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Challenges in funding innovative SMEs

Small and medium sized businesses in Israel need financing in many stages of their life-cycle. The current credit shortage is a major barrier for the development of new, innovative companies – especially when trying to break into global markets. The Israeli government should therefore aim to identify these firms and consider mechanisms to improve their access to financing.

by Reut Marciano
Researcher at The Jerusalem Institute of Israel Studies, Israel

January 22nd, 2012

The current shortage in financing causes problems exceptionally acute in small companies which are mainly based on intangible assets, particularly in innovation and human-capital-intensive fields. Due to problems of a-symmetrical information, high-uncertainty and lack of collaterals, banks view such businesses as high-risk investment and usually withhold credit. Unlike other sectors in the Israeli economy that enjoyed specific policy tools aimed at enlarging their available credit, there are some sectors where companies have major difficulties in financing their investments; in particular SMEs based on the integration of existing products, but also innovative mid-tech firms.

Against this background, the Israeli government operates various funding tools in order to increase the credit supply for SMEs. The Ministry of Industry, Trade and Labour in collaboration with the ministry of Finance are operating the State Guarantee Fund for Small and Medium size Businesses. Although far from meeting the credit demands of small business in Israel – at a credit availability of about 500 million NIS per year, the fund is able to assist some business and entrepreneurs, mostly in the services sector. The ministry of Industry, Trade and Labour also operates the Business Development Centers ("MATI"), aimed at assisting small business in the process of achieving finance and negotiating with banks; as well as providing business guidance and advice.

In some fields in the Israeli economy, more sophisticated financing tools have been created. The successful Israeli ICT sector owes much of its prosperity to a government initiative that created the extensive venture capital funds sector in Israel. The Israeli venture capital funds, crucial to the existence and success of the high-tech industry, were established mainly due to governmental intervention. The Israeli "Yozma" ("Initiative") program that was established in the 90' after the Israeli government identified the market failure of financing sources for high-tech entrepreneurs, led to the establishment of numerous venture capital funds. The Israeli government offered the investors, trough "Yozma", to share the risk in investing in the young ICT start-ups; and allowed them, in case of success, to buy the governmental share of the fund in the level of the investment, thus sharing all the risk but leaving all the profit to the investors. Apart from creating the needed funding for the high risk, human-capital intensive ICT firms, the venture funds also offered the entrepreneurs the professional business knowledge and local and international networks, thus supplying them with "Smart Money" that enabled their success in global markets.

From another angel, the ministry of Industry, Trade and Labour is employing various policy tools in order to help and promote low and mid-tech firms, mainly in the mode of aid in financing traditional R&D; and is also assisting such firms in global activity trough the Exporters' Fund.

Unlike the ICT sector, that receives an efficient (relatively speaking) and smart credit source from the venture capital model, other innovative companies, with many similar characteristics of the ICT sector - based also on intangible assets and human capital, are unable to attain credit from regular sources, due to the lack of guarantees and assets. Such firms are presumably based on integration of existing products; mid-tech firms that present innovative products and do not fall under the existing of the sectors that receive the incentives and aid from the government; innovative design firms etc.

So long as Israel does not succeed in developing customised financing mechanisms that could cope with these adverse trends, such firms cannot develop to their full- and international - potential. This process will require the development of new financing tools which, like venture capital funds, have the ability to develop expertise in assessment and pricing of the components of intangible value. The main challenge is to create the mechanisms that will identify the companies with growth potential - as the Israeli venture capital funds are doing today for the ICT sector; and will provide these companies with added value, in the form of advice, guidance and accumulation of management knowledge and business networking. The fact that Israel was able to lead, on a global scale, the development of the venture capital industry (through "YOZMA") gives reason to believe that it can lead the development of funding sources in other areas.