Thomas Nastas is an American venture capitalist based in Moscow.
You can read Tom's profile in the Moscow Times here
Hungary, Brazil, Russia, India, China (BRIC), Chile and others are replicating the strategies that made Israel, the US, Korea and others so successful in the creation of knowledge economies. Do alternatives exist with less risk and better chances of success in taking a seat at the global table of tech developers?
This article was originally published in The Harvard Business Review's Russian and Hungarian language editions in 2007. To read this article in Russian, complete with text boxes, click here for a PDF version, here in Hungarian and here for an English translation.
Click on the extended post to read the rest of the article without text boxes. To read an abbreviated version of this article previously published on Russia Blog, click here.
The Russian government has established a $500 million venture capital fund to spark innovation
Innovation, small & medium size enterprises (SMEs), entrepreneurship and venture capital (VC) are ingredients in the creation of knowledge based economies; witness the success of Silicon Valley and replicated in France, Germany, Japan and elsewhere. Small country economies like Israel, Ireland and Singapore with little domestic demand for technology developed unique approaches of exporting knowledge creation with excellent outcomes.
SMEs in partnership with governments and foreign investors are working to create technology capacity and ensure their future in a knowledge-based world. Much energy is directed at replicating the strategies that made SMEs in Israel, Ireland, Korea, Singapore and Taiwan so successful -- the development of tech for global markets with government and donor monies supporting technology creation and VC initiatives to finance innovation.
Are these the best strategies with the greatest chances of success? Do alternatives exist, to build from a base of technical needs for the local market instead, to move developing country SMEs up the path of knowledge creation incrementally with greater numbers succeeding domestically, and help position a few for entry into world markets? If yes, how can SMEs, governments and multinationals work together to generate new wealth and prosperity?
In this article I present a GoForward plan to scale up the innovation ecosystem and the investment needed for execution. I draw upon my experiences in transacting seed and early stage VC investments in technology for the oil/gas, IT, biotech and medical industries from Central & East Europe (CEE) and the Commonwealth of Independent States (the CIS, countries of the former Soviet Union).
The Leverage of Venture Capital
In the U.S., companies that raised VC from 1970-2005 created 10 million new jobs and contributed more than $2.1 trillion in revenue in 2005 to the economy. 10 million new jobs are 9% of the total private sector workforce in the US and 16.6% of U.S. GDP, an increase from 8.7 million jobs and $1.5 trillion in revenues in 2000.
Over the past thirty years, some of the most famous brands were financed with VC (Table 1).
Microsoft --------------------------------------------------------------------August Capital
Intel & Apple----------------------------------------------------------------Venrock
United Healthcare---------------------------------------------------------Warburg Pincus
Cisco & Yahoo!-------------------------------------------------------------Sequoia
Hotmail-----------------------------------------------------------------------Draper, Fisher & Jurvetson
Genentech, Amazon.com, AOL, Intuit & Netscape--------------Kleiner Perkins
Google---------------------------------------------------------------------------Kleiner Perkins & Sequoia
Skype-----------------------------------------------------Draper, Fisher & Jurvetson,Index Ventures
Before Hotmail, people communicated by telephone, telex, fax and letter; no big deal. Once Hotmail was launched, communication was turned upside down as users realized huge gains in productivity, simplicity and convenience by accessing e-mail over the Web, 24/7, from any computer, anywhere in the world; with such benefits it's easy to see why new industries formed around this solution.
Before eBay, people bought and sold collectables at auctions for centuries; no big innovation here either. But eBay created an innovative trading platform that combined live auctions, the Internet and collectables that became the biggest online marketplace and seeded the creation of entire industries based on online trading.
Venture capital has given America - and the world - some of its most popular technology companies
Retailing and delivery existed for centuries too. Amazon innovated in the graphical interface to make product ordering simple and combined it with efficiencies in warehousing and distribution to make the user experience pleasant.
What these successes have in common is that each created an innovative business model, mostly around a GameChanging technology; disruptive technology with superior performance or high cost reduction features. GameChanging solutions make products and services accessible to global customers.
Each of these tech and business model platforms spawned business ecosystems of new suppliers and partners. It's estimated for example, that for every $1.00 of revenue that Microsoft earns in Chile, another $11.00 is made by partners, suppliers, system integrators and the like in the Microsoft Chilean ecosystem. Such leverage demonstrates the broad economic value generated by integrating new ideas, innovation, technology and VC.
The Allure of Global Technology Markets
Emerging market country governments see the business and financial successes of SMEs solving global needs. They encourage their enterprises to attack world markets with government money like VC to support this strategy.
Large opportunities attract the best scientific minds, entrepreneurs and investors: cures for human health problems in aging and disease, needs for security in an increasing violent world and energy alternatives as natural resources deplete. In solving global needs and wants, new wealth and prosperity results as the reward for industrial creation.
The actions of the Hungarian and Russian governments illustrate the commitments that governments are now making to jump into the global technology, commercialization and VC game. The Hungarian Government implemented a number of schemes to catalyze more investment, VC and tech development such as the Development and Innovation Program, Microcredit Program for SMEs and Enterprise Promotion. The Administration expanded its intervention to support innovation, investment, trade, and SME development in other ways too through the R&D division of the Ministry of Education and the Hungarian Investment & Trade Development Company.
The Putin Administration is spending billions of petrodollars to diversify the Russian economy away from its reliance on oil, a prudent and worthwhile strategy. It is investing state money in infrastructure like enterprise zones, technoparks and incubators, implementing a 'build it and they will come' strategy.
Especially ambitious is the creation of the Russian Venture Company, a US$500 million fund-of-funds modeled after Israel's Yozma fund-of-fund scheme. The mandate of this PPP (public-private partnership) is to co-invest with the private sector and create up to twenty new Russian tech VC funds with a total capitalization of $1 billion, half from the Russian Government, with the matching $500 million from the private sector. All these initiatives are developed with the intention of taking a seat at the table of global technology development.
The private sector is active in the CEE and CIS too. Global powerhouses in multiple industries -- Intel, Ford, TI, Nokia, Siemens, Motorola, Microsoft, Boeing, IBM, United Technologies, Samsung, Cadence and Sun -- established R&D centers and selectively incorporated CEE and CIS technology into their products. A few international VC funds have invested in Hungarian and Russian innovation.
Yet with all this capital and horsepower invested and to-be-invested, something is amiss in the CEE and CIS. A critical mass of seed and early stage SME investment opportunities do not exist for domestic or foreign VCs. This is not due to a lack of money, as these economies are awash with capital and investors looking for opportunities. And they have advantages not enjoyed by other developing countries: scientific accomplishments that fed the Soviet military machine, leading universities and world class researchers.
Russian/Eastern European Innovators in Technology
Hungary-born American software developer Charles Simony led the development of Microsoft Excel and Word, products that revolutionized financial analysis and word processing to create billions of dollars of new wealth for his employer and himself.
In the 1950s, 43 horizontal oil wells were drilled in the Soviet Union, one of the most ambitious drilling efforts for the then-untested technology. Building on this work and that of U.S. scientist Lester Uren, Alexander Grigoryan put theory into practice by branching the oil wellbore, and in doing so, he became the father of multilateral drilling.
In 1953, the Soviets drilled a main bore in the Bashkiria field (Bashkortostan today) with nine laterals and a horizontal reach of 136m (446ft). Although the cost was 1Â½ times more expensive than other wells, it penetrated the oil reservoir 5Â½ times better and generated 17 times more oil per day. During the next 20+ years, the Soviets drilled 110 multilateral wells with Grigoryan drilling used on more than 30 wells.
A postage stamp from the USSR, cerca 1968. Soviet geologists pioneered many of the horizontal drilling techniques in use around the world today
Other Russian technologies widely used in hydrocarbon E&P (exploration & production) include in-situ combustion and vertical seismic profiling (VSP), invented in 1957 by geophysicist Evsei Galperin of the Soviet Institute of Earth Physics. Galperin's VSP profiles showed the structure of seismic wave fields, which generated huge productivity gains in locating hydrocarbons more accurately. After 50 years of improvements by Western developers (led by Bob Hardage of Phillips Petroleum), VSP is now used throughout the world.
With such technology successes in the petroleum industry and others in aerospace, IT and space exploration, investors and technology customers naturally look to the CEE and CIS for innovation in other spheres.
Few GameChanging Technologies
Over the last seven years, Innovative Ventures Inc., or IVI, and other VC investors evaluated hundreds of Russian deals in IT, telecoms, biotech, medical and others; yet collectively we have invested in only twenty-five or so. Likewise only a few dozen investments have been transacted in the CEE and the Baltics during the last ten years.
Specifically, over the past three years, we've looked at oil E&P technologies for investment. Our findings provide a microcosm and a reflection of current events in the market, and why so few VC investments in technology are made. Leveraging the Soviet science and scientific foundation into knowledge-based economies is a real challenge.
In Russia for example, only 2% of the E&P innovations evaluated (Figure 1) have the performance characteristics that one might classify as disruptive, with superior performance or cost reduction features. Such GameChanging benefits are required to attract international customers and investors and to compete in global markets.
Even though the technologies evaluated had interesting features, they are not ready for customers or VC. They are R&D stage concepts and require money and time for testing and development, to get them market ready, customer ready and advanced enough for VC investment. Contrary to conventional wisdom, venture capitalists rarely invest in R&D (text box: What Does VC Invest In?).
Our findings disprove the notion that Russian institutes and SMEs have great technologies, but investors are blind to the potential. No, what institutes & SMEs have are great ideas, but customers buy products not concepts, and investors invest in deals, not conceptual stage ideas.
Returning to Figure 1, 52% of the technologies were rejected due to poor descriptions of the value of the idea, inconclusive performance data and competitive benchmarking. Many ideas appear interesting and worth a second look if only reliable performance data was available. Rejection was not due to lack of intellectual property (IP), business plans, management or capital markets, typical reasons given as why so few VC tech investments are made in Russia, the CEE, Ukraine and the Baltics.
Good test data is essential to prove performance benefits. Once an SME decides to compete in tech markets, it positions itself against global competitors, many with closer and deeper access to customers and a customer orientation that provides buyers with the information they require to make purchasing decisions.
Even with good performance data, attacking international markets requires disruptive technologies to overcome the purchasing habits of customers and to penetrate established supply chains. However GameChanging technologies are far and few between as they frequently result from coincidence and timing vs. planned innovation (text box: Moving Up the Innovation Value Chain).
If the chances of creating disruptive solutions are so slim, what can a country, its scientists, universities and SMEs do to get into the technology and commercialization business? Given so few GameChanging technologies in oil E&P, IT, biotech, etc., what can Estonia, Hungary, Poland, Russia, the Czech Republic and others with money and lots of talent but only ideas, do to build their place in the knowledge world? And what actions can other developing countries adopt when they lack the technical foundation of Soviet science institutions?
Let's return to Russia to see what an alternative strategy might be and its learning curve lessons to move up the innovation chain.
Overlooked Opportunities in the Domestic Sector
While few Russian innovations have GameChanging qualities for international buyers, others (Figure 2) have value in domestic E&P. Most were rejected as their technologies are behind those offered by international competitors like Schlumberger and Halliburton. But a few are low cost solutions that give customers (both Russian and international oil companies) almost world class performance, but with lower prices compared to Western competitors. Low cost technologies attract price sensitive customers.
What makes this set of opportunities appealing is that they represent an alternative to pursuing a GameChanging strategy. Instead of trying to outperform international competitors on all fronts, one can build a locally competitive SME technology sector for domestic use. Once this base is established, invest new resources to develop their international capabilities for global marketing.
Given higher probabilities of growing a locally competitive technology sector, a GoForward strategy exists to build technology platforms in and around domestic assets rather than diversifying resources away from home market advantages. And if overlooked potential exists in tech for the domestic sector, then how does one do a better job in identifying opportunities early, to nurture them through commercialization?
The GoForward Plan in Technology and Knowledge Creation
Action Item #1: Target Domestic Users First
SMEs and governments cite the low absorption rate of technology by domestic users as the reason to pursue a GameChanging innovation strategy for world markets. Yet every country has industries that are knowledge based; some are clusters formed around a particular industry while others exist from natural advantages.
The automobile industry is a tech cluster with excellent growth in the CEE and the CIS as Ford, General Motors, Toyota, VW, Peugeot and others increase production in the Czech Republic, Hungary, Russia and Slovakia to meet customer demand. These auto multinationals need to build the domestic auto component supply chain to a Western equivalent to meet their business plans just as Shell, Chevron, LUKoil, KazMunaiGaz and others seek more and better oil field service suppliers in the CIS.
Both industries struggle to localize more purchasing and satisfy local content commitments. "The local car industry 'is handicapped by the quality of local suppliers, who are far below world standards," said Carl Hahn, chairman emeritus of Volkswagen. "That's the most challenging part for our team." said Skoda chairman Detlef Wittig.
Yet the GoForward plans of CEE and CIS governments are to build knowledge based sectors like IT, bio & nanotech, etc., but not tech investment for domestic needs in auto components, oil field services and mineral extraction/processing; sectors with immediate payoffs to catalyze a chain reaction in domestic tech absorption (text box: What's the Role of Governments in Tech Creation?).
Israel has become a powerhouse for water treatment technologies in demand worldwide
Israel is well known as a powerhouse of GameChanging technologies for global markets. What are less known are the innovations of Israelis for domestic use, e.g., solutions for clean and pure water. Israel could have had a water shortage as its population surged from less than one million in 1948 to more than seven million in 2006. But it didn't due to actions of the Israeli government in promoting technology.
To provide fresh water needed for life, the Israeli government sponsored R&D in low pressure irrigation systems (for agriculture), rain harvesting, wastewater treatment and desalination. The private sector built on these foundations to produce innovative solutions in water security/management, on-site biological treatment of solid waste, medical waste and biologically contaminated materials. While the focus was and is on domestic demand, pure water needs from global customers stimulated the creation of a new Israeli export sector for clean water tech that now exceeds $800 million/year.
With a proposed new government investment of $160 million over the next five years, Israeli firms are projected to increase exports of clean water tech to $2 billion by 2010, $5 billion by 2015 and $10 billion by 2020 in a world water market estimated at $400 billion a year with growth of 7% per year. With citizens of Planet Earth forecasted to face a 35% water shortfall over the next 15 years, luck (opportunity + preparation) and timing again work to the favor of Israeli SMEs and their VC investors.
The city of Kirov is becoming a center for innovation in the Russian cosmetics industry
Other SME development approaches are possible to build tech sectors for domestic needs, when single technology hubs are less obvious, e.g., in logistics, where multiple technologies intersect. For instance, Latvia sits on the Baltic Sea with new technologies required in IT, warehousing and transportation to grow a nascent logistics platform into a regional distribution powerhouse.
Russian and international corporations are establishing back office administrative centers in the major cities of Siberia, as well as in Budapest and Tallinn, in order to escape the high costs of doing business in Moscow, thereby stimulating new clusters and VC investment opportunities. The city of Kirov, a small Russian regional city 1,200 kilometers from Moscow, is funding bio-clusters to manufacture creams, lotions and emollients used in the domestic production of everyday cosmetics.
Action Item #2: Provide 'Mini Grants' to Document Business Opportunities
Once domestic industry tech hubs are identified, fund a 'mini-grant' program to define the business opportunity for proposed technologies. A mini-grant of $3,000-$10,000 is not intended to fund an entire business plan, but a 3-4 page document detailing the technology's potential.
Action Item #3: Capitalize a 'Proof of Concept' Fund
Commercialization of new technology starts with R&D and product development to demonstrate 'proof of concept' and the value of novel ideas. SMEs are only able to approach customers when they clearly present technology strengths and weaknesses, conducted to a comprehensive analysis under different user conditions.
A 'proof of concept fund' finances the costs of testing a technology and benchmarking it to direct competitors, alternatives or substitutes. To invest capital wisely, mandate that developers and SMEs benchmark the technology early and often to products/services that buyers already purchase from domestic or international competitors.
Action Item #4: Inventory SME/Institute Technologies and Publish as a Database
Provide an Organizational Service (OS) that gives customers and investors the information needed to consider technology from your country:
1.) SMEs/institutes organized by technology, product & market segment, with full contact information
2.) Benefits of the technology with performance & cost benchmarked against domestic and international competitors, with data generated to international testing standards
3.) Stage of development, meaning R&D, product development, alpha or beta testing
4.) Product development plan with timetable & milestone inflection points, line item budgets
5.) Patents issued or filed, by country, date and number, & competing technologies similar in form or function
Publish this information as an Internet database and searchable by keywords like technology or market.
Action Item #5: Establish an IP Facility to Protect Your Country's Intellectual Assets
The IP Facility pays legal costs of filing domestic or international patents with costs reimbursed through revenues generated from product sales. Royalty repayments replenish the Facility so it becomes a revolving instrument with a one-time investment.
Action Item #6: Offer Targeted Business Development Support
Innovations too often sit on the shelf since scientists lack the knowledge to make the business case for the technology, the energy and drive to move them into the market. Many scientists and (some) development stage SMEs lack the skills to make the transition from development to commercialization and growth.
Establish a business development office which actively 'scouts' for opportunities in the SME community and academia. This office identifies and develops projects for financing by the 'mini-grant' program and 'proof of concept' fund, and helps sell innovations from academia/SMEs to customers.
One responsibility of the business development office is to identify IP early in the development cycle and work with legal council to protect it. Scientists and businessmen are rightfully proud when they create new innovations. Yet they sometimes announce their solutions in the public domain before protecting them, inadvertently weakening their legal rights. Business developers must educate scientists and SME managers to the issues of IP, and on what can and cannot be said in public.
Action Item #7: Organize R&D & Supply Chain Competitions for Users of Technology
R&D competitions are used in combination with VC forums or a substitute when deal flow is too scarce to attract VC investors. R&D competitions present technology to generate interaction between tech developers and the R&D staff from corporations. R&D competitions are organized in areas like nanotechnology, alternative energy, greentech, engineered materials, biotechnology, hydrocarbon E&P and so on. The audience is corporations and corporate venture capitalists, not financial VC investors.
Attracting large corporations to R&D competitions has many benefits. They are able to invest in promising technologies, guide their development with customer feedback, speed commercialization and help access opportunities in the supply chain.
Most multinationals hunt for technologies no matter where they come from, and they are able to benchmark technologies from one country to another, to help developers identify the strengths and weaknesses of their technology vis a vis global competitors. Others (text box: Integrating Multinationals into the Innovation Ecosystem) have a strategic priority to integrate technology into the corporation as supply chain linkages, thereby stimulating innovation, growth and job creation in ways such as:
1.) Be the technology platform that helps SMEs model and scale their solutions in advance of customer demands
2.) Reduce development time and get products and services to market quickly
3.) Lower investment risk and help SMEs secure funding
4.) Jump-start sales
5.) Expand the market reach of SMEs by integrating them into corporate & international business ecosystems.
The venture capital arms of multinationals are especially helpful. Corporate venture capitalists Siemens, Nokia, Sony, Dow, DuPont, Shell, Chevron, Norsk Hydro, Cisco, Intel, Sun, Oracle, Motorola, SAP, Schlumberger, IBM, etc., invest into SMEs just like VC investors do. But they add-value in ways that financial venture capitalist cannot.
They take technology risks by investing VC in the R&D of young SMEs, and invest directly in IP with technology right-of-use, a structure that accelerates the diffusion of technology to markets and customers. Corporate VCs also provide access to corporate R&D budgets for the funding of technologies at their early stages of development, before financial VCs are able or willing to invest.
Corporations help SMEs apply their technology to customer needs. As Esther Dyson, an investor in Russian and Eastern European startups remarked: "One thing that the market requires is a more demanding customer base. They need to become better buyers and users. They have all the necessary technical skills, but they don't have the business experience to apply the technology as well as they should."
Strange as it may seem, New Zealand is a fitting model of success. While not a developing country, New Zealand is small and remote from global demand. Its strategy for making the transition from a low tech to a high tech economy is illustrative of how a solid domestic focus created a technology in the SME industry.
In the mid 1990s, New Zealand government planners invested in biotech R&D to create more flavorful and different varieties of wine, as well as sheep and cattle with more meat and less fat. Their focus was on new solutions for domestic needs in agriculture and animal husbandry, not global biotechnology, where New Zealand enjoyed little comparative advantage. Five years later, government initiatives have yielded results, and VC investors have financed the commercialization of New Zealand SME innovations.
New Zealand wines
Today New Zealand meat and wine are found in Australia, Europe, Japan, Russia and the U.S. Their SMEs sell technology products and services to Australian, European and U.S,. winemakers and animal growers, truly a win-win for all.
Build the deal flow; customers and investors will follow.
To read this report complete with text boxes, click here for a PDF version.
Venture capitalist Thomas D. Nastas is president of Innovative Ventures Inc. of the USA and Russia and serves on the Board of Directors of Sotsgorbank of Moscow. Mr. Nastas is also Professor of Marketing at the American Institute of Business & Economic College in Moscow.