Start-ups seek the smart roubles

In 2002, Russian computer programmer Igor Sysoev began to work on a new program “as a hobby” in his spare
time while working for a Moscow-based search engine.

More than a decade later, the web-hosting software he designed is the second most popular on the internet –
customers include Facebook, Netflix and Groupon.

Last year, with the help of a $3m investment from a group of venture capital firms, he started a company known
as Nginx (pronounced “engine x”) and moved into a swanky suite of offices in Moscow’s Prechistinka
neighbourhood.

From there, he and 12 employees plan how to wrest global market from Apache, the dominant web hosting
software, and – more importantly – how to make money from their open source product. “We have 60 per cent of
the Russian market but no one pays,” says Andrei Alexeev, head of business development.

Nginx is a new species of company. Despite a few big success stories in the internet market such
as Yandex and Mail.ru, the latest cohort of young Russian internet companies is struggling to grow.
While Russia’s government has made an “innovation economy” an important goal, Mr Sysoev says that it is the
private sector, rather than the government, that is vital if the industry is to grow.

The key to getting more start-ups in Russia, Mr Alexeev says, is to get more investors. The right investors, he
emphasises. Private venture capital firms are comparatively rare in Russia, which is why most Russian start-ups
go overseas.

The most successful and active of our [entrepreneurs] go to work over there [abroad] because there are so few
funds that will work normally with you,” he says.

By “normally” he means funds that will not demand an extortionately high chunk of equity in exchange for
modest finance. After much shopping around, Nginx found a consortium of American VCs that offered a “typical
for Silicon Valley” deal for $3m initial investment – he will not reveal the size of the stake but experts estimate it
to be about 30 per cent.

A number of other Moscow start-ups, Mr Alexeev says, have not been so lucky, falling prey to a buyers’ market
with power to extort large shareholdings in exchange for initial capital.
“I don’t know what the wisdom is of leaving the founder with only 20 per cent of the company,” he says, speaking
of some deals that he has knowledge of but will not name.

“Finding money for Russian venture firms is no longer a problem,” says Serguei Beloussov, head of Runa
Capital, one of the three VCs that took the stake in Nginx. Runa, for example, set out to raise $15m a little over a
year ago but last summer was able to announce that it already had $135m. “Tech companies need smart money
and smart money is still in relatively short supply.”

VCs typically take an initial stake in a high-risk venture, then help it navigate the markets towards a “big exit”
such as a sale or initial public offering. A VC will help a start-up to hire executives, plan successive rounds of
finance, and market itself to customers and investors. Mr Sysoev says Nginx, for example, is still learning how to
“monetise” open source software through technical service agreements.

The signs of a boom in Russia’s high tech sector are everywhere; good engineers are in short supply because
start-ups are all the rage. “It used to be you would go into business and then after 10 years you’d start your own
business,” says Stanislav Protassov, head of engineering at Parallels, a software company headed by Mr
Beloussov. “Now it’s the opposite – you graduate, try a few start-ups, and if it doesn’t work out you go work for a
corporation after a few years.

According to research by Fastlane Ventures, a Moscow-based incubator for internet ventures, the total value of
high-tech deals more than doubled from $220m in 2010 to $550m in 2011. Among the big ones were Rakuten, a
Japanese VC, which took a $100m stake in Russian online retailer Ozon.ru; Northwest’s $70m stake in Avito, an
eBay-like website; and a $55m investment by Bessmer and Russia Partner in Kupivip, a shopping website.
In May, Avito.ru, a Russian online classified site cofounded by two Swedes, raised $75m from local private equity
firm Baring Vostok and global venture capitalists Accel Partners, alongside existing investors Kinnevik and
Northzone.

Pay-offs can be immense. In 1999, ru-Net, one of the pioneer tech investing firms in Russia, led a consortium
that put $5m into a start-up venture known as Yandex, valuing the company at $15m. In May 2011, Yandex listed
on Nasdaq with a value of $11.2bn.

This makes Mr Beloussov optimistic. “Russia is the only country aside from the US and China that can
produce a tech company with a $10bn market cap today,” he says.

The main obstacle to greater venture interest is not language or lack of prospects, he continues. Ironically, it is
that Russian tech start-ups are too small. Most cannot absorb more than a few million dollars, and advising such
a venture takes hours of staff time, with little immediate pay-off.

The biggest Russian venture capitalists are no longer able to operate in Russia because “they can only write
minimum $300m cheques, and there is no start-up here that can take that kind of money”, says Mr Belousov.
Such is the case with the largest Russian venture firm Digital Sky Technologies, which invested in Mail.ru and
Vkontakte early in the game, and became a big investor in Facebook. “DST is now too big for Russia,” says
Marina Treshchova, chief executive of Fastlane Ventures. “When they come back, we’ll know the Russian
venture market has arrived.”

Getting private capital involved is crucial says Alexander Galitsky, a prominent Russian venture capitalist.
“Governments cannot do venture investing because governments invest taxpayers’ money and taxpayers’
money hates risk. And venture investing is the riskiest there is.”

The government’s effort to jump- start a technology sector is focused on Skolkovo, a high-tech innovation hub
located on the outskirts of Moscow, scheduled to open in 2013. It will offer grants, office space and support for
visas for tech entrepreneurs.

Mr Beloussov welcomes the Skolkovo project but says government money comes with too many strings
attached. For comparison, he brings up the Yozma programme, which in 1992 successfully launched the venture
industry in Israel. “I know it’s self-serving, but if we had bigger budgets we could help more companies,” he says.

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