In the wake of a boom period that saw the birth of tech unicorns at a dizzying pace, successful IPOs, M&As, and enormous capital inflow into the high-tech sector, the industry is now entering a phase of "market correction” as some have defined it. There is no shortage of signs to this effect, whether it is industry cuts or the growing difficulty in securing sources of financing. The latter is the result of fear of an economic slowdown that may yet increase and turn into a full-blown recession, and the rising interest rates, those that have already occurred and those that, by all assessments, will inevitably follow in the foreseeable future.

With venture capital funds scaling down new investments in response to the new financial circumstances, large banks are becoming a central and important factor in providing complementary credit to revenue-growth tech companies. It is important to talk about the challenges currently facing the high-tech industry from my point of view, as head of a major bank in Israel, and the solutions that banks can provide to entrepreneurs in the new and unfamiliar climate.

As early as November of last year, we identified the beginning of the market correction. Initially, we observed a decline in the value of public companies, followed by difficulties for private companies to raise sufficient funds moving into the Series D and E stages. In addition, we saw a significant decrease in the number of new companies established this year compared to previous years, which indicated difficulty in raising equity. Another sign of a slowdown was the number of IPOs and SPACs since the beginning of the current year on the NASDAQ, which has dropped to only four – about a quarter of what we saw in the same period last year.

On the other hand, we noticed an increase in the volume of mergers and acquisitions (M&A). That is, the established high-tech companies have taken advantage of the new situation to acquire knowledge, technological capability, and customers of rival companies at relatively low costs, thereby achieving controlled and efficient growth. Similarly, major corporations have also begun to acquire high-tech companies, taking advantage of their multiplier reduction.

Are we looking at some bad years ahead for the tech industry? There is no reason to panic, and indeed, amidst the crisis, there is an opportunity. We do not anticipate a lateral collapse in the industry, since this is a strong market, with good checks and balances in place. Companies with good Product-Market fit and Unit Economics will likely overcome the challenging period, and quite possibly even come out of it stronger than before. Also, let us not forget the fact that venture capital funds have raised a great deal of money throughout 2020-21, which they are required to invest. Therefore, the market slowdown we are currently experiencing is temporary - and we expect that by 2023 the volume of investments will bounce back and grow.

Closer Scrutiny and Harsher Criteria

At the forefront of Israeli banking and tech debt, Discount-Tech directs venture debt primarily into software companies, offering them additional financing sources in the form of venture term loans to complement financing by venture capital funds. Discount-Tech offers two types of loans that largely complement each other: ‘Venture Lending’ is essentially designed to support companies between fundraising series; the second type, MRR credit facility, is cheaper and does not entail equity dilution, but is given in several installments and is contingent on reaching certain predetermined revenue targets.

Given the current economic situation, which is especially evident in the hi-tech sector, Discount-Tech is taking extra cautionary measures compared to the past. Beyond the standard analyses we would normally perform before financing a company – KPIs, growth, Unit Economics, and gross margin metrics – we have now defined two additional factors as qualifying criteria for investment: the ‘runway’, which refers to the company’s cash balance leading up to the next fundraising series; and the ‘burn multiple’, a relatively recent financial indicator that expresses the efficiency of the company in terms of how much cash it ‘burns’ to generate new revenue. The requirement for bank credit approval is usually a ratio of below 2.

Banks have also introduced conditional "milestones" for venture lending in the past year. Let's say a company has $5 million in annual revenue and sufficient cash balance for two years – the bank may approve a request for a loan, on the condition that the company reaches $8 million in Annual Recurring Revenue by the date which has been scheduled for the first transfer; the condition for the following installment would be $12 million.

The message that the banks are conveying to entrepreneurs in this way is important: we are not here to throw you a lifeline; venture lending is not for bailing out a struggling business but for facilitating more efficient and controlled growth. The point is to provide the company with some oxygen between rounds of fundraising to achieve a milestone. To a large extent, this cautious approach speaks to the level of maturity that the banks have reached in terms of their view of the tech industry.

A Positive Outlook Moving Forward

Another development I’d like to point to, which affects the newly assumed centrality of banks in the world of high-tech financing, has to do with the deposit rate differential between Israel and the U.S. banks: Despite the central bank having recently increased interest rates, interest rates on deposits in Israel are higher than in the U.S. As a result, in the past year, companies have transferred a great deal of money from the U.S. to Israel. The implication is higher deposit capability for banks in Israel. Many companies have already figured this out on their own, and certainly, it is an important factor to keep in mind going forward.

We receive hundreds of loan requests from tech companies each year, and while we never shy away from good debt finance, compared to the past, we are much more selective. This is Discount-Tech's new approach in the face of the new reality. We continue to support Israeli high-tech partly because it is vital for the industry but also because we believe in this cause wholeheartedly. Sure, some will have to give up the dream, but in the end, those companies with cash and Product-Market-Fit will come out on the other side of uncertainty – bigger and stronger.

***Failure to repay the loan could result in late interest charges and debt collection proceedings. Subject to the terms of the bank***

Written by Guy Navon, Ph.D., Head of Discount Tech