Russia rolls out welcome mat for VCs

The Russian government, enjoying a period of sustained economic growth fueled by oil and gas revenue, has committed to spending billions of rubles over the next few years to support the growth of Russia’s technology sector.

Vladimir Putin and his government are keenly aware that Russia’s economy cannot continue to depend on hydrocarbon exports. Accordingly, investments into fundamental and applied science have grown exponentially, driven by federal and regional government initiatives to diversify the economy.

For example, since 2002, more than 130 billion rubles have been invested in nanotechnology alone. In addition, during the past two years approximately 20 public-private venture funds have been launched, representing an aggregate of approximately 40 billion rubles ($1.6 billion) of committed funds.

Stimulating startup investments

The Russia Venture Co. (RVC) is a 15 billion ruble fund of funds established by the Russian government in 2006. Through this flagship public-private fund, the government has committed to provide newly formed venture funds with 49% of their capital. Contributions from private LPs provide the remaining capital, and the yield on government investment is capped at the rate of inflation up to five percent.

The stated goal is to fund 10 to 12 new high technology venture funds, each with deployable capital between 1.2 billion and 3 billion rubles. To accept RVC capital, each fund must commit to investing at least 80% of its capital in early stage companies developing technologies in “priority” areas such as security and counterterrorism, nanotechnology, medical technologies, IT and alternative energy.

Earlier this year the RVC conducted a competitive tender to determine the first set of funds to receive RVC money. Having previously filed documents, 12 competitors presented to the RVC’s board of directors, one after another, in a marathon session on a Saturday afternoon in April. The following month, the RVC chose three winners with diverse profiles: VTB Asset Management (managing a 3 billion RUR fund), Bioprocess Capital Partners (3 billion RUR) and FinansTrust (2 billion RUR).

According to Russian business publication Kommersant Daily, VTB Asset Management—an affiliate of VTB, Russia’s second largest bank—has a controlling interest in a fund created with EBRD and several other foreign partners. FinansTrust, a private equity group, formed its fund with the participation of large Israeli investment bank Tamir Fishman. Bioprocess Capital Partners was organized by Bioprocess, a Russian pharmaceutical firm.

In the past two years, approximately 20 public-private venture funds have been launched in Russia, representing an aggregate of approximately 40 billion rubles [$1.6 billion] of committed funds.”

Harry Kelly, Principal, Starboard Ventures

The RVC’s second tender competition will take place this fall, and given that the RVC has a mandate to contribute to approximately 10 funds, the RVC surely will make awards to more than just three firms. Entrants for the second tender will likely include certain firms that submitted in the first tender but didn’t win, including Lider, Russia’s largest pension fund management company.

Some of the entrants will be well-established Russian financial firms that heretofore have managed more conventional asset classes (such as real estate and commercial lending) but are starting to build venture capital and technology investment teams. Some of this build-out is motivated by the tremendous returns that venture investment in compelling technology businesses can bring. Additional impetus comes from outside the board room, as the government has strongly suggested that there is an aspect of “corporate responsibility” in high-technology investment.

What about seed financing?

The RVC envisions that the first venture funds created with RVC money will begin investing this fall. The RVC’s press office suggests that this initial tranche, together with funds to be deployed to subsequent tender winners, “will provide venture capital for up to 200 innovative companies and encourage emergence of another 1,000.”

Heady expectations to be sure, especially since the conditions governing RVC money permit funds to invest only in companies that have progressed beyond their seed stage. The RVC’s board of directors has determined that funds must invest at least 80% of their capital in early stage companies—which for the RVC means companies that already have clients and revenue.

As such, it appears that funds cannot use RVC money to invest in seed companies. This limitation reflects a broader global VC trend: an increasing hesitation among VC firms to invest at the seed level, to do deals with companies that are still in their earliest stages. This trend is particularly unhelpful for Russia, which must address the question of where all these new companies—worthy investments for RVC-involved funds and other investors—will come from.

The result is that there will soon be significant amounts of deployable capital but too few companies to make investments in and start developing businesses.

In the West, investing in companies in their earliest stages has for many years been supported by business angels. In Russia angel investing is just now beginning to emerge. This development is illustrated by the Society of Business Angels of Russia, a group formed last fall by a handful of investors interested in technology investments. Like some other angels and entrepreneurs, this group believes that seed-focused venture funds can shrink the deficit of investment-worthy companies that would prove attractive to RVC-backed and other venture funds, and is lobbying the government to support such a fund.

The venture ecosystem is developing quickly in Russia, but more work remains to organize and seed companies that will attract the increasing number of venture firms preparing to invest in the promise of Russian high technology.”

Harry Kelly, Principal, Starboard Ventures

A developing ecosystem

Although the venture ecosystem is still emerging, technology investors are increasingly willing—and being welcomed—to work in Russia. At a speech to the 11th St. Petersburg International Economic Forum held in June, First Deputy Prime Minister Sergei Ivanov, a leading contender for Putin’s support in the presidential vote to take place in March 2008, pointed to “human capital” as “the foundation for diversifying our economy” and opening the country to further investment. This human capital is expressed through the country’s prodigious technical capabilities. Approximately 1 million scientists and researchers work in Russian R&D centers, Russian universities graduate more engineers and computer scientists per capita than almost any other country in the world, and in recent years teams from Russian schools have roundly defeated their American and Asian opponents in international computer programming competitions.

At least two of the Western businesses represented at the International Economic Forum, Alcoa and Hewlett-Packard, have opened new R&D centers in Russia since the beginning of 2007. These centers, like other R&D centers opened this year by Boeing, DuPont, EMC and Google, help international businesses enjoy the benefits of Russian technical expertise and illustrate the opinion of many multinational firms that Russia continues to offer substantial promise for developing game-changing technologies.

Innovative technologies, however, do not by themselves magically convert into scalable businesses. Entrepreneurs and researchers in Russia working outside of corporate R&D need seed capital and professional management to create what really matters to investors: investment-worthy companies. Without more available seed financing and market-savvy managers, Russia will face a continued deficit of venture deals.

My firm, Starboard Ventures, has teamed up with Moscow-based International Foundation of Technology and Investment to support the emerging venture ecosystem. We address the relative lack of venture deals by supporting the formation of seed companies and businesses built around innovative Russian technologies. Through our joint effort, called “Parus,” our team identifies technologies and teams that can be developed into businesses, then builds seed companies that are oriented to the global market, reflect international VC standards and are attuned to VC needs and trends.

A venture ecosystem can thrive only where financial investors, angels, researchers, entrepreneurs and other human capital are able to interact and grow together. Government fertilization of the ecosystem is needed to ensure enough success stories to make it sustainable. In Russia, the ecosystem is developing quickly, but more work remains to organize and seed companies that will attract the increasing number of venture firms preparing to invest in the promise of Russian high technology.

Harry Kelly is a principal in Starboard Ventures LLC. For more information about Starboard Ventures, visit www.starboardventuresllc.com. For more information about the International Foundation of Technology and Investment, visit www.ifti.ru.