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Russia to invest in venture capital firms

Kremlin plans to sink more than $1 billion into tech start-ups via top-tier VC firms. But are the firms really ready for "the last frontier"?

Russia has long wanted to be a major player in high tech and the country will now use the profits from oil and natural gas to get there.

The Russian Venture Company (RVC), created by that country's government, has set out to hand over $1.25 billion to top-tier venture capital firms. The venture firms have to invest the money--along with some of their own money--into Russian start-ups, or start-ups created by Russian expatriates that are based in Russia.

The terms, though, are generous. The RVC doesn't want stock in the companies that receive investments. Instead, it only wants its original money back plus 5 percent in interest, said Yan Ryazantsev, the investment director of the RVC, in an interview with CNET

A correction was made to this story. Read below for details.

Effectively, the money is being loaned at a low rate by the RVC; typically, investors in VC funds get significantly larger returns based on equity returns. If the start-up skyrockets, the VC firm and the company founders enjoy all the benefits of a zooming stock.

If the fund loses money, well, the RVC loses money. The RVC won't demand full payment of its money or the interest, Ryazantsev said. So far, the Duma, Russia's parliament, has given $625 million in funding, but will soon double that.

Abu Dhabi has created a similar fund to create a clean tech industry in the Middle East.

The catch to all of this, of course, is that we're talking about Russia. President Vladimir Putin has moved to centralize control over the country over the past several years. Various businessmen have been put in prison on controversial charges. Corruption and piracy are rampant, according to many analysts and reports.

"We need brains, talent and professional advice. This is what we expect the partners to contribute...Russia is the last frontier."
--Yuri Ammosov, Russian Ministry of Economic Development

"Hooo, boy. Just look at the papers," said one prominent venture capitalist, who doubted many top-tier firms would be interested. "But there are plenty of firms out there looking for funding."

So far, three firms--Draper, Fisher, Jurvetson; Asset Management; and Tamir Fishman--have entered into deals with the RVC. Under these deals, the VC firms create a new, separate fund with their own money and money from the RVC. By the end of next year, the RVC hopes to have alliances with seven to nine more funds.

The RVC has also recruited Yigal Erlich, who was instrumental in creating the incubator program in Israel, to help run the program.

Tech ambitions
The idea is to close a gaping hole in Russia's tech ambitions. Rising oil and gas prices have made Russia one of the fastest-growing economies in the world. The country also has a long history in chemistry, physics, aeronautics and mathematics. Ryazantsev himself is a scientist and a member of the Russian Academy of Natural Sciences.

However, the country is short on people with experience in taking interesting ideas in labs and turning them into multibillion dollar companies.

"We need brains, talent and professional advice. This is what we expect the partners to contribute," said Yuri Ammosov, a senior policy officer in the Russian Ministry of Economic Development and Trade. "Russia is the last frontier."

Investors who have tried to do business in Russia say the same thing, according to various people who have tried to invest there. One investor said it's tough to persuade scientists and professors to go commercial with their inventions.

"We still need to build that generation of leaders," said Evgeny Zaytsev, a partner at Asset Management working with the RVC in a new fund called Bioprocess Capital Partners. (Born in Russia, Zaytsev earned an MBA at Stanford University and has worked in the U.S. for some time.)

Ammosov, Ryanzantzev and others, though, contend the picture is changing. A large percentage of the Russian population is under 35, and typically start-ups are formed or incubated by the young. (Some VCs such as Sequoia Capital's Mike Moritz often assert that "youthful energy" is a key factor in success.) Successful Russia tech outfits include Yandex, a former Cisco reseller that has become a search site, and several outsourcing firms. Hewlett-Packard, Intel, and others have also expanded labs there in recent years.

Domestic Internet use and PC sales are growing rapidly as well. Five years ago, Ammosov said the so-called Israel model looked the most promising route for a Russian tech industry. In that mold, companies come up with products heavy on scientific intellectual property and export them.

Now investors in Russia are flocking to Web 2.0 companies that serve local markets, more like to what's going on in China.

"A Russian company can expect to serve the domestic market," said Ammosov.

The country is also working to make it easier to do business there. The Duma passed laws, which will take effect next year, that have reformed several parts of Russia's intellectual property code. It is also working on laws, similar to regulations from the Securities and Exchange Commission, which will create more transparency in accounting.

Additionally, the RVC has set up its program in a way, conceivably, to put some distance between the government and the RVC and between the RVC and the venture capital firms. The RVC's board consists of three government directors and three independent directors, two of which are foreigners (Israel's Erlich and Esko Aho from Finland).

The RVC, meanwhile, will not participate in the day-to-day management of the Russian-based funds. The RVC will put up 49 percent of the money in the fund. The U.S. (or European) venture fund will put up 51 percent. Approximately 80 percent of the money will get invested in early stage companies. The foreign venture investors, however, get to decide which companies to put the money into.

Are the safeguards, combined with the ability to use millions of dollars of someone else's money for practically nothing, enough to attract VCs? It's still probably a tough sell. The first three partners are clearly the most amenable. Tim Draper of DFJ and Pitch Johnson, who founded Asset Management, have spoken for years about Russia's potential. DFJ is also more focused on foreign investments than most U.S. firms.

Tamir Fishman, meanwhile, comes out of Israel, which has an established relationship with Russia's tech community. Israel's incubator program, which helped the country become a tech powerhouse, was created as a way to employ Russian ?migr?s in the 1980s.

Other investors were less enthusiastic.

"I am guessing that someone with Russian roots will take them up on it," wrote one VC. "Or some fledgling new VC that could use a jump start."

Correction: This report misspelled the last name of Yuri Ammosov, a senior policy officer in the Russian Ministry of Economic Development and Trade.