Encouraging signs from Russian VC market

23rd Jul 2013
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The Russian venture capital market is growing fast. A recent study carried out by PwC and VentureDatabase, which used figures fromRusBase, found that it has grown by 30-50% during the last 10 years, bringing its total value to more than $900 million.

This is encouraging and suggests that Russia is a good place for investors to make a profit. However, Russia is a complex place and the startup sector is no different. Let us study the Russian startups in the global startup ecosystem, and also look at the government’s involvement in the sector.


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Russian startups in a global context

The Russian venture market remains very hard to predict. The state-owned Russian Venture Company, RVC, optimistically forecasts that the industry could be worth as much as $10 billion by the end of 2014. However, this leap forward will be impossible without strong support from domestic and foreign investors.

While there is no shortage of startups seeking investment, the way that state funds currently seek to attract more private capital is thoroughly ineffective. Venture market consultants compile a rankings list of 100-150 projects which are deemed worthy of investment. However, very few of them actually have sustainable growth models or the sort of financial records that foreign investors require to carry out due diligence.

It is in this context that one should try to assess the investment potential of Russian startups. Investment potential doesn’t only depend on formal indicators, but also on the specific economic rules of the country in which the startup operates. Globally, the most interesting models currently include the American (as seen in North America, Japan, the Anglo-Saxon countries), European (Germany, France and some countries in Latin America, Africa, Russia excluding Moscow and St. Petersburg), and Asian (China, India, Southeast Asia, Moscow and St. Petersburg).

The main difference between the models relates to the way that risk is perceived, and the mechanisms associated with it. The American model accepts that investing in startups is risky. However, investors are willing to take big risks because of the pragmatic attitude to failure and the readiness of both startups and investors to make big changes, or call off projects completely at the first signs of failure.

A second big difference is the relative absence of cronyism and burdensome regulation in the US system. Both investors and startups accept that the “free hand of the market” is the best possible regulator for their activities. This has a very positive effect on startups, that are held to account by their clients, not by bureaucrats. This means that they focus their attention on securing the attention and loyalty of as large a market share as possible. On the whole, successful startups are those with a significant market share.

This gives us two measures by which we can evaluate the investment potential of startups, particularly in the tech sector - consumer demand and market penetration.

The European model is conservative and contrasts with the American one. In Europe, the market is considered static, where as in America the market is dynamic. Americans develop a successful product and expect it to change the market, whereas Europeans develop a product to fit the market as it currently is. Therefore Europeans seek to scale their businesses according to the purchasing power of individuals from particular social, geographic and economic groups within society.

For this reason American startups are more likely to make revolutionary breakthroughs, while European startups are more likely to clone US ideas, with adaptations to fit their own specific domestic market. European clones are often very successful, as the US and European markets share many common features. However, cronyism and burdensome regulation are a much bigger problem in Europe. This often prevents beginners from breaking in to sectors already dominated by major players. Therefore, when evaluating the investment potential of European startups you must take into account the current state of that specific sector in that specific country, as well as relevant legislation.

According to the Asian model, startups tend to target their domestic market than European and American ones. Their success often relies on a plentiful supply of cheap labour and strong material support from the state. They are designed to fill a specific gap in a specific sector, and are often happy to be bought out when a stronger market player from America or Europe comes calling. So called ‘blind imitation’ is also prevalent. Entrepreneurs claim that imitating a Western model should reduce the risk to investors. However, in practice this is often not the case. Domestic situations often differ significantly from the Western contexts in which the original idea was successful. Asian startups may fail to properly copy the Western idea, particularly if they lack the funding to do so. Even if they manage to copy it effectively, they might not attract a user base as quickly as their Western analogue, or the state may put up barriers. Therefore, an adequate risk assessment of Asian start-ups must consider how the project fits in to the domestic market, which means taking into account the amount of competition and the likelihood of state support.

The Russian startup sector, perhaps unsurprisingly, contains elements of both the European and Asian models. St. Petersburg and Moscow startups by and large operate according to the Asian model, with many imitations, reliance on the state and a willingness to be bought out by Western rivals. However, outside of Russia’s twin capitals, the prevailing model is the European one. Society is more conservative, and startups, often clones, are likely to target specific groups. Among them, one may see example of Yandex dominance instead of Google, VK.com instead of Facebook, Mail.ru instead of Yahoo or Live, etc. These differences must be taken into account by potential investors in Russia.

While the Russian startup sector has plenty of problems, there are some good things about it as well. One of the main advantages of the Russian ICT market is the availability of tech personnel. Russian programmers’ talent is valued globally, and there is an abundance of highly-educated specialists capable of developing solutions to complex problems. However, they usually have very little business sense, and so can be hired for low wages as usually large business incubators do (Fastlane Ventures, Farminers etc.).

This is one reason why foreign investors have invested money in startups that carry out outsourced research and development in Russia, Ukraine and Belarus. One may notice that so-called wordwide companies like Acronis and Paralles have R&D in Russia, same as Virool, Viewdle and Displair. However, investors are more reluctant to trust Russia’s business developers and marketing specialists, and often prefer it when these roles are performed by expats. It is widely used model in Russian eCommerce – Ozon.ru, KupiVIP, Heverest, and new media – Zvooq, T&P, Bookmate, Third Place.

The role of the state

The most active investor in Russian projects is the Russian state, which invests through grants, investment rounds and, in some cases, acquisitions. It has also sought to encourage private investors to enter into public-private partnerships to support Russian innovation. It is hoped that this will lead to better cooperation between universities, research centres, institutional investors, local authorities and private investors. When innovation budgets are being squeezed, it is also hoped that private capital could fill the funding gap.

Public-private partnership often helps high risk projects requiring serious capital at an early stage, for example, to buy hi-tech equipment or carry out research. Private investors are reluctant to risk these sums, but are willing to commit when the state acts as a guarantor. This sort of partnership may also help genuinely innovative startups raise seed money.

At the moment private investors display much greater willingness to put money into seemingly risk-free copycats, while brilliant startups with a great idea, clear market intelligence and a strong team often run out of money at the very beginning of the growth stage.

Therefore, some state involvement should be welcomed. However, it comes with serious risks. When the state acts as investor, it should never do so through a state owned fund managed by salaried employees like Rosnano did. Fund managers must personally share the investment risks and also be entitled to enjoy the rewards. The state should also assign fund managers with feasible tasks. Investing in projects to make a quick profit is very different to building a new industry. Investors tend to be better at the first than the second.

Finally, when establishing an investment fund, the state should seek to employ as few people as possible, so as to avoid the creation of a bureaucratic hierarchy. When that happens, investment decisions start to be guided by the rules of the hierarchy, and not by the personal opinions of investors. In light of this, the best thing that the state can do is to hand over the running of business incubators or accelerators to serial entrepreneurs.

Conclusion

Hopefully, the above serves as a helpful introduction to the Russian venture market for any Indian investor with an interest in the country. Indian and Russian startups share some advantages and challenges: on the one hand, both countries have an abundance of cheap, educated professionals, particularly in provincial towns; on the other, they are both plagued by excessive bureaucracy and a state that, by trying to help, sometimes does more harm than good.

Sectors which might be of particular interest are medical IT systems, clean-tech, nanotechnology, pharmaceuticals and the development of new machinery. Startups in these fields tend to be seeking solutions to global problems, which makes them open to international investors that can help them expand.

Having said that, the Russian startup sector, for all its faults, has interesting ideas in a whole range of niches. Finding them requires some hard work, but can deliver great rewards.

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