Russia: Finding its feet

Author: | Published: 1 Oct 2010
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Regulatory framework

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 Laws regulating investments are outdated and of practically no use, the effective legal definition of a private equity transaction is far from accepted standards, and venture capital is still not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 impossible.

Industry background

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.

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 such funds.

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 of return.

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

Valuation

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 company.

Due diligence

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 success.

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 activities.

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 services.

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 activities.

Tax considerations

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 tax

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 companies.

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 following requirements:

  • 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 environmental protection).
  • The company must commission or itself be involved in:
  • 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 investors.

Finance considerations

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.

Transacting

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 unenforceable.

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 such agreements.

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 on:

  • The subject matter of the agreement.
  • The level of consideration.
  • Mutual rights and obligations of the parties (including completion mechanics).
  • 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 out.

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.

Management

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 director.

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 documentation.

The following actions are also available for JSCs and LLCs:

  • 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 recommended.

Employee incentivising

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 diluted basis.

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.

Exit considerations

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 interests.

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 investment, including:

  • 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 investor).

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 "Zakon-TV".

Contact information

Anton Klyachin
Salomons Partners

8/1 Skatertny lane, 3rd Floor
Moscow 121069, Russia

Tel:+7 495 691 1184
Fax: +7 495 691-1508
Email: anton.klyachin@salomons.com
Web: www.salomons.com