K.White book

Innovation for Business: a 21st Century Development Model for Russia

Part XII

A dearth of R&D investment

Through the course of the privatization process in the 1990s many people were able to buy and take control of companies, their accounting and financial management, and were able to use those companies to their own benefit. The companies did not receive substantial investment in development and modernization. As a result, much of Russiaís industry has suffered over the past twenty years through the severe lack of reinvestment in R&D.

Originally, those running the companies were government supervisors, and when they became private owners they continued to use the companies the way the government had used many enterprises prior to that, which is to take whatever resources could be taken.

Iím not going to comment on the moral implications of this; Russiaís history is what it is. But it now must change dramatically in order to embrace a market economy.

Todayís owners of those companies are oftentimes different from those who privatized them. The new owners must understand that the firms they happened to take over need tremendous investment in R&D. Thereís been too long a period of non-investment.

This aspect of Russiaís systemic problems is not less important than the lack of business angel investment. In any given innovation economy the first and foremost market renovation is the local domestic market. My experience shows that very often innovators see thereís no market in Russia for their ideas, so they conclude that their ideas have to me marketed and commercialized overseas.

This has to change. The domestic manufacturing markets need to be improved to the point that they actually begin to demand innovation, and innovation first and foremost needs to be implemented in local manufacturing and then, when the idea takes hold, exported to other markets.

Russian business owners need to invest in themselves out of their own self-interest. When a company invests in its own modernization, its total asset value and market capitalization will go up.

See who your investor is

A company needs to prepare itself to attract investment because the cash flow from the companyís operations is not always enough to pay for the modernization that would help it adapt to 21st century market demands and competition from foreign or Moscow companies.

Itís important to understand where your company lies at the development stage. Is it an older company that needs dramatic restructuring? Or is it a younger company that needs capital for modernizing its production facilities?

There are different levels and stages of investment, and at each stage thereís a specific type of investor. For seed capital you need business angels, proof-of-concept centers or grant financing; you need technical assistance in how to move your ideas from a laboratory to a commercial workplace. At the start-up phase there are different types of business angels and VC funds. At the early stage there are more VC funds. For rapid expansion you need yet another type of investor.

At each of these stages expectations of the investors would change as far as their rate of return on investment, the internal rate of return, the money multiple, and so on.

Peering into your horizon

For example, an angel investor investing in a seed capital level brings a relatively small amount of money: $10k, $50k or $100k. This money is required to make a prototype, prepare a commercialization strategy, pay for market assessment, and prepare the company for the next round.

The next round, the start-up, will look for more money, a combination of business angel and VC money.

If an angel investor envisions a ten-to-twenty year time horizon, a start-up venture investor may be looking for a five-to-ten year time horizon. It is shorter than the first stage but itís still fairly long, and the money multiple may be ten.

If you look at early stage investment, the time horizon may be four-to-six years, and the money multiple might be seven, meaning if you invest $1m, the expected return might be $7m.†††††† †††††††††

If you look at the rapid expansion phase, the risks are lower; the firm has already proven it has a marketable product; thereís a market interest and buzz about this product; and the time horizon for the investor is shorter. It may be three-to-six years, and the multiple may be five. So if you invest $3m, within six years your return may be $15m.

If you look at the growth stage, the time horizon is likely to be within five years, and the multiplier may be reduced to four. If you invest $10m in the growth of the company, you may be expecting after three or a maximum five years to get back $40m.

So, the amounts of investment are higher, the horizon is shorter, the money multiple is lower; but because the amounts are bigger, the overall return is much bigger.

If you look at restructuring, it may take two-to-four years, so the time horizon again is lower, and the amount of money required may be substantially moreó$30-50m for major corporate restructuring. But the money multiplier may be only three.

At the final pre-IPO stage, the time horizon may be just two-to-three years. The company may be ready for an IPO, but the market may not. If there are global macroeconomic currency issues, inflation rates, or maybe some external factors such as war or pandemic disease, then the market may simply not be ripe to go to an IPO in London or Hong Kong or New York. So what should exist is pre-IPO financing, which is like bridge financing.

This financing may come in for a short period of time; maybe itís one year, maybe two or three. The expected rate of return is low, and this is risky. One can never tell; maybe the IPO takes place in a year, or in three years, or it will take longer. Because of the risk this may be equity or quasi-equity investment, but the rate of return is still expected to be higher than a simple bank loan.†

Look for sector-specific expertise

There are different types of financing for different stages, and within each stage of corporate development you as an owner of the company must look at who the investors are.

If youíre a telecom, you will not necessarily go to a VC fund that does biotech. You will look for a fund experienced in telecoms or IT. If youíre a large manufacturing company seeking $10m, you would not go to a small nanotech investment fund; you would look for an investor nimble in your sector.

If you go the Russian Venture Capital Associationís website, youíll basically be able to find the listing of all the different investment funds operating in Russia, and you can see whoís running those funds. Who are the specific people? What experience do those specific people have? What companies have they invested into, and what have they done?

You could look at the example of Almaz Capital, a very successful IT venture capital fund in Moscow. The company has a very specifically defined investment target; it has specific experience in it. If they come to look at your project in IT, they bring in not only their money but also investment managersí personal experience.

If you look at another investment fund focused on automotive components, then its investment managers should have experience in the field. This is useful because what you want to find is an investment fund with the kind of experience that will help you avoid mistakes.

So my advice is that you should understand your company very well, and you should understand what investors are out there that may be interested in your sector. And donít waste your time going to the wrong investors. Target the relevant ones; explain to them why their experience is going to be useful for you.

If you explain to the investment funds that you know they are experienced in your area, this will immediately show your sophistication, reduce risk barriers, and help you negotiate better valuation for your company.††††††

15 Nov '10

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