There is a lack of special regulations for investments in
Russia and it concerns both private equity in general and
venture capital in particular. Laws regulating investments are
outdated and of practically no use, the effective legal
definition of a private equity transaction is far from accepted
standards, and venture capital is still not defined at all.
Reforms were proposed in the Bill on Innovations and State
Innovation Policy that was tabled to the State Duma in 1999.
However, it was sent back by the government in 2001 for further
modification and was never tabled again.
The Law on Investment Funds (No 156-FZ, November 29 2001)
provides regulation for mutual investment funds and
incorporated investment funds organised in Russia. It severely
restricts those funds' activities, often making them unsuitable
for venture financing.
The Federal Service for Financial Markets (FSFM) has defined
venture financing as investments in high-technology or similar
companies connected with significant risks for investors.
However, this definition in itself does not provide a clear
distinction between venture capital and private equity.
Therefore, there is almost no special legal regulation of
venture capital and venture funds and it is impossible, from a
legal point of view, to clearly distinguish venture capital
from private equity especially as venture financing is
usually provided in form of a private equity transaction. This
lack of regulation significantly complicates venture capital
activities in Russia, although does not make it totally
Compared to western countries, venture capital has a short
history in Russia. Its early development is strongly connected
with international financial institutes, such as the European
Bank for Reconstruction and Development and the International
Finance Corporation. For several years until other
foreign and local venture investors emerged venture
funds organised by these institutions were the sole source of
special purpose venture financing,. Venture capital funds of
international and foreign origin are still one of the main
sources of venture financing in Russia and the number of local
venture investors remains low. In recent years, Russian banks
and public companies have been reluctant to provide venture
investment in recent years. On account of the global finance
and credit crunch which significantly affected Russia
such financing almost stopped. However, huge finance and
credit corporations (in particular, Alfa Group, Rosno, etc.)
still maintain their own venture funds, providing moderate
Investment funds organised under Russian investment
legislation, including mutual investment funds and incorporated
invested funds, often cannot provide sufficient venture
financing, owing to restrictions provided by legislation and
their internal regulations. Pension funds have not become large
investors as they face similar restrictions to investment
funds. However, potentially all are able to provide financing
for venture companies.
The state can invest in the national economy through
specially created state investment funds, which are another
source of venture funding. In 2000 a state Venture Investment
Fund was established. Later, the Russian Venture Company (RVC)
received substantial financing from the state to distribute
between 10 and 20 venture funds. The RVC is modelled on the
Israeli Jozma programme as a fund of funds providing financing
to private funds on a 50/50 basis. We note however that during
the whole of 2009 RVC was almost inactive.
Fund structuring considerations
Funds with different structures, sources of financing and
management have different views on acceptable investment
targets, the way the investments are made and exit structuring.
In particular, Russian-based investment funds usually have more
limited means of making investments and less to invest compared
to foreign funds, although the targets of investments are
mostly the same. Where a Russian-based investment fund is
established in the form of a mutual investment fund or
incorporated investment fund, it has even less options for
investing owing to a number of limitations imposed by the
Federal Service for Financial Markets on structure of assets of
Foreign investment funds, having more complicated
structures, higher funding and much greater experience may take
more risks and currently have a big advantage over the local
funds; this is expressed in the level of investment and rates
It is possible to establish a representative office of a
foreign company in the Russian Federation and to use it as a
vehicle for venture capital funds; we acknowledged several such
cases. The representative office shall be deemed as a separate
department of the foreign company rather than a separate
company. Owing to an insufficiency of regulation, however, and
some procedural difficulties connected with the establishment
and maintenance of representative offices, most investors,
including foreign ones, prefer to establish separate
Russia-based companies and use them as investment vehicles.
The company may be organised as either a limited liability
company (LLC) or a joint stock company (JSC). As there is
currently no distinction of legal form between public and
private companies, the choice of structure does not
dramatically affect the way investments are made.
Another option is to use a mutual fund. Mutual funds are
regulated by the FSFM and are obligatory for managing state
funds. However for major investors capable of participating in
the management of the target company, it is less convenient
than a JSC, and especially less than an LLC because of the
applicable requirements and restrictions.
Foreign venture capital funds operating in Russia aim to
invest in start-up and early-stage companies with unique
research and development projects, which will allow them to
gain market power, become self-sufficient and start to provide
returns within a short period of time.
The life of a fund is usually five to seven years and
produces returns of 30-40% internal rate of return (IRR) or
above. For example, in last year one of the largest foreign
venture funds declared IRR on several projects as high as 70%
per annum which resulted in considerable profits for investors,
though these amounts are expected to decrease this year and
beyond on account of the overall economic situation.
A fund will usually exit a project after four to five years.
It is, however, currently impossible to provide detailed
figures regarding timing, financing on each stage and returns
of domestic venture projects, since venture financing is still
undeveloped and the general economic situation is unstable in
the long run.
In the most recent years the Russian Government constantly
declared that it was concerned with underdevelopment and low
amounts of venture financing in the country. As a result of
such concern several organisations were formed which should act
in order to provide state financing for start-up companies (for
example, Russian State Corporation for Nanotechnologies) and in
addition some special state venture funds are planned to be
organised (for example it was declared that since October 2009
there would be a new venture fund fully financed by the state
Russian Venture Company with the capital of two billion roubles
($64 million)). These measures will support start-up companies
and it is assumed that they will incentivise the development of
venture capital industry in Russia.
However there were no regulatory changes proposed in respect
of venture financing and the changes proposed in the past are
still not being considered. The state financing for start-up
companies itself is unlikely to solve the main problems of the
venture industry in Russia, and it does not incentivise private
investors to act more dynamically.
Investment structuring considerations
As recently as a year ago, investors would consider
investing in a simple licence or patent with little development
or commercialisation. However, this is no longer the case and
funds are now largely investing in companies already generating
income or making a profit.
This demonstrates a considerable change in how capital funds
are assessing risk. Previously funds would look at the
potential of a business, now they would rather evaluate its
sustainability. Instead of evaluating intellectual property
(IP) or even the basic idea of the founders, the investors are
looking for a developed and well-supported business plan, a
proven and tested business concept, and an able management
team. In general, the investors, even venture capitalists, are
trying to accept as little risk as possible.
If referred to the share in the capital of the target
company which the venture capital fund may desire to obtain
within the framework of the financing, there are no strict
rules and this matter is resolved fully on the basis of
agreements between the fund and the founders of the investee
When considering potential investments, venture capital
funds closely examine the target company's business plan and
compare it with current market trends to estimate the company's
prospects. If the conclusion is positive, the fund carries out
a due diligence exercise, which includes the following:
- Technical due diligence. Regardless of
what stage the project is at, technical due diligence is the
most important part of this process.
- Legal due diligence. This covers IP
matters and, where the target company has existed for some
time, its documentation and legal history are also subject to
thorough legal due diligence.
- Financial due diligence. This is carried
out for existing target companies.
- Management due diligence. The fund
assesses the current management of the company, as its
abilities will be crucial to establishing long-term
Debt or equity?
Since it is usually impossible to secure obligations from
the target company, venture capital funds provide equity
financing, especially in the first stages.
Equity financing also has the advantage of allowing funds to
nominate their own managers for the governing bodies of target
companies. Funds can therefore gain control over the company
and get reliable information about the company's
Although equity financing is a priority, sometimes the
target company applies for debt financing from the venture
fund. This is usually to cover operating costs or to receive
bridge financing during the fund's decision making period. Debt
financing in this form is usually done in combination with
basic equity financing.
At the same time, debt financing is increasingly popular for
seed or angel investments where these earliest stage investors
hope to replace the debt provided by them with equity on a
later investment stages or rounds.
Which corporate form?
Most companies attracting venture financing are small- or
medium-sized companies engaged in innovative, high-tech
research and production, such as IT companies or
telecommunication companies. They are usually early-stage
companies offering or intending to offer new products and
The company may be organised as either an LLC or JSC.
Depending on the form of the company, the investor may receive
participatory interest or shares in the company, both
representing its stake in the company, but having slightly
different legal regimes. Both LLC and JSC may conduct any
activities not directly forbidden by the law, however the
special license is required for certain types of
There are no special tax incentive schemes to encourage
investment in venture capital, which is another serious barrier
to its development. Generally, the tax aspects of any
investment are under regulated as the result of overall lack of
specific legal regulation of investing. However, the Tax Code
can provide some basic benefits to the parties of an investment
transaction as shown below.
Income received from contributions to a company's charter
capital or within the framework of target financing shall not
be taxable by income tax (article 251, Tax Code). Therefore,
investments in a target venture company are not taxed if they
come from either direct financing or contributions to its
charter capital from its shareholder(s), including holding
Investment tax credit
The investment tax credit provides a time period when the
target company may (within certain limits) decrease its
payments on certain taxes, gradually repaying this debt and
accrued interest in the future (article 66, Tax Code). To apply
for an investment tax credit the company must meet one of the
- The company must be involved in research and development
or technical upgrading to its own production (for example,
upgrades aimed at employment of disabled persons or
- The company must commission or itself be involved
- innovative activities;
- creating or upgrading technologies;
- developing new sources of raw materials.
- The company must provide an important contribution to the
social and economic development of a region or provide
important services to the general public.
Double taxation treaties
Russia has double taxation treaties with many countries,
providing potential tax benefits for foreign investors. Local
investors can also enjoy these benefits by including a company
organised under the law of one of these countries into the
structure of an investment transaction. This is an important
consideration as the overwhelming majority of venture investors
acting in Russia use structures and instruments based on
foreign law. The benefits provided by double taxation treaties
are not directly referred to venture financing or private
equity investments; however they may and shall be used by
The first venture capital funds were organised and fully
funded by international organisations. Later a number of
private foreign funds were established. Local financing still
has a small part in the amount of overall investments.
While private foreign financing, local financing or a
combination of the two is usual, state financing (both on
federal and regional levels) is also available.
In their turn, international and local venture capital funds
receive funding mostly from private and corporate investors and
amounts of such funding exceed attracted credit funding. Due to
the global credit situation this tendency is not likely to
change, on the contrary, in the foreseeable future funding
received from investors shall compose the great majority of
funds invested by venture capital funds.
In practice, venture funds mostly invest independently and
without the participation of other funds. This is because
venture financing in Russia is mainly done by large foreign
funds able to provide the necessary finance. However joint
financing with other funds or strategic investors is possible.
It is more common when attracting a new investor on a later
stage in the next round of investments. Venture funds sometimes
also cooperate in the finding of potential targets in
this case they finance independently, but exchange information
regarding target companies.
As before, a shareholders agreement regulated under foreign
law is usually used as the principle legal document,
transferring participatory interests or shares in the target
company to the fund (represented by its vehicles) in exchange
for future financing.
This is because share or asset purchase agreements under
Russian law are generally of limited use, since it is
practically impossible to include in the agreement any
conditions other than those related to the sale and purchase.
For example, representations and warranties (as they are known
in common law jurisdictions) are not accepted in Russia and the
courts would most likely consider this part of an agreement as
The Law on Joint Stock Companies was recently added with
provisions regulating shareholders agreements between the
shareholders of Russian JSCs. Recent changes to the law
regulating LLCs, effective from July 1 2009, provide that LLC
participants can also enter into participants' agreements,
quite similar with shareholders agreements.
The said, agreements may, among other things, regulate
voting issues, pre-emption and first refusal rights, and other
matters of cooperation among the shareholders or participants.
Owing to the short period of time passed after the amendments
became effective, there is still very little information
regarding the practice of concluding and the practical use of
Therefore, many investors still seek, and will continue to
seek in the future, mechanisms to have the transaction governed
by foreign law; for example, using a holding company registered
outside Russia. While it is theoretically possible to include
some provisions regarding further financing in the purchase
agreement, the parties to such a private equity transaction
still usually have additional and detailed shareholders
agreements regulated by foreign law.
Stock purchase agreements made under Russian law (used if
the investor acquires existing shares) contain provisions
- The subject matter of the agreement.
- The level of consideration.
- Mutual rights and obligations of the parties (including
- Arbitration, in case the parties to the agreement wish to
submit their disputes to arbitration.
Normally, venture investment transactions also include
changes to the target's constituent documents. The target
company would also usually need to execute certain
documentation required by the investor as a result of legal due
diligence, for example to transfer intellectual property rights
to holding level, etc.
Though significant changes were made into Russian corporate
legislation regarding agreements between shareholders, such
agreements still have limited use in Russia owing to the lack
of information on the practical use of such agreements.
Therefore, the parties to a venture investment transaction,
even if both of them are Russian, still prefer to perform the
deal through a foreign special purpose vehicle (usually
offshore) and submit the agreements connected with transaction
to foreign law (usually one of the common law systems) as the
only way to execute a comprehensive and effective shareholders'
agreement and set out future obligations relating to further
financing and the operation of the target company, as well as
mutual representations and warranties.
The form of equity interest to be taken by a fund depends on
whether the target company is an LLC or a JSC. Equity interest
in an LLC is represented by a participatory interest, which is
not recognised as a security. The participatory interest
provides rights to:
- participate in the company's management;
- receive a part of company's profits;
- In specific cases the participants of the company can
agree to grant a participatory interest holder additional
rights similar to those given to a shareholder by preferred
shares (for example, rights connected with the management of
the company and distribution of profits).
JSCs issue ordinary and, if necessary, preferred shares,
which can be distributed among a limited number of shareholders
(closed JSC) or placed and traded publicly (open JSC).
Shareholders holding preferred shares cannot vote at
shareholders' meetings except in limited cases (generally,
matters of restructuring and matters directly related to
preferred stockholders' powers) (Law on Joint Stock Companies
(No. 415-II, 13 May 2003)).
The target company's charter must provide a fixed amount or
rate of interest to be paid to the holders of preferred shares
and define which part of the company's assets will be delivered
to them in case of the company's winding-up. The charter may
also allow for the conversion of preferred shares into ordinary
shares, in which case the order of any conversion must be set
If the company fails to pay interest to its preferred
shareholders, they obtain voting rights starting with the first
shareholders meeting after non-payment of interests.
The management structure of Russian companies differs from
the Anglo-American model. The role of the board of directors in
Russian private and public companies is less important, while
the shareholders usually control the company's activities.
Therefore, it is more important for the fund to have a major
shareholding in the company, in the form of a controlling or at
least a blocking stock, and to approve the company's general
director (chief executive officer). In addition, young
companies are usually established as LLCs and closed JSCs,
which may have no board at all, provided that the management is
performed by a shareholders' meeting and a general
Share transfer restrictions
LLC participants and JSC shareholders may provide
restrictions on the transfer of shares of the respective
company in the agreement concluded between such participants or
shareholders; the agreement shall be a part of the investment
The following actions are also available for JSCs and
- Restrictions can be imposed in the constituent documents
of Russian-based LLCs on the ability of participants to
transfer their participatory interests.
- Even if no additional restrictions are set out in the
constituent documents or participants' agreements,
shareholders of closed JSCs and participants of LLCs have
pre-emption rights for any shares or participatory interests
offered to a third party, which is not a shareholder or
participant of the company.
Owing to certain legislative lags in the regulation of
pre-emption rights and lack of practical implementation of the
participants' agreements, the incorporation of all restrictions
in a comprehensive shareholders' agreement regulated by a
foreign law, preferably a common law system, is still highly
It is not customary to grant shares and options to employees
except for the top managers. Employees are usually incentivised
through bonuses which may be connected with efficiency or
length of service. However management may be granted with
options for the total amount of up to 15-20% of shares on fully
Founders commonly have shareholdings and occupy top
management positions in venture companies. They are therefore
directly motivated to be successful and increase capitalisation
of the company. Employees' bonuses are subject to general
payroll tax at a flat rate of 13%.
As most venture investors acting in Russia are foreign or
international venture funds, they generally implement the same
conditions of financing and protections as they use in other
countries. This also means that all the usual contractual
instruments used to ensure founders' commitments could be used
for Russian-based foreign venture companies and their
respective founders. Founders' lock-ups are quite common and
can be structured under Russian law. Good leaver and bad leaver
provisions are usually structured outside Russia, since
shareholders' agreements regulating these issues are most
commonly governed by foreign law.
Russian corporate legislation does not recognise drag-along
and tag-along rights. While these concepts might be recognised
by the courts in the future under the freedom of contract
concept, currently the only guaranteed way for the investor to
get this type of protection is to be a shareholder of a foreign
holding company solely owning the target company in Russia.
We also note that in accordance with recent changes to the
law on limited liability companies, LLC participants may agree
and implement into a target company's foundation documents
various rights of minority participants regarding sale of their
participatory interests, for example fixed price of sale of
participatory interests, criterions and ways to determine the
sale price (including net assets, net profit of the company,
etc.) This makes LLC t a convenient instrument for minority
shareholders, where they can effectively secure their
A venture capital fund's stock in an unsuccessful company is
primarily realised through a sale or buyout. However if the
target unsuccessful company is an LLC the investor may have an
additional option under the Law on Limited Liability Companies
(No. 14-FZ, 8 February 1998). If included in the charter of the
target company, this option provides that in exchange for the
investor's equity stock the company can, within a set period of
time, deliver to the investor a part of its total assets in an
amount pro rata to the investor's shareholding in kind or the
cash equivalent. The participant of an LLC can use this right
at any time. If there are no investors willing to purchase the
equity stock and a management buyout is not possible, this type
of exit may become a valuable tool for the investor.
The exit repayments are exempted from taxation as part of
the initial contribution made by the investor to the company,
so the investor does not have to pay a profit tax in Russia for
the amount of gains up to its effected contributions (see
income tax above); although, the investor would still be
subject to taxation if it sold its equity stock normally. If
the investor owns substantial equity stock, such an exit may
have a serious impact on the company.
A venture capital fund holding equity stock in a successful
company usually has a wide range of ways to realise its
- Initial public offering (IPO);
- Management buyout;
- Leveraged buyout;
- Sales to strategic investors.
The most commonly used exit is a sale to a strategic
investor, due to the currently limited opportunities for
international IPOs, the underdeveloped stock market and the
lack of private equity transaction regulations. Nevertheless,
IPOs in Russia do take place and it is expected that their
numbers will grow in the future with the further development of
infrastructure and the securities market.
An exit strategy is normally built into the investment by
contractual means. In particular, by its inclusion in the
shareholders' agreement or any similar instrument used to
govern the parties' relationship.
The investors must consider any provisions in the target
company's foundation documents that could delay or make
impossible a desired exit strategy (for example, a restriction
on selling a participatory interest in a LLC, if the investor
wishes to sell those participatory interests to the strategic
About the author
Mr. Klyachin is responsible for corporate practice,
support of direct and venture investments and
employment law. Before his arrival at the firm, Mr.
Klyachin was the head legal adviser for Russian
Technologies - one of the first Russian venture capital
investment funds. Previously, Mr. Klyachin was an
attorney at the Moscow office of the firm
White&Case, and also an attorney at leading Russian
legal firm Monastirsky, Zyuba, Stepanov & Partners.
Mr. Klyachin graduated from the faculty of law at
Moscow State University. He speaks fluent English and
is a member of an advisory council on legal regulation
and protection of intellectual property. Anton hosts TV
show "Who's For?" on first Russian legal TV channel
8/1 Skatertny lane, 3rd Floor
Moscow 121069, Russia
Tel:+7 495 691 1184
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