The R&D Fund is the innovative technological ideas into innovation at pre-seed stage) and the main instrument by which the OCS viable start-up companies that, after Life Science Fund, as well as various provides its support. Its annual budget the incubation period (typically 18-24 international programmes for is approximately NIS 1.5 billion, and is months), will be capable of raising cooperation in R&D.

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sales. In addition, by receiving OCS funds, a company subjects itself to the Export of manufacturing OCS's rules and regulations. As part of the process of approving the The rate of such royalties starts at 3% The Law for the Encouragement of plan that it has submitted to the and increases over time to up to 6% .8 Research and Development in Industry, Committee for OCS funding, the A decision to manufacture outside of 1984 (the ‘Law’) constitutes the legal company is typically required to Israel requires the prior approval of the basis for the restrictions on the export undertake that the product which will be Committee, which has sole discretion to of know-how and manufacturing rights, developed as part of the OCS-funded accept or deny the application for such and it sets up the framework under research and development project (or approval. If manufacturing outside of which a company may receive OCS any part thereof), will be manufactured Israel is approved by the Committee, funding. in Israel. then the approved company will be The process begins when a company The company will be obligated to pay obligated to pay royalties to the OCS in requesting OCS funding submits to the royalties to the OCS based upon its amounts starting at 120% of the total OCS's Research Committee (the sales of such products and any services funding amount, plus interest, that it ‘Committee’), a detailed plan for provided in connection with such received from the OCS – with the products, up to the total funding amount possibility of going up to 300% of such research and development, in received from the OCS, plus interest. amount, as shown in the table below .9 accordance with specific criteria, 2 with the hope of obtaining its approval. In Percentage of manufacturing Maximum royalties this respect, it should be noted that the transferred outside of Israel (as a % of OCS Committee is obligated, when deciding funding provided) whether or not to approve the granting of OCS funds to a company, to consider Up to 50% 120% seriously the candidate company's 50%-90% 150% declarations with respect to its plans to Over 90% 300% conduct the development and manufacturing in Israel. 3 Where funding is approved by the Committee, the Committee then In this context, the Law approval is subject to the sole discretion proceeds to determine the level of distinguishes between two separate of the Committee, which is not limited funding that it will provide. This scenarios, both of which require the by, or subject to, any specific statutory typically ranges from 20% to 50% of the prior consent of the Committee: (a) the criteria. research and development expenses. export of know-how derived from An obvious concern will be that the Here, too, in determining the scope of research and development conducted lack of pre-defined and structured the funding, the Committee is required with OCS funding; and (b) the export of criteria in relation to the Committee's to allocate significant weight to the manufacturing rights with regard to discretion could enable it to take into company’s declarations regarding products developed with OCS funding. account random considerations, development and manufacturing plans. Although the Law creates a distinction resulting in uncertainty for a company In this manner, the OCS seeks to between these two scenarios and as to whether its export application will achieve long-term benefits by way of applies different rules and quasi- be approved. In addition, receipt of the supporting those projects which, in its ‘penalty’ payments to them, the basic Committee's approval does not view, (i) have a high prospect for rationale for discouraging each by way constitute the end of a company's success and (ii) are likely to yield of applying the ‘penalty’ payments to relationship with the OCS. In fact, a commercialization and manufacturing both scenarios is the same: to increase company which has received an export activities in Israel. the financial value resulting from approval may be required to pay A company that has received the research and development for the statutorily-mandated increased OCS Committee's approval for its proposed Israeli economy, to create jobs, to sums, which are generally perceived as research and development plan is then develop science-based industry, to a financial ‘penalty’ for exporting granted OCS funding. The company is encourage research and development in outside of Israel Know-how which was required to repay the funding amount, the industry, and to improve Israel's funded by the OCS with the original plus interest, to the OCS, by way of balance of inbound/outbound intent (of both the company and the royalties from future sales of its payments. OCS) that it would be exploited by way products 4, which are produced by way of commercialization and manu - of implementation of, or which Export of know-how facturing in Israel. The company will incorporate or otherwise exploit, the The Law states that know-how which is almost certainly be required to repay know-how generated from the derived from research and development certain amounts to the OCS, in approved plan and any derivatives conducted with OCS funding, and any accordance with the manner in which thereof. Among other limitations, the right resulting from it (collectively the Know-how is exported, as follows: 5 company will be subject to restrictions hereafter referred to as ‘Know-how’), regarding the transfer of its know-how will not be transferred outside of Israel (a) If the company wishes to remain outside of Israel (but not of products unless such transfer is carried out with, incorporated in Israel but sell its which are manufactured in Israel and and pursuant to, the Committee's Know-how to a foreign entity, it will are subsequently exported for sale approval (which is supposed to be be required to pay an amount equal outside of Israel. This includes sales to granted by the Committee only in to the ratio of the aggregate grants end-users, resellers and distributors). special circumstances). In theory, such received by the company according

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to the Law to the aggregate financial the export. However, it is important company may try to import alternative investments invested in executing to note that such imported know- know-how. the approved plan, multiplied by the how will then become subject to all Third, in our experience, it is sale price of the Know-how, of the OCS restrictions, as if it were possible to make specific requests to the provided that this amount (i) will originally developed with OCS Committee, seeking confirm ation that not be less than the aggregate sum funds. certain types of quasi-transfers, or of all such grants, plus annual apparent transfers, of Know-how will interest (certain amounts may be In accordance with the recently nevertheless not be deemed or treated deducted from the outcome in published Regulations for the as such according to the Law. One accordance with the Law 6), and (ii) Encouragement of Research and common example is where a foreign will not exceed what is known as the Development in Industry (The purchaser (often an international brand ‘Ceiling Sum’ (see below); Maximum Amount Payable Pursuant company with worldwide goodwill and (b) In the case of a company ‘Exit’ on Account of a Transfer of Know-how reputation) of an Israeli company is (M&A) event – where the company Pursuant to Sections 19B(1) and (2) of permitted, with the Committee's wishes to export its Know-how the Law), 2012, the maximum amount approval, to view the source code which outside of Israel as part of a sale of that the OCS may require from was developed by the Israeli company the company and as a result the companies for the export of their Know- using OCS funds, in order to perform approval recipient has ceased being how in accordance with (a) or (b) above, integration with the purchaser's (and its a company incorporated in Israel. is six times the total OCS funding that subsidiaries') products. In this scenario, the company will The complexity of the question of be required to pay the OCS an There are ways to what actually constitutes an export of amount equal to the ratio of the Know-how outside of Israel may lead to aggregate grants received by the lessen the impact of different outcomes: we often encounter approval recipient according to the these restrictions. situations in which the OCS agrees, in Law to its ‘Aggregate Research and writing, that certain activities will not Development Expenses’ less certain be treated by it as a transfer of Know- financial assets, multiplied by the the company received, plus interest – how provided that certain OCS-dictated sale price of the company, provided this is the ‘Ceiling Sum’. This Ceiling conditions are complied with. that this amount (i) will not be less Sum provides certainty with respect to than the aggregate sum of all such the maximum exposure to OCS Conclusion grants, plus annual interest (certain payments. Furthermore, the Ceiling When dealing with Israeli companies amounts may be deducted from the Sum might be further reduced in cases that have received OCS funding, and outcome in accordance with the where it can be shown that the when a transfer outside of Israel of Law 7); and (ii) will not exceed the company's research and development Know-how or manufacturing rights ‘Ceiling Sum’ (see below); activity itself was not transferred relating thereto is being contemplated, (c) If the company imports to Israel outside of Israel (i.e., only the Know- it is extremely important to conduct alternate know-how ‘in exchange’ how itself was exported). proper OCS-related due diligence, for the exported Know-how, then thoroughly understanding the relevant provided that such imported know- Export of Know-how: possible OCS rules and regulations and how is expected to provide a solutions analyzing all possible scenarios in significantly higher return than The export restrictions imposed on depth. Only in this way will a purchaser would the exported Know-how, the OCS-funded Israeli companies reviewed be able to propose and consider company may not be required to in this article may appear to be, at first practical solutions regarding OCS make any payment on account of glance, a substantial obstacle and requirements which can make all the barrier to foreign investment in OCS- difference in receiving the correct OCS funded Israeli companies. However, approval or confirmation in a Links and notes that would be looking at the empty half satisfactory manner. 1 The question as to what may be considered, of the glass: there are ways to lessen the Although the OCS export de facto, an export of technological know- impact of these restrictions which, restrictions may appear at first glance how outside of Israel is subject to different based on our experience, may help turn both burdensome and severely interpretations and beyond the scope of this ‘lemons into lemonade’. restrictive to the operations of the OCS- article. First, in the event that the company 2 Section 16 The law for The Encouragement funded companies, a closer look reveals of Research and Development in Industry, wishes only to transfer its Know-how, that certain methods, if used properly, 1984 (‘The Law’) the Law permits the Committee to can be utilized to achieve a ‘win-win’ 3 Section 17(a)-(a1) The Law approve such a transfer without the situation, for all parties involved. 4 Section 2 The Regulations for the payment of any additional amounts, Encouragement of Research and provided that the transferee will grant Development in Industry (Royalties Rate and rules of payment) – 1996 (the ‘Royalties the Israeli transferor an exclusive, Daniel Marcus is a partner and Regulations’). perpetual, worldwide and irrevocable May-ad Katz an associate in the 5 Section 19b(b) The Law licence, for full use of the Know-how Tel Aviv office of Amit, Pollak, 6 Section 19b(b)(1) and 19b(g) The Law 10 and any rights derived from it. In this Matalon & Co. 7 Section 19b(b)(2) and 19b(g) The Law way, the OCS continues to benefit 8 Section 2 The Royalties Regulations [email protected] 9 indirectly from the fruits of the Sections 2 and 4 The Royalties Regulations [email protected] 10 Section 19b(c) The Law exported Know-How. Second, as discussed above, the

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