Every Thursday at 6pm, Yair Geva, co-head of Herzog Fox & Neeman (HFN)’s high-tech department, drinks a beer on the rooftop of a client’s office in central Tel Aviv. The weekly drink, which started seven years ago when he returned to Israel from New York, is a routine that is borne out of professional commitment and friendship. In the start-up and high-tech world, the two often go hand in hand.
‘We share a long journey with our clients and we are often with them from day one,’ Geva says. ‘The only way to keep in touch with this very vibrant dynamic ecosystem is to hang out with friends, clients and hear the news.’
Geva, like many of his peers in the Israeli legal community, enjoys the day-to-day adrenaline rush from taking a gamble in working with clients from such a fast-moving sector. The gamble is that start-ups and high-tech companies cannot afford typical legal fees, meaning firms have to wait for their payday. ‘When we bet on the right people, we usually do well,’ Geva says. Yet, often the investment of time and effort into a client comes to nothing.
For a profession that is notoriously risk averse, the start-up-driven Israeli economy naturally pushes local lawyers out of their comfort zone. Working with a whizz-kid, who happens to have a great idea and may or may not become one of the richest humans on the planet, is a different experience to advising established institutional clients.
Gambling big
Israeli law firms have had to develop a sophisticated investor mentality in the hope that they can back winners, but along the way there will be inevitable losses and time that is written off. Given the make-up of the Israeli economy, local firms have little choice but to take that gamble.
‘You have young kids with offers from the biggest law firms to advise them for free. I have to persuade some kid to retain me even if they are not going to pay me.’
Simon Jaffa, Barnea & Co
Israel is the second-most innovative nation in the world, according to the World Economic Forum’s Global Competitiveness Report 2016-2017. The drive for innovation is self-perpetuating, with frequent reports of entrepreneurs achieving billionaire status by selling their businesses to foreign investors or listing on global stock exchanges. It has created a nation of romantics.
David Schapiro, a partner at Yigal Arnon & Co, says: ‘Every single day of the week, you see a dramatic exit of one form or another. The average person opens the newspaper and they see that you can become a multi-millionaire. People feel the only way to realise that dream is to have a start-up.’ In 2016, Yigal Arnon advised a Chinese consortium on its $4.4bn acquisition of Israeli online gaming company Playtika (see box, ‘Selling out’, below).
But the risk-and-reward mentality is not one that sits well with the average law firm business model. Firms, in large part, are still wedded to the billable hour, enabling them to meet monthly and quarterly financial targets. Working with an early-stage tech company, means the client is likely to have very little capital to spend on legal advice.
Firms are then forced to offer very low fees, deferred fees or even work for free until the client has sufficient capital. Some firms are even willing to take equity in the client’s business in the hope that they will be rewarded once the company is sold or goes public (see box, ‘Big winnings’, below).
Simon Jaffa, a partner at Barnea & Co, says that all firms are chasing the same start-ups, despite these clients’ inability to pay typical legal fees. ‘You have these bizarre situations where you have young kids who already have offers from the biggest law firms to advise them for free and they ask whether you can do better than that,’ he notes. ‘I have to persuade some kid to retain me even if they are not going to pay me.’
Jaffa says that firms will often defer fees until a client reaches a certain milestone, such as a seed investment. They tend to agree a fixed period of time or a fixed number of hours the start-up will receive free or at heavily-discounted rates. At each round of funding, hourly rates gradually increase until they reach standard rates. In the end, the firm hopes to advise the client on a lucrative sale to a strategic or financial sponsor, or on its initial public offering, often on Nasdaq.
‘It’s a long-term investment,’ remarks Daniel Chinn, a partner at Tulchinsky Stern Marciano Cohen Levitski & Co, suggesting that working with young companies is akin to spending time at business and industry conferences. Sometimes it pays off, often it doesn’t.
However, Israel’s reputation for innovation encourages investors from all over the globe. In February this year, Apple acquired Israeli artificial intelligence (AI) facial recognition company RealFace. This followed its acquisition of other Israeli facial recognition AI companies PrimeSense and LinX over the last few years.
‘We can keep prices low in the expectation that the company will find an exit, or become a big company with substantial operations and many employees.’
Amit Steinman, S Horowitz & Co
Israeli companies are frequently snapped up, but Yigal Arnon partner Barry Levenfeld admits that identifying potentially lucrative clients can be a shot in the dark. ‘For every one of these successful exits, there are many that don’t succeed,’ he says.
Firms then have to find ways of mitigating the risk of chasing a client that never makes it. Many have created efficiencies, using standard documents and boilerplate terms in the early stages of a company’s lifecycle, and for the first rounds of financing. ‘We can do this efficiently and keep prices relatively low in the expectation that the company will find an exit or sale, or become a very big company with substantial operations and many employees,’ says Amit Steinman, a partner at S Horowitz & Co.
Firms are also adept at using younger partners and lawyers, often those that have a tech or sector background, to identify and nurture these clients in the initial stages. The problem, though, is that young entrepreneurs can be needier than a larger company that has its own general counsel.
Levenfeld says: ‘With freshness and idealism you get a lack of experience, and that requires a lot of hand holding. Israelis may have had great success in the army and be brilliant in the technology field, but they could struggle with daily business and legal issues.’
Many successful tech entrepreneurs have come out of the Israeli army, which continues to select the best candidates for its most prestigious forces such as Unit 8200 – the intelligence unit known for its cyber security and high-tech spying activities. Investments in Israel’s cyber security sector increased by 9% in 2016 according to PitchBook – the private equity and venture capital database – which said 365 Israeli cyber security companies raised $581m. This amounts to 15% of global investment in cyber security.
Chinn asserts that even the finest military minds require premier legal advice: ‘My view is that young companies require a level of senior advice that is inverse to their age and size. Young people are less experienced in running companies and do not know what to look out for.’
This presents a particular challenge to Israeli firms, given their relatively small size; HFN is the largest domestic practice with 300 lawyers. Firms need to guard against becoming overstretched by the demands of the start-up and growth company community, especially when it is not especially remunerative. Barnea’s Jaffa asks: ‘How many start-ups can we take on this year given our resources of 85 attorneys? We don’t want to be in a situation where we don’t have enough manpower to deal with a large and intensive acquisition.’
Picking winners
Chinn has had success in identifying early-stage businesses that have gone on to make an impact. He represents New York-based Lemonade Insurance Agency, a company driven by AI and behavioural economics. It uses algorithms to assess claims, and through this automation can claim to be faster and more transparent than the traditionally opaque world of insurance payouts. In December, only two months after its launch in New York, it announced a $34m funding round led by General Catalyst Partners. Chinn has known the company’s two founders Daniel Schreiber, a former Israeli attorney, and Shai Wininger for some years, and says he knew they would make an impact: ‘They are serial entrepreneurs with great backers doing fascinating work in an area crying out for innovation.’
‘Lemonade’s founders are serial entrepreneurs with great backers doing fascinating work in an area crying out for innovation.’
Daniel Chinn, Tulchinsky Stern Marciano Cohen Levitski & Co
Although Chinn spent time as a seed investor before returning to the law in 2010, few lawyers are professional investors, meaning they have a difficult task in assessing whether to invest their time in a client. ‘I’m not trying to assess whether a particular product is going to be in demand in X years’ time,’ comments Barnea’s Jaffa. ‘I’m not going to kid myself that I have that skill – plenty of lawyers believe they do – but I can look at young entrepreneurs and make a judgement call as to whether these guys are going to succeed.’
Geva says a law firm’s risk is not as great as that of a venture capital fund and that the key for firms is to believe that a client is going to reach the next stage of financing. When clients are funded, firms can at least recoup all or a significant proportion of outstanding fees. Geva believes a few well-placed conversations with venture capitalists and market participants can give him and the firm a good understanding of whether a client is going to succeed.
Chinn says that he and his contemporaries are now much more plugged into the start-up and high-tech ‘ecosystem’ than when he was first practising law. As an attorney at HFN back in the 1980s, he received a call from a partner, saying that Baker & McKenzie’s San Francisco office was asking for help with a stock option plan for Microsoft. The partner had heard neither of Microsoft nor a stock option plan.
For Chinn and others, the priority is to be part of the high-tech start-up environment. Many will sponsor or take a prominent role with start-up accelerators and incubators, getting to know the promising entrepreneurs and company founders. Lawyers also feel compelled to spend time overseas, most notably in Silicon Valley, where a high proportion of Israel’s most enthusiastic acquirers and investors come from.
Jaffa visited Silicon Valley six times in 2016, speaking to big tech companies and investors about what they were interested in. He is consistently surprised by Silicon Valley’s connection to and understanding of Israel: ‘I sat with a venture capital investor in California last year and he asked about fintech companies in Israel. I mentioned ten names and he knew every single one.’
Jaffa believes that his regular visits to the US and his connections there provide another reason for Israeli start-ups to work with him: ‘They might see the advantage of us making interesting introductions. We are not going to operate like an investment bank, but if we see an opportunity then we could try to add some value and make that connection.’
He also says that buy-side clients want to see that their lawyers are part of the high-tech and start-up scene: ‘Venture capital investors on the West Coast want to have a feel for what is going on.’
There may be a strong bond between Israel and Silicon Valley, further cemented by the now direct flight between Tel Aviv and San Francisco, but the start-up and high-tech ecosystem goes way beyond that. Berwin Leighton Paisner’s head of corporate, Jonathan Morris, says that London, as one of the world’s principal financial centres, has its sights set on Israel’s thriving fintech scene. And then there is China, a nation that now spends billions of dollars on Israeli companies and technology. In light of this, committing fully to the start-up and high-tech ecosystem requires a lot more than a bold partner and a couple of young associates. LB
Big winnings: Taking equity or stock options in a start-up
‘We prefer not to take equity. We may lose a lot of money from that stance, but we really think it is the right thing to do.’
Barry Levenfeld, Yigal Arnon & Co
Deferring fees or taking equity or stock options in a start-up is not a new concept, but it continues to divide the legal profession, not least because it leads to accusations of conflicts of interest.
In the 1990s leading up to the dotcom bubble bursting, Silicon Valley firms took equity stakes in start-ups and growth companies on a relatively frequent basis. They often established separate funds to hold the equity and asked clients to sign a waiver prohibiting them from launching conflict-of-interest claims.
The concept of deferred fees until a start-up achieves a designated milestone, such as a round of financing, also leads to accusations of conflicts, not least because a deferred fee equates to a success fee. The lawyer or adviser effectively has an interest in pushing the client towards that milestone, irrespective of whether it is truly in their interest.
Noory Bechor, the founder of Lawgeex, an Israel-based contract review automation start-up, and a former senior associate at local firm Meitar Liquornik Geva Leshem Tal, is sceptical about handing over equity to a legal adviser: ‘If a lawyer is good at their job, they should be paid for doing that job and you should keep your equity.’
Yigal Arnon & Co partner Barry Levenfeld agrees that taking equity is not the right way forward: ‘We prefer not to take equity. It might be a mistake in the long run and we may lose a lot of money from that stance, but we really think it is the right thing to do. We don’t want to compromise our professional position.’
Osnat Sarusi-Firstater, a partner at Lipa Meir & Co, says that the firm has in rare situations taken equity in businesses that have cashflow difficulties, but only when the firm has had absolute belief in the client and its prospects: ‘Some simply do not want to share equity and others say putting the name of a law firm as a partner will improve the start-up’s chances of getting investment and reaching the designated milestones.’
Sarusi-Firstater says that the firm is diligent about eliminating conflicts of interest, believing that taking such small minority stakes means the firm is not able to exert any control over the start-up. It also appoints proxies to the board to eradicate any perception that the firm can influence executive decisions.
Yaron Sobol, a partner at Hamburger Evron & Co, is expecting a client that the firm holds equity in to list on Nasdaq in 2017. He expects to achieve a return of some three to five times the hours his team has invested in the client since it began working with it in 2008. The value of its shares can only be realised after a six-month lock-up period. Sobol says that this is dependent on how the initial public offering (IPO) is received, the outcome of potential clinical studies and whether the management team is delivering. The firm’s rewards are uncertain.
Sobol says such transparency is pivotal to the avoidance of conflict accusations, noting that in public offering documents, for instance, it will explicitly state that the firm providing a legal opinion also holds equity or stock options in the company. Clearly though, where a start-up does eventually achieve a significant milestone, it gives even minority shareholders an opportunity to be generously rewarded. In 2016, Israeli high-tech exits topped $10bn, according to the IVC-Meitar Israeli High-Tech Exits Report. Of these exits, only three were through IPOs, raising a modest aggregate total of $15.1m – a far cry from 2014 when Mobileye raised $890m on Nasdaq.
Selling out: foreign investors battle for Israeli targets
Clifford Davis, a partner at S Horowitz & Co, says that he and colleagues at the firm worked on eight auction sales during 2016, believing this is a symptom of mounting foreign interest in the Israeli economy.
A report by IVC Research Center and Israeli law firm Shibolet & Co said that private equity investment in Israel rose to $3.5bn in 2016, up from $3.1bn in 2015 and $2.73bn in 2014. This comes despite a 17% drop in the volume of deals in 2016.
The $1.4bn buyout of Keter Plastic by BC Partners was the marquee deal of the year with Linklaters and Meitar Liquornik Geva Leshem Tal advising BC Partners, and White & Case advising the Sagol family, the sellers. China continues to generate headlines with a number of bold investments. A Chinese consortium paid $4.4bn to acquire Playtika, the Israeli online games company, from US-based Caesars Interactive Entertainment in 2016. Yigal Arnon & Co and Silicon Valley-headquartered Fenwick & West advised the Chinese consortium, while Latham & Watkins advised Caesars.
Recent efforts to decentralise the Israeli banking market are likely to fuel deal activity in 2017. In January, the Israeli parliament issued a new law demanding that Israel’s two largest banks, Bank Leumi and Bank Hapoalim, sell their credit card businesses. The two businesses account for over 75% of the domestic payment card market. Under this new law, Israeli financial and non-financial businesses are prohibited from buying these credit card companies, effectively opening up the market to foreign players, including private equity sponsors.