Russia's Venture Capital Boom

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But the picture soon could change, say observers of the Russian scene. "The Russian market is going to get hot," promises Ashish Patel, the managing director for Intel Capital in Europe, the Middle East, and Africa. Intel (INTC) got into the market early, back in 2003, and has invested in three Russian tech companies: Acronis, a maker of storage management and disaster recovery software; Yandex, Russia's largest search portal; and SWsoft, which makes virtualization and automation software.

Big Potential Market

Patel and others say they expect all three of these companies to achieve valuations of greater than $1 billion by 2008, and one or more of them could go public. Indeed Geneva-based venture capitalist Sven Lingjaerde, founder of the European Tech Tour Assn., anticipates lots of acquisitions and initial public offerings in Russia next year.

What a difference a few years make. Lingjaerde organized a Moscow visit for 53 venture capitalists from the U.S. and Europe in 2004, but recalls that many of the participants were skeptical. Now, many VCs recognize the potential of Russian tech startups—especially because, unlike counterparts in tiny countries such as Estonia or Slovenia—they can gain significant scale just by serving a domestic market of 250 million in greater Russia.

Though the population of Russia is far smaller than China's, it offers investors some of the same advantages. For one thing, connectivity is exploding. Russia is now home to more than 140 million mobile-phone users, and Internet usage and broadband penetration is reaching critical mass. Also like China, local players have had the chance to gain traction in the domestic market, meaning that giants such as Amazon, Yahoo! (YHOO), and Google (GOOG) don't dominate.

Making It Big at Home

"The opportunity is not as big as China, but it is absolutely up there," says Johan Brenner, a general partner at Benchmark Capital, a VC firm with offices in Silicon Valley and Europe. Benchmark has invested in Elecsnet, a Russian company that makes an electronic payment system allowing people to "top-up" their prepaid mobile-phone cards.

For some Russian startups, the biggest opportunity lies at home. Ozon, for instance, booked $30 million in sales last year, which works out to only about a dollar for every person currently online. "There is an opportunity to grow Ozon very, very fast," says Index's Zocco. "We see a 60% to 70% growth rate in the next few years."

Another local champion is Yandex, which boasts 23 million users and claims 60% of local-language desktop search in Russia, compared to about 8% for Google, according to researcher LiveInternet. Yandex rose to prominence on the strength of its search technology.

Now it's a full portal with its own mail service, news clustering and aggregation service, blog search, free Web hosting, research, shopping, and many other services, including its own payment system. It also runs one of the largest networks of free Wi-Fi hotspots in Russia. And like Google, it's branching out into mobile search. Its search engine was one of two recently incorporated into the Russian version of one of Nokia's (NOK) new smartphones.

Yandex's success has not gone unnoticed. Mr. Lingjaerde recounts how he tried to help Yandex find a Silicon Valley-based investor a few years back. One well-known Valley firm replied "we don't do Russia," Lingjaerde recalls. Later the same firm begged to get into the deal, but it was too late.

Difficult to Do Business

VC funding will help other Russian companies grow their presence abroad. Galitsky, the Russian entrepreneur-turned-venture capitalist, sees particular opportunity for software firms such as Acronis and SWsoft that are less tied to language and culture. There are hidden gems in Russia, he says, that "need hope and advice and money." Venture funding can take them to the next level.

Despite the progress, Ammosov, the government official who oversees the new matching fund, says Russia was disappointed that more Western firms didn't vie for money. Only 12 have applied to date, and three have been chosen to receive funding. To encourage more applicants, the Russian government is now revising some of the rules regarding the investment of the matching funds to make them more in line with Western VC practices, Ammosov says.

But kick-starting the VC market in Russia isn't only a question of money. Key elements in the business ecosystem, such as serial entrepreneurs and angels, aren't yet in place. And despite government efforts to attract venture capitalists, Russia remains a difficult place to do business, says Index's Zocco, citing uncertain intellectual-property protection, chaotic taxation, and onerous business registration procedures.

"Clearly there is a higher level of risk doing business here," says Zocco. At the same time, he says, "there is a high level of opportunity." That's why Index and others are willing to make such high-stakes bets.

Schenker is a BusinessWeek correspondent in Paris.