Russian tech startups face a growing number of challenges in the year ahead, given the economic crisis, geopolitical stability and the unpredictable nature of the Kremlin’s politics.

What prevents Russians from building successful internationally competitive businesses is the lack of support mechanisms, such as those provided by thriving innovation ecosystems. Photo: Theory and Practice

The exacerbation of the economic crisis in Russia in early 2016, combined with the Kremlin’s stance against small business — as witnessed by the unprecedented demolition of more than 100 commercial structures in Moscow last week during “the night of the long shovels” – continues to weigh heavily on Russia’s already uncertain investment climate.

With the ongoing impact of Western sanctions and the growing instability brought on by crises in Ukraine and Syria, Russia is still searching for a bottom to the current economic downturn. This has obvious deleterious consequences for the nation’s investment climate. As a result, it’s becoming harder for Russian tech startups to secure funding from foreign investors, many of whom have exited the country afraid of the risks and potential losses. 

Today, despite the general slowdown in the economy, the devaluation of the ruble and high domestic inflation rate, some of these tech startups are attempting to benefit from the crisis and grow. Moreover, spurred by the economic challenges at home, some of them are increasingly focused on entering international markets, as indicated by a recent Russian Startups Rating, presented by Russia Beyond the Headlines (RBTH), a media outlet, in early February. The ranking introduced the most promising young Russian tech companies, with detailed descriptions of their success stories and feedback from experts.

At the same time, there have been new initiatives from several of the country’s venture funds to introduce Russian startups to the global market. For example, on Feb. 9 Pulsar Venture Capital, located in the Tatar Republic, announced the launch of an accelerator program to boost Russian startups and integrate them into the global innovation market by attracting both foreign and Russian investors.

Dominique Fache, the administrator of prominent French technological park Sophia Antipolis Foundation, has been doing business in Russia more than 20 years, focusing on investment in innovation and science. He argues that the current crisis is not the best time for Russian startups, but it should drive them to change their approaches and, thus, benefit from any market instability

Even though most foreign investors are fleeing Russia saying, “It is not the right time to go to Russia,” Fache prefers to go in the opposite direction, adopting the position of a contrarian. He describes himself as “the advocate of the counter-cycle.”

“You have to do business when everything is in bad condition and, especially, with startups,” he told Russia Direct when asked about the odds of Russian startups attracting foreign investment. “I prefer to give a chance for Russia to recover.”

In his view, these startups do not carry the burden of negative experiences or the same types of controversial track records as traditional big companies. The common Russian company is inflexible, while startups are more adaptive to the current economic situation, which gives them more advantages and encourages them to be more competitive. After all, necessity is the mother of invention. 

“The startups are more agile, more flexible and more reactive,” Fache says. “They can do better in business, which is difficult, crowded and a little bit gloomy at the moment. They are ready to react most rapidly to the changes of the situation and they need quick decisions, which is not in the main capacity of many current businesses.”

Andrei Yakovlev, director of the Institute for Industrial and Market Studies at the Higher School of Economics, echoes Fache.

“Generally, despite all this political turbulence, there are positive shifts in higher technical education, because the government launched many encouraging programs in the mid-2000s, which are bringing certain results. We see the increase in links between fundamental science and industry, where projects with commercialization potential are emerging and technology transfers are becoming reality,” he told Russia Direct in an interview. He further points out that the promotion of startups and innovation “is happening independently from geopolitical instability.”

Media publicity for startups, spurred by various rankings or other government initiatives, is supposed to help investors understand the potential and the nature of the country’s startup ecosystem and, at least indirectly, help to attract investment. Even though it could be the case, Fache sees such obsessions with publicity and aspirations to be included in the rankings as a double-edged sword, which could have negative consequences.

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“The more you talk of a company and the attracting of investment, probably, the less investing will be in any real business,” he explains. “After all, it is not the noise around the company that makes a success of the company. On the contrary, some of the best innovation “jewels” – the true “diamonds in the rough” you never know about them at the beginning. So, investors should be careful about it. There is a tendency of increasing noise about a company, but noise is not music.”         

The challenges that limit investment in Russia startups

Even though there are some positive initiatives launched by Russian Venture Company (RVC) and the Association for Strategic Initiatives (ASI), both of which are trying to boost the innovation ecosystem in Russia by supporting exchanges, developing international technology and competitiveness programs, there is a lack of business accelerators and business angel programs in Russia.  

If one looks at the U.S. innovation ecosystem, by comparison, it is easy to see a huge number of business angels and business incubators, and the type of infrastructure that supports projects at the early stage, when they are most at risk and there is no funding at all. This is what some investors and entrepreneurs call “the bottom-up infrastructure,” from where the real innovation comes.

Many, including Fache and Kendrick White, the founder and director of Marchmont Capital partners, agree that bottom-up innovation primarily thrives locally, in the regions, because it is very challenging to manage that from Moscow.  And this is one of the problems for Russia’s startups. All money is primarily invested in Moscow government initiatives and big projects like Skolkovo, Rosnano or Rostech, not on the same programs in Voronezh, Novosibirsk or elsewhere.

Experienced investors usually argue that this problem should be tackled on the local level, but the local government doesn’t have money to do that and they don’t have know-how or understanding. So, it creates a vicious circle, a classic Catch-22 problem: those who need the government investment and support the most also have the most difficulty attracting it.

The good news is that there are some projects aiming at resolving this challenge at the regional level: One of them is a comprehensive Technology Commercialization Center (TCC) at Lobachevsky University of Nizhny Novgorod (UNN), created by White, who has worked in Russia for 22 years, helping its inventors find common ground with local and international businesses. The TCC includes one of Russia’s first ever proof-of-concept centers, which tests the commercial viability of new discoveries and assess their market value, which is essential for angel investors, corporate partners or venture capitalists.

However, such grassroots initiatives don’t resolve the problems. Yakovlev points out technology transfer and commercialization facilities in Russia are not yet complete.

Indeed, they are many obstacles for their full implementation. One of them is the Kremlin’s tax policy, which is unfavorable for nurturing innovators. Fache is skeptical about Russia’s current tax environment. Like other prominent foreign investors, he calls for alleviating the tax burden on innovation companies and providing more opportunities and a more welcoming environment to invest in more risky (and hence more profitable) startups. This is what attracts more investors. If one goes in the opposite direction, it might provoke investors to leave the country.

Another critical problem is the Kremlin’s narrow planning horizon. Last year the Russian government’s shift from a three-year to a one-year budget was a not good sign, especially for Russian startups. Some experienced investors and economists call for reconsidering such a budget limitation. With such an approach, Russia is hardly likely to achieve impressive results in the sphere of innovation, which requires long-term thinking of 10-15 years, not short-term planning.     

Why investing now might be a good idea

Just as the crisis created more risks, it also opened new doors for Russian innovators and their partners. According to George Gogolev, head of innovation ecosystem development at Russian Venture Capital (RVC), a state-funded agency that finances developments in Russian high-tech, potential investors can really benefit from opportunities emerging as a result of the crisis.

“Russia has heavily invested in building up its innovation ecosystem since 2006 and has created proper institutions and practices resulting in a decent flow of quality startups. This pipeline is now being underfinanced for growth stage companies and therefore investors can find really good value for their buck,” he told Russia Direct.

Read the Q&A with Alexander Auzan: "Why Russia won't be able to modernize economy in times of crisis"

Another good reason to invest in Russian startups is the dramatic decrease in wages and costs: Quality development and engineering are now available at a much cheaper rate than before the crisis and this disparity will take no less than five years to level out, said the expert.

Malgorzata McKenzie, the director of the Innovation and Knowledge-based Economy Program at Poland’s Center for Social and Economic Research (CASE), echoes this view. She argues that it is worthwhile to invest in Russian startups now for a simple reason: “With the depressed ruble and likely undervalued startups, an outside investor can get more value now.” At the same time, she warns against investing in Russian startups because of a high level of uncertainty.

“There seems to be no clear plan of structural reforms at the macro level and there is still high possibility of low oil prices continuing, further constraining Russian GDP,” she told Russia Direct. “In such a situation, even if there are market niches for the startups to grow, the overall picture may not be indicative of growth.”

McKenzie said that Russian startups are known to be relatively high-tech intensive, yet with weaker links to successful business models.

“So bridging the gap between inventions themselves and these inventions being sold and valued on a market has always been good strategy,” she said. “Also, in the view of shrinking opportunities domestically, helping with international development opportunities may be a good strategy. 

Controversial policy-making by the Russian government

During the last decade, the Russian government has been taking steps and measures to improve the environment for Russian startups to help them thrive. For example, the ecosystem grew from being virtually nonexistent to one consisting of more than 150 venture funds, 100 high-tech hubs and 100 incubators producing thousands of startups. 

Now, “it’s about time to step back and redesign some of the support mechanisms,” thinks Gogolev. What startups always need is access to the market and capital. Learning to attract private seed capital into the ecosystem is also crucial, the expert says. While the government seems to be keen to privatize some of its assets, which might lead to higher competition and better market conditions, thinking about the overhaul and redesign of the system seems like a good idea.

On the other hand, this seems a bit odd against the backdrop of the current geopolitical and economic crisis. Coupled with the traditional suspicions about the work of the Russian legislative system and unpredictable policies of the Kremlin, this introduces even more doubts in the heads of the potential investors. The demolishing of the commercial structures in Moscow, which the authorities deemed as illegal, is just one recent example of the risks that smaller businesses have to face while doing business in Russia.

Some experts are also concerned about the Kremlin’s priorities related to its general vision for the future of the country.

Richard Burt, former U.S. chief negotiator during the Strategic Arms Reduction Talks (START) in 1991 and currently managing director for Europe, Russia and Eurasia at McLarty Associates (a Washington-based firm that does international strategic consulting) argues that people in Russia are just as smart as those working in Silicon Valley. What prevents them from building successful internationally competitive businesses is the lack of support mechanisms, such as those provided by thriving innovation ecosystems.

“To me it is a question of what are the priorities around here. Russia can’t be simply a military power. It should be an economic power, a cultural power. It should be a well-rounded power – not simply strong in one dimension,” Burt believes.