Russia lays out the welcome mat

If Russia becomes the next great venture capital destination, some of the thanks should go to Pitch Johnson. Back in 1990, the VC pioneer gave a talk about entrepreneurship to the Leningrad City Council. Sitting in the audience that day was City Councilman Vladimir Putin. Yes, that Vladimir Putin.

Now Russia’s president, Putin has been instrumental in turning around his country’s economy and he wants to rev it up even more by fostering venture capital and entrepreneurship. As part of that effort, the Russian government recently launched a fund-of-funds to stimulate the growth of technology companies.

Thanks to Putin, “The Russia of the future is orderly, and a place where you can do business without worrying too much about crooks and gangsters,” says Johnson, founding partner of venture firm Asset Management Company. Putin’s law-and-order approach to government has helped businesses tap into Russian technologists who are more entrepreneurial than their Western European counterparts. “People keep talking about China and India, but Russia is on the verge of a great time,” Johnson says.

To tap into the good time, Johnson is developing an offering memorandum for a tech venture fund targeting Russian startups. The target size of his Russian Technology Fund II is undisclosed, but the effort comes 11 years after he launched his first $10 million Russian fund in 1995, with Harry Fitzgibbons, the managing director of Top Technology Ventures in London. The fund did well, Johnson says, until the Russian financial crisis of 1998. It made a handful of investments after the correction that are recording revenue of $10 million, enough to make the fund worthwhile, he says.

Johnson’s portfolio isn’t the only thing looking up since 1998. The Russian economy is in the midst of resurgence, averaging 6.4% GDP growth over the last eight years. The Russian Trading System, that country’s version of the NYSE, is up 330% over the past three years.

The Russia of the future is orderly and a place where you can do business without worrying too much about crooks and gangsters.”

Pitch Johnson, Founding Partner, Asset Management Company

More money all around

It’s not just oil oligarchs who are making money. Personal incomes have increased more than 12% each year since 2000, according to the “CIA World Factbook.” This has led to an increase in the country’s middle class, which has more power to consume and more freedom to take entrepreneurial risks. Over the next four years, computer penetration is expected to grow to 43% from 10% today and Internet penetration will go to 45% from 15% today, according to estimates from Russia’s communications ministry. The ministry also expects the IT and communications portion of the country’s GDP to double to 10% in the next four years.

Russia’s Communications Minister Leon Reiman announced earlier this summer that the government had launched a $500 million fund-of-funds to stimulate growth among technology companies in the region. The fund could expand to $1 billion, depending on the interest of outside investors. The Russian government may own up to just less than half of the fund, and will only claim its principal and 3% of any carry from the fund’s upside—very much like a venture debt firm—according to people familiar with the fund.

That’s good news for U.S. investors such as Colin Breeze, the founder of Breeze Ventures Management, an emerging fund manager based in Palo Alto, Calif. Breeze says he has been working with the Russian government over the past year to help it tailor an offering for potential investing partners. “This is the clearest effort to date from the government saying that Russia’s future isn’t just petrochemicals,” he says. “It’s defining Russia’s future in technology, communications and services.”

It’s a future that will be fed on foreign investment. The first generation of Russian technology startups didn’t look for outside capital. Companies such as Moscow-based antivirus software maker Kaspersky Lab, founded in 1997, bootstrapped its way into global competition. The company now competes with Symantec and McAfee and often gets its antivirus updates out faster than larger U.S. companies.

The general viewpoint is that they’re stepping away from democracy and toward an authoritarian regime, and that corruption is something you really have to worry about.”

Rob Kuhling, General Partner, Onset Ventures

Wanted: foreign capital

Today it’s much more difficult to bootstrap a Russian company. Prices for everything are rising in Russia, from real estate to engineering talent. “You can’t start with $20,000 anymore; you need at least $200,000,” says Jonathan Solomon, who started a warehousing and logistics business in Russia in 1994 and successfully sold his share to a private equity consortium.

The need for startup capital has created an opportunity for U.S. investors such as Breeze, who formerly worked for tech law firm Wilson Sonsini Goodrich & Rosati. He is raising a fund of funds called the Russia Strategy Fund. The fund might work closely with such venture firms as Russia Partners, Quadriga, Mint and DFJ Nexus, the Russian affiliate of Draper Fisher Jurvetson, Breeze says.

One of the most compelling reasons for foreign capital to flow into the country is its great engineers. “When we tell people we’re working with Russian scientists, their eyes light up. Russia had 50 years of having to do more with less,” says Stewart Guenther, a co-founder of Starboard Ventures, an emerging venture firm based in San Francisco.

Russian engineers have unique talents that are hard to find in the United States. Nowhere is this more evident than in the development of analog semiconductors, the chips that drive digital music players, power management systems on mobile phones and other consumer technology products. Designers in the U.S. don’t typically go to startups. They can make big bucks as contractors. “One of the places where you find analog designers is in countries like Russia,” says David Epstein, a partner at Crosslink Capital, a venture capital firm in San Francisco. He also looks in Iran and other countries he describes as having a long history of working in technology, but that “didn’t advance as much as the Western world during the boom times of digital circuitry or during the isolation of the iron curtain. These guys know how to do analog design and circuitry.”

When we tell people we’re working with Russian scientists their eyes light up. Russia had 50 years of having to do more with less.”

Stewart Guenther, Co-founder, Starboard Ventures

Fears of violence, corruption

But for all the advantages Russia offers, some VCs are reluctant to invest there. “The general viewpoint is that they’re stepping away from democracy and toward an authoritarian regime and that corruption is something you really have to worry about,” says Rob Kuhling, a general partner at Onset Ventures in Menlo Park, Calif. He says he’s not interested in investing in Russian startups because he’s seeing enough deal flow in Silicon Valley.

Kuhling’s concerns were reinforced on Sept. 14 with the assassination of a top Russian banking official who had been trying to clean up money laundering. Andrei Kozlov, the first deputy chairman of Russia’s Central bank, was gunned down in the street. “The obvious suspicion is there was a small bank, with very dirty transactions, run by criminals of a very nasty character,” Nikolai A. Kovarsky, a private consultant and one of Mr. Kozlov’s friends told the New York Times.

Even investors who are committed to the region see problems with it. “If you’re successful and you decide to be honest, the government really comes down on you with taxes,” says Guenther, who has just started investing in the area. The Starboard fund he’s trying to get off the ground will apply what he calls a “head and shoulders” model to help get around this problem. The firm will invest in Russian research and development centers, then establish a management team in another country with lower tax rates.

The Starboard partners are trying to get one or two wins with their own money before trying to access institutional capital. So far, the firm has invested in Sparsix Corp., a software company with headquarters in San Francisco and an eight-person team of developers outside of Moscow. The first problem the Starboard team ran into was a lack of Russian management. Although many U.S. scientists transition into management roles in the early stages of a startup, Russian scientists are often reluctant to do so, Guenther says. They like to be close to the cutting edge, where they perceive the hardest problems to be, he explains.

You can’t start [a Russian company] with $20,000 anymore. You need at least $200,000.”

Jonathan Solomon, serial entrepreneur in Russia

Another challenge for foreign investors is that there is still a lingering confusion in many Russian minds about exactly how to look at a startup, Guenther says. “After 70 years of capitalism being defined as piracy it’s hard for some people to appreciate it.”

The emerging Russian business culture is different from what many U.S. VCs may be comfortable with. Business is fast and fluid, says Solomon. Much of what gets done is based on trust. “Russians are willing to move where others won’t by doing a deal without crossing the t’s or dotting the i’s,” he says. “VCs come from the West and require everything to be written up. It just doesn’t exist.”

While Western VCs are demanding more legal protections and better kept books, Russian financiers have a chance to come in and undercut their deal. “When there is ambiguity, the big guys know how to move the business forward,” Solomon says. “It’s the new guys that lose out.”

But that’s starting to change as competition increases and the business environment slows down. Ten years ago, it was hard to lose with a Russian startup. It might have been the only company in its industry. But businesses now look at good book keeping and well-defined contracts as a potential competitive advantage.

The secret to not getting caught as the most naïve investor in the room is to partner with the locals. Says Johnson: “Russia’s a great place to go with capital if you set up an organization with adequate understanding of the economy and environment—that takes a Russian. Setting up shop there with just Western people would be a risky business.”

Even with the right people in place, success doesn’t happen over night. Johnson has been investing in the country for 11 years and still has yet to have an exit.