Russia Woos U.S. VCs

Russia is rolling out the red carpet for U.S. VCs, but venture capitalists should be cautious about breaking out the caviar and champagne.

Hosting American VCs is part of Russia’s latest plan to diversify its economy so it can compete globally and reduce its dependence on revenue from oil and natural resources. Russian President Dmitry Medvedev is trying to establish a culture that welcomes not only scientific and technical innovation, where Russia has been strong, but also startups and venture capitalists, and he’s turning to Russia’s old Cold War enemy for help.

“The problem with venture financing [in Russia] is very acute,” Boris Gryzlov, speaker of the State Duma (the Russian house of parliament), told Russian news agency Interfax in July. “Innovative development needs capital and people who are prepared take risks and invest in principally new technologies and developments.”

If Medvedev succeeds, it will be the first time that Russia has ever had a VC-friendly culture. Since the fall of the Soviet Union, the country has been plagued by corruption and bureaucracy. Its effort to seed its own VC industry has also run into problems, with Russian prosecutors last year alleging that the head of the Russian Venture Co., a government-owned fund of funds set up in 2006, had misspent funds. (Russian Venture Co. CEO Alexei Korobov resigned after receiving a warning from the Russian Prosecutor General’s Office.)

Now Russia is looking beyond its borders for help. So far this year there have been two U.S. high-tech delegations to Russia, and a third delegation of VCs, executives, academics and California Gov. Arnold Schwarzenegger is planned for next month.

The group is expected to meet with Medvedev, Russian VCs and RUSNANO (the Russian Corp. of Nanotechnologies, established by the government). Participants are also expected to tour Skolkovo, the Western-style tech and innovation center near Moscow that Russia is spending billions of dollars to create.

Russia’s venture industry is anemic. Of the country’s 108 venture funds, only 43 function, according to the Russian news service RIA Novosti, and their combined capital under management of $2 billion is only slightly more than the amount raised by U.S. VCs in the second quarter of this year. Russian venture capital “is about 0.1% to 0.2% of GDP,” Gryzlov told Interfax. “In other words, there is essentially no venture capital in our country, and this problem needs to be resolved.”

Russia needs its Baidu. When Baidu went public in China, investors said you can make returns, and that opened the floodgates. I think it’s coming in the next one to two years.”

Peter Loukianoff

Peter Loukianoff, managing partner of Almaz Capital, which has offices in Moscow and San Francisco, says the key thing that Russia is missing is a “shining example in the tech space to investors and entrepreneurs. Russia needs its Baidu. When Baidu went public in China, investors said you can make returns, and that opened the floodgates. I think it’s coming in the next one to two years.”

U.S. VCs say they are under no illusions about Russia’s challenges. “[Limited partners] have all the concerns historically that people have had about Russia,” says Don Wood, a managing partner with Draper Fisher Jurvetson (DFJ), who visited the country earlier this year. “Can you rely on the legal system or the bureaucracy? How do you interact with the government? Can you rely on the courts? The fear of corruption [is] still on people’s minds.”

And how could it not be, when it’s in the news? This summer, a dozen or so Russian undercover agents were arrested in the U.S., including one who worked for Microsoft. (Ten of the agents were exchanged for four U.S. spies in Russia.) And a Wisconsin woman hired to work at home was duped into shipping rifle scopes, night vision equipment, GPS units and camouflage clothing—all purchased with stolen credit cards—to the Russian city of Novorossijik, according to ABC News.

The U.S. VC who probably knows Russia best is Pitch Johnson, who founded one of Silicon Valley’s first venture firms in 1965: Asset Management Co. Johnson has invested in Russia with what he calls modest results for about 20 years. He says he’s “a little bit optimistic” about what’s happening in the country now and plans to join the group going next month.

Two years ago, Johnson dropped out of a fund backed by the Russian Venture Co. because he didn’t think the Russians understood well enough how venture capital, as opposed to private equity, is supposed to work.

Private investors have been hard to come by in Russia because the individuals who had money didn’t want to let go of it and let others control it, Johnson says. “There’s little understanding in Russia that the market comes first and the technology is used to serve the marketplace,” he says. “There should be little restriction on what companies can be formed, and there have to be VC-backed companies where there’s quite a bit of private money at stake and people have something to lose.”

Another long-time investor in Russia, Esther Dyson, says U.S. VCs will find Russia rewarding if they have a Russian person on staff and invest time in the Russian people, who are incredibly smart but lack management skills. “They’re so creative, they’d rather figure it out all by themselves—they don’t always solve old problems,” she says. “They know how to think, but they are less good at following directions.”

[LPs] have all the concerns historically that people have had about Russia. Can you rely on the legal system or the bureaucracy? How do you interact with the government? Can you rely on the courts? The fear of corruption [is] still on people’s minds.”

Don Wood

Details about Skolkovo, the centerpiece of Russia’s plans to transform its economy, are still scarce. For example, the area is expected to operate under separate laws that will offer better protection for intellectual property and make it easier for both foreigners and Russian expatriates to work there. But the mere fact that Skolkovo needs separate laws raises concerns among some Americans about its future.

“I think they will learn from it, but I told Medvedev to think of Skolkovo as a virtual concept and [he needs to] spread it through the country very quickly,” DFJ’s Wood says. DFJ is working to set up DFJ VTB Aurora, a $100 million fund backed by RUSNANO and the Russian bank VTB, which DFJ will manage. “They nod, but they are eager to have something they can point to, to show visible progress in a short time frame,” Wood says. “I think it probably is a good first step, but it’s not sufficient.”

Several prominent U.S. technology executives—hoping to get on the ground early in Russia—are helping with Skolkovo’s planning, including Intel Chairman Craig Barrett and Cisco CEO John Chambers.

Cisco in June committed $1 billion to Russia over the next 10 years to fund startups and technology, build Cisco Networking Academies and establish a physical presence inside Skolkovo. “People said, ‘Russia! Who in their right mind would invest in Russia?’” Chambers said in August at a speech at Stanford University. “It’s not about creating Silicon Valley outside of Moscow. It’s about a president who clearly understands that … the country has to diversify its economy and focus on innovation and execution. Medvedev and Putin will figure it out. It’s a grand risk, but it’s a business risk.”

Even simple things like registering a business or getting office space are still hard, according to Serguei Beloussov, who chairs two large Russian technology companies: Parallels and Acronis. In July, Beloussov launched a $30 million seed fund called Runa Capital to back Russian tech startups in hot areas like cloud computing, machine learning, virtualization, and mobile Internet that would sell products to the global market. (See sidebar: “Entrepreneur Launches Russian Seed Fund.”)

“You need to take care of security and cleaning the office and UPS [in Russia],” Beloussov says. “Various business services like legal or accounting or marketing or PR are not well developed, and it’s hard to get them. It’s harder to bring people and technology from abroad—there’s bureaucracy. Skolkovo promises to make it easier, and that’s why we like it.”

Russians don’t have a strong culture of paying for software, and that makes the Russian software market artificially small, says Emergence Capital General Partner Brian Jacobs, who went on the VC trip in May. Jacobs wants Emergence to be the “go-to firm” for Russian companies that sell software as a service globally, but he says the emphasis right now seems to be on the Russian domestic market, which is “way too risky for us.”

There’s little understanding in Russia that the market comes first and the technology is used to serve the marketplace. There should be little restriction on what companies can be formed, and there have to be VC-backed companies where there’s quite a bit of private money at stake and people have something to lose.”

Pitch Johnson

“One of the reasons why Russians are so good at software is that they’ve had to do this for decades—figure out stuff without the help of traditional software support,” Jacobs says.

Although Russian science and technology is highly regarded, and there are technology gems buried inside Russian research labs, the labs also need an infusion of capital from the government, because some of their technology has been abandoned or is already developed in the West, says Sasha Johnson, managing director of DFJ VTB Aurora.

Other U.S. VCs have questions about tax incentives for investing, how easy it is to move capital in and out of Russia and what happens if Medvedev is defeated by former President Vladimir Putin, says Mikhail Chuchkevich, project office director for RUSNANO.

Chuchkevich says the Medvedev-Putin question is a non-issue. “RUSNANO was created by President Putin and he is currently Prime Minister Putin,” he says. “RUSNANO has been provided $5 billion more of capital now, and has put forward several changes to the customs, fund management and other codes … to make business more efficient. Those changes are supported by both Medvedev and Putin.”

SIDEBAR: Entrepreneur Launches Russian Seed FundLawrence AragonEditor-in-Chief

The anemic Russian venture market got a much needed shot in the arm recently, with the launch of a $30 million seed fund called Runa Capital.

Runa was founded by serial entrepreneur Serguei Beloussov, who is presently chairman and CEO of Parallels, a Swiss virtualization software company backed by Bessemer Venture Partners, Intel Capital and Insight Venture Partners.

There is a huge opportunity for seed and early stage investment in Russia. It has great engineers, management teams and entrepreneurs, but it also needs professional investment.”

Serguei Beloussov

“There is a huge opportunity for seed and early stage investment in Russia,” Beloussov says. “It has great engineers, management teams and entrepreneurs, but it also needs professional investment. It needs money, but it also needs smart money.”

Runa plans to do its part. In addition to the initial $30 million, which was raised primarily from high-net worth technology entrepreneurs, Beloussov says he is in discussions with institutional investors in hopes of growing the fund to $50 million.

Runa is targeting a return in the range of at least 3x to 5x, “but we hope to get much better than that,” Beloussov says. “We believe we will create a significant number of Internet companies with multiple millions of dollars in revenue,” he says.

The fund has already made two investments in two stealth Internet companies and is looking at 10 other deals, including one software company and nine Internet companies (including consumer- and enterprise-focused startups), he says.

In the software sector, Runa is interested in startups working on cloud computing, machine learning, virtualization and mobile apps.

A typical investment will range in size from $200,000 to $700,000 and max out at $2 million. Runa expects to fund anywhere from 10 to 20 startups in the next three years.

Beloussov says his goal is to help Runa’s portfolio companies grow to the point where they will be attractive to early stage investors, especially those based in the United States. “We would be glad to work with international funds, since most of the companies we back will expand globally.”

Although he founded Runa, Beloussov says he can devote just 10% of his time to it since running Parallels takes up almost all of his time. He says he hopes to find a CEO to replace him so that he can put about half of his energy into Runa.

Besides Beloussov, Runa’s investment committee is comprised of Dmitry Chikhachev, Runa’s managing partner; Alexander “Sasha” Galitsky, a Runa advisor who is also co-founder and managing partner of Almaz Capital Partners; and four Runa venture partners: Igor Borovikov, founder and chairman of Softline, which bills itself as Russia’s largest software reseller; Andreas Gauger, a serial entrepreneur and former CEO of 1&1, which says it’s the world’s largest Web hosting company based on number of servers; Achim Weiss, entrepreneur and former CTO of 1&1; and Ilya Zubarev, who helped found several companies with Beloussov, including Parallels and Acronis, a provider of backup, recovery and security services.

All of the members of the investment committee are investors in Runa.