Russia's Investment Climate Begins to Warm Up
While Russia's tech centers are hardly investment magnets on a par with the Valley, foreign interest is growing.
Oct 02, 2003
While Russia's tech centers are hardly investment magnets on a par with the Valley, foreign interest is growing. In May, Intel Capital placed its first venture investment in a Russian company, ru-Net Holdings, parent company of a large Russian systems integrator. Even Cambridge University has taken note of Russian activity and sought to link its own science park with the park at Moscow State University. Part Two of my interview with Alistair Stobie of Moscow-based Mint Capital looks more specifically at the management of venture capital investments in Russia.
Nash: What is the nature of Russian technology innovation?
Stobie: Until the end of the Cold War and the subsequent collapse of the Soviet Union, Russian technological innovation occurred in a self-contained environment. While the Former Soviet Union (FSU) was aware of R&D in the West and there was limited interaction, the FSU did not have access to most cutting-edge Western technologies, and therefore delivered different answers to the same problems. This does not always mean that the solutions were better, but that they were different.
Furthermore, the input materials they had to work with were generally inferior. The best solutions adopted multi-disciplinary approaches that overcame the inherent drawbacks. For example, high-brightness LEDs: the solution in the West was to focus R&D on the chip to generate more light. In the FSU they worked to better collect the light emitted and put it into the viewing angle, as well as solve the thermal issues caused by pushing greater voltage through the chip.
Russia/FSU has a tradition of excellence in mathematics and science. We are consistently impressed by the quality of portfolio companies' software engineers. Not just their ability, but their work ethic and their focus on producing a finished product. This is a result of technological necessity. Mir is an example of this. The space station had to stay up-there was no room for buggy, half-finished code. The result is smart software that works, and works faster than similar products in the West. Our portfolio companies compete in global markets because their products are better, even if their marketing is not.
Nash: How does the government role in financing research affect the ability to commercialize state-funded innovations?
Stobie: The end of the Soviet Union witnessed a collapse in funding to the plethora of universities and institutes. It also witnessed the end of state-owned corporations' funding of closely related R&D institutes. To an extent Darwinism (or is it capitalism?) played a positive role. Those institutes that were not advancing knowledge and without entrepreneurial or connected directors experienced a painful demise.
It was not until President Putin came to power that a semi-coherent funding policy was put in place. But the government is still behind in its stated strategy. So the more enterprising universities and institutes have solicited outside funds. It is estimated that the total revenue from outsourced R&D of all of the Russian Academy of Sciences constituent parts was $1.6 billion in 2002. So despite these funding issues, Russia still has a competitive edge in its science.
While there has been some progress on funding, the legal framework in particular remains vague. In short the Russian intellectual property (IP) situation remains unclear, and each potential investment has to be individually negotiated with the institute or factory. To complicate issues, the inventors are unwilling to see the State as a co-shareholder when for seven years it abandoned academia. This is a serious disincentive to invest in State-funded innovation.
On the issue of IP protection, the laws are clear, but enforcement is not. To the best of our knowledge the export of IP rights from Russia has not been challenged.
Nash: How does the type of investment you would make in Russia differ from opportunities seen in other markets, like India, that would be considered "offshore markets" by US investors?
Stobie: Russia is not analogous to India and China. It is not selling bodies; its price point is not dollars per hour, but dollars per effective technology development. The closest analogy is with Israel, and I am not sure many would deem Israel to be an offshore market. Indeed 1-in-4 diploma holders in Israel acquired them in the FSU. Russia builds and sells products at the entrepreneurial level and undertakes advanced R&D for large corporations. Intel may not have invested as much in Russia-yet-as it has in Israel, but privately Intel executives speak very highly of the R&D undertaken in its Nizhny Novgorod facility. Motorola, Sun, and Boeing have also praised both privately and publicly their R&D efforts in Russia.
The analogy with Israel should not be pushed too far; there is a framework for innovation in Israel and there was when its venture industry kicked in to gear a decade ago.
As Russia's economy continues to grow and its business practices mature, the domestic market will become a good starting point for developing global products. Unlike China and India however, Russia's domestic economy is unlikely, in the next five years or so, to be large enough to sustain a large tech-oriented company.
We believe Russia does not compete well with India for offshore programming contracts. It cannot compete for cost (especially in Moscow), management talent, or language skills. There are some Russian offshore programming houses attempting to compete in the global market. I believe that if they don't specialize and offer quality per dollar they will rapidly end up dead. It's difficult to monetize the segment of the offshore programming market where Russia can realistically compete. We believe that it is in the top 5% of offshore projects (ranked by complexity) of all outsourced R&D, i.e., where price is not the driving factor.
Nash: What is the largest impediment to explosive growth in investment in Russia?
Stobie: Management is by far the largest impediment, followed by government regulation and IP issues.
Nash: Can offshore investors repatriate gains from Russian venture investments, or do capital controls prevent this?
Stobie: We have not invested in one Russian company. R&D in Russia, yes; but company domicile, no. There are a number of reasons for this, of which two stand out. First is the 35% capital gains tax. Second is the rule of Russian corporate law, which will always be read ahead of any shareholder agreements that you craft. So counting on repatriation of gains from Russian-domiciled companies is risky.
Nash: What is the nature of Russian technology innovation?
Stobie: Until the end of the Cold War and the subsequent collapse of the Soviet Union, Russian technological innovation occurred in a self-contained environment. While the Former Soviet Union (FSU) was aware of R&D in the West and there was limited interaction, the FSU did not have access to most cutting-edge Western technologies, and therefore delivered different answers to the same problems. This does not always mean that the solutions were better, but that they were different.
Furthermore, the input materials they had to work with were generally inferior. The best solutions adopted multi-disciplinary approaches that overcame the inherent drawbacks. For example, high-brightness LEDs: the solution in the West was to focus R&D on the chip to generate more light. In the FSU they worked to better collect the light emitted and put it into the viewing angle, as well as solve the thermal issues caused by pushing greater voltage through the chip.
Russia/FSU has a tradition of excellence in mathematics and science. We are consistently impressed by the quality of portfolio companies' software engineers. Not just their ability, but their work ethic and their focus on producing a finished product. This is a result of technological necessity. Mir is an example of this. The space station had to stay up-there was no room for buggy, half-finished code. The result is smart software that works, and works faster than similar products in the West. Our portfolio companies compete in global markets because their products are better, even if their marketing is not.
Nash: How does the government role in financing research affect the ability to commercialize state-funded innovations?
Stobie: The end of the Soviet Union witnessed a collapse in funding to the plethora of universities and institutes. It also witnessed the end of state-owned corporations' funding of closely related R&D institutes. To an extent Darwinism (or is it capitalism?) played a positive role. Those institutes that were not advancing knowledge and without entrepreneurial or connected directors experienced a painful demise.
It was not until President Putin came to power that a semi-coherent funding policy was put in place. But the government is still behind in its stated strategy. So the more enterprising universities and institutes have solicited outside funds. It is estimated that the total revenue from outsourced R&D of all of the Russian Academy of Sciences constituent parts was $1.6 billion in 2002. So despite these funding issues, Russia still has a competitive edge in its science.
While there has been some progress on funding, the legal framework in particular remains vague. In short the Russian intellectual property (IP) situation remains unclear, and each potential investment has to be individually negotiated with the institute or factory. To complicate issues, the inventors are unwilling to see the State as a co-shareholder when for seven years it abandoned academia. This is a serious disincentive to invest in State-funded innovation.
On the issue of IP protection, the laws are clear, but enforcement is not. To the best of our knowledge the export of IP rights from Russia has not been challenged.
Nash: How does the type of investment you would make in Russia differ from opportunities seen in other markets, like India, that would be considered "offshore markets" by US investors?
Stobie: Russia is not analogous to India and China. It is not selling bodies; its price point is not dollars per hour, but dollars per effective technology development. The closest analogy is with Israel, and I am not sure many would deem Israel to be an offshore market. Indeed 1-in-4 diploma holders in Israel acquired them in the FSU. Russia builds and sells products at the entrepreneurial level and undertakes advanced R&D for large corporations. Intel may not have invested as much in Russia-yet-as it has in Israel, but privately Intel executives speak very highly of the R&D undertaken in its Nizhny Novgorod facility. Motorola, Sun, and Boeing have also praised both privately and publicly their R&D efforts in Russia.
The analogy with Israel should not be pushed too far; there is a framework for innovation in Israel and there was when its venture industry kicked in to gear a decade ago.
As Russia's economy continues to grow and its business practices mature, the domestic market will become a good starting point for developing global products. Unlike China and India however, Russia's domestic economy is unlikely, in the next five years or so, to be large enough to sustain a large tech-oriented company.
We believe Russia does not compete well with India for offshore programming contracts. It cannot compete for cost (especially in Moscow), management talent, or language skills. There are some Russian offshore programming houses attempting to compete in the global market. I believe that if they don't specialize and offer quality per dollar they will rapidly end up dead. It's difficult to monetize the segment of the offshore programming market where Russia can realistically compete. We believe that it is in the top 5% of offshore projects (ranked by complexity) of all outsourced R&D, i.e., where price is not the driving factor.
Nash: What is the largest impediment to explosive growth in investment in Russia?
Stobie: Management is by far the largest impediment, followed by government regulation and IP issues.
Nash: Can offshore investors repatriate gains from Russian venture investments, or do capital controls prevent this?
Stobie: We have not invested in one Russian company. R&D in Russia, yes; but company domicile, no. There are a number of reasons for this, of which two stand out. First is the 35% capital gains tax. Second is the rule of Russian corporate law, which will always be read ahead of any shareholder agreements that you craft. So counting on repatriation of gains from Russian-domiciled companies is risky.