At the beginning of April, an amendment to the R&D law was
approved by the Knesset's Finance Committee. The amendment makes it possible
to export Office of the Chief Scientist-supported IP and manufacturing, which
marks a major shift from the previous version of the law, which unconditionally
prohibited any transfer of such knowledge abroad, even if the support of
the OCS was partial or limited.
Making the OCS an Attractive Funding Option
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This change allows companies to positively consider the financial attractiveness
of the OCS R&D funding support without worrying that such support
would eliminate the possibility of selling the company, or its knowledge,
abroad.
Limitations in the Old Law
Until the recent amendments, companies that sought OCS funding
were usually mature companies that developed new generations of their
products or new companies that had difficulties with financing and had no
other choice but to "live with the OCS limitations." Among
those companies that turned to the OCS, there were many
with limited potential for a marketing breakthrough.
According to our estimations, approximately one third of the companies that sought
R&D financing routes — most of them companies with products with
substantial international potential — abstained from turning to the OCS
largely due to the legal restraints regarding IP and manufacturing transfer abroad.
These companies figured (1) they stood a better chance of making an exit
by selling the IP to a company abroad, or (2) they planned to manufacture
abroad in large scale and preferred to reduce their R&D expenses and to develop
their products with the assistance of alternative financing entities (such as
angels or private equity) until they were able to demonstrate their product
and then raise funds from VCs.
This process slowed the entire R&D period
and reduced the chances of successful development. Worthy R&D projects
with substantial potential were quite often forced to stop development due to
financing difficulties they encountered before they achieved a significant milestone.
In other words, many of these projects had excellent potential but failed
because they refrained from turning to the OCS for support.
Until the recent legislative
amendments, many companies supported by the OCS were
forced to find creative ways to bypass the legal limitation. The first player
to lose because of the limitations? The OCS (meaning the state
of Israel). Why? Since the manufacturing took place abroad, no
royalties were paid to the OCS.
Grants Are the Way To Go
Now every entrepreneur
can quantify the cost of the OCS funds in case of successful
R&D, including the transfer of IP or manufacturing abroad. (Obviously,
if the R&D effort fails, the OCS funds paid to the company turn into
a grant that the entrepreneur is not required to repay.)
For a company planning to develop and manufacture a product
in Israel, the OCS money is equivalent to a very attractive loan (prime
+ 1%), without guarantees and with convenient reimbursement terms (3% of annual
sales, up to full reimbursement of the grant sum).
For a successful company that has decided
to transfer manufacturing abroad, the OCS money is still equivalent
to a loan — but a more expensive one. The transfer of manufacturing
abroad gives the OCS a right to increased royalties (120% to 300% of the grant,
less royalties that have already been repaid).
For an entrepreneur who believes that the R&D will succeed
and plans from the start to manufacture abroad, the OCS money can be uneconomical. However,
the new law includes a section that permits royalty-free manufacturing
transfer in return to the transfer to Israel of manufacturing rights of
a product that is of a higher technological level than the
original (OCS-supported) one.
For a company with successful R&D and decided to
transfer or sell the IP abroad
and close the activity in Israel, the OCS money is equivalent
to a capital investment. Its cost to the entrepreneurs is less than the
cost of funds that are raised from regular investors or private equity.
In this case, the company will have to repay to the OCS an amount
equivalent to the following: a ratio of all the grants received from
the OCS and the total investments in the R&D multiplied by the acquisition
price. For example, if the OCS supported the company's R&D with
a $100,000 grant out of a total investment of $1 million in the company
(at the time of the IP was sold), the company will have to pay the OCS
10% of the acquisition price.
This might lead one to conclude that in the case of an IP sale, the OCS
grant seems like a regular capital investment; however, there are a few
mechanisms that make the OCS money less expensive than a regular investment.
Royalties that have been paid to
the OCS prior to the IP transfer will be deducted from the compensation sum
to the OCS.
A "technological depreciation" figure,
measured by the time that passed since receiving the OCS funding, will
be deducted from the compensation sum.
A
part of the compensation sum will be paid by the purchasing company.
The OCS approves the exchange of part of the compensation sum (or
under certain conditions, the whole sum) with significant substitutional
IP from abroad, which is assimilated and turned into an Israeli-developed
technology, bringing an excess rate to the Israeli economy in
creating
new opportunities and jobs in Israel. (By "substitutional IP," we
mean a situation whereby the foreign acquirer of an Israeli company decides
to scrap the Israeli R&D center and set up an
R&D center for another product in its place. In such a case, the acquirer
may be exempt from paying the "fine" to the OCS.)
With the amendment to the R&D law, entrepreneurs
who plan to develop and manufacture in Israel, the OCS money is equivalent
to an inexpensive loan. For entrepreneurs who plan to manufacture abroad,
it is a more expensive loan, and for entrepreneurs who sell the company
abroad, it is a discounted capital investment
Considering that the OCS supports risky projects, and that if
the R&D
fails, there is no repayment of royalties,
then raising R&D funding from the OCS has
turned out to be an extremely attractive route for the entrepreneur.
The Implications of the Legislation
The increase in the attractiveness of the OCS grants will
bring about a situation where higher quality companies, which previously
preferred to turn to private investors, will apply for OCS grants. Assuming
that the government will not raise the R&D budget in the short term
(after the addition of NIS 300 million announced recently, the OCS planned
budget for 2005 is NIS 1.2 billion, slightly less than
the 2004 budget), the competition will increase for OCS grants. The
OCS will have to disqualify a larger percentage of the applications, cut
off the company’s
approved R&D budget
in each application, and reduce the support rate to each approved company.
If the current trend continues (giving the OCS flexibility in
determining funding rates between
20% and 50% with an average support rate of 30% to 40%), it
is reasonable to assume that due to the expected raise in demand, the average
support rate will be reduced to between 20% and 30%.
In the long term, the increase in the quality of the applications will
raise the success rate of the OCS- approved projects and the return
to the OCS. In fact, the OCS budget will profit twice:
(1) from royalties of that have been successfully developed
and commercialized and (2) from royalties for IP/manufacturing transfer
abroad. Due to the rise in royalties paid, the OCS budget is expected
to grow, which will allow for the support of more companies.
Increased Support by the Treasury Ministry
In general, we can say that the amendment to the R&D law
is a refreshing change, which has the potential to bring better projects
to the OCS. In the short term, this trend will lead to an improvement in the
level of developed products. In the long term, it will increase the amount
of royalties returned to the OCS and an increase in foreign investments
in Israeli technological companies and broaden of the technological
industry in Israel. There is no doubt that the law amendment is a blessed moved, encouraging and
strengthening Israeli entrepreneurship.
Having said that, however, without a parallel significant
increase in the OCS budget, all of this positive progress will be questionable,
especially in the short term. Entrepreneurs with well thought out R&D plans
will not be satisfied with low funding and might (once again) be reluctant
to approach the OCS for support.
An
increase in the R&D
budget of the OCS by the government in the short-term
is a must. It goes in line with the amendment and requires the support of
the key policy- and decision-makers in the Ministry of the Treasury.
About the author:Moshe Rotem, an engineer, is the founder
and partner of Sunrise
Projects Ltd., Israel's leading company specializing in obtaining and maximizing
R&D grants from the
Israeli Office of the Chief Scientist (OCS) and American Federal Funds.
