Between 2007 and 2013, the Russian venture capital (VC) market grew from $108m to $1.2bn, making it the second biggest in Europe. This change came largely due to the support offered by the government to create an ecosystem of innovation.
The success of the state stimulus for VC activity is best highlighted by the overall decrease in the percentage of investments made by funds with RVC support in relation to total investments made since 2007 has dropped from 39% in 2010 to 13% in 2013.
However, the early success in the creation of a Russian VC culture has now stagnated and there are clear states of decline. Problems that in the past were labelled as “concerns” are now seen as obstacles that are sufficiently large to prevent US and European funds from entering Russia. A cheap (and educated) labour force and low market saturation are now offset by macroeconomic and socioeconomic issues.
A Shifting Macroeconomic Climate
There has been a shift in the perception of the Russian VC market by the US and European funds. Whereas 5-8 years ago it was closely correlated to the performances of the European market, it is today attached to the outlook for the Russian economy.
International sanctions imposed on Russia during the Ukrainian crisis in 2014 and the response by the Kremlin led to an overall decline in the performance of the Russian economy, which resulted in a drop in the cumulative number of active VC and private equity funds in Russia.
The graph below shows that relative gain of cumulative volume of active VC and private equity funds in Russia decline for the last three years (-0.5% in 2014, -13.8% in 2015, and -11.5% in 2016).
This means that the VC and PE funds are now only 75.9% of what they were at the end of 2013. Note that there has also been a decline in the proportion of funds that were VC from 92% to 76% (as a proportion of VC and PE funds).
Foreign investors’ previous considerations about Russia’s “informal” business culture with no established customs for the settling of deals between foreign investors and entrepreneurs, and its challenging cross-country legal bureaucracy are now just part of the overall risk borne upon entry.
Therefore, a lack of clarity on government regulation and a rise in the chance of not being able to successfully exit the market (through confiscation, or otherwise) has led to a deterioration of Russia’s VC climate and resulted in the overall shrinking of the market.
Lack of End Markets
Countless VC investors are apprehensive about the lack of end market options and the limited number of strategic investors. Many CEOs are reluctant to purchase new technology because they are averse to waiting for the long-term benefits of optimisation (and lower COGS) or because of their firm conviction in the ability to foster innovation in dedicated in-house research labs (reminiscent of the Soviet era of state-led innovation).
With a weaker rouble and the domestic economy in stagnation, incomes of many companies have been undercut over the last few years, thereby leading to a deterioration of demand for startups. This lack of demand, combined with weak IP regulation, and on many occasions, poor economic knowledge of real market valuation by the innovators, has resulted in the ability of big players (such as Yandex) to buy companies for a lower value than before.
Outflow of Russia’s Resources
More recently, two further issues have developed: a rise in the outflow of Russia’s VC capital (mainly to Israel and Europe), and a rise in the number of startup innovators going abroad in order to complete their projects and achieve their funding targets.
As noted by Haaretz, ‘Israeli startups have a more promising route to exit than the Russian companies’. Absence, or passive presence of international technology giants such as Google, Apple, Amazon, etc., makes it difficult to sell at a fair value; a weak rouble brings the chances of orchestrating a successful IPO close to zero.
This issue brings a related problem – many Russian software engineers and startup engineers seek to go across to the US, or Europe in hope of better opportunities. Many Western-led VCs have local offices in Russia predominantly for the purpose of attracting the best talent and taking it across the border.
From their point of view, Russian innovators are attractive due to their high quality of education and low income (average software engineer annual salary is under $20,000). The brain drain, therefore, is often seen as beneficial by both parties.
Solutions and Projections
The issues that the Russian VC market faces are interrelated and to do with the operation of the country’s political and economic mechanisms. The decline in the level of VC investment is likely to have an adverse impact on the capacity of the economy as a talented workforce leaves the country and businesses fail to become fully efficient.
The good news is that this situation is recoverable. If Russia’s economy recovers over the next 2-3 years, and the government gains credibility by making the rules more transparent, then the reversal of the current cash flow is likely.
Together with investors, Russian innovators, now have a better understanding of their craft. However, the likelihood of such a dramatic reversal is slim – full credibility will be hard to achieve given, not just the past 5 years, but the last 100 years of Russia’s foreign relations.
The climate of the Russian venture capital market will be decided by the powers in the Kremlin and the Duma, and will most likely come as a side-effect of their foreign policy, and their ability to maintain political and economic stability at home.
The right path is clear: greater transparency, a better business climate, and a significant rise in private capital participation. Whether or not this path will be chosen remains to be seen.