Innovation for business a 21st centurydevelopment. Model for Russia

Innovation for business a 21st century development. Model for Russia.

Kendrick White

Kendrick White

Contents Part I .......................................................................................................................................................3 Part II ......................................................................................................................................................5 Part III .....................................................................................................................................................8 Part IV...................................................................................................................................................12 Part V ....................................................................................................................................................13 Part VI...................................................................................................................................................18 Part VII .................................................................................................................................................20 Part VIII ................................................................................................................................................24 Part IX...................................................................................................................................................26 Part X ....................................................................................................................................................28 Part XI ...................................................................................................................................................30 Part XII ..................................................................................................................................................32

2

Kendrick White

Part I Kendrick D. White, the founder and CEO of Nizhny Novgorod-based Marchmont Capital Partners, starts with this series of postings sharing his thoughts of where, in his opinion, Russia should go to reinvent itself for the 21st century.

The Russian Federation today faces an extraordinary opportunity to change its historical development pattern and create for itself a new unprecedented future of prosperity and wealth for its vastly disbursed and diversified population. This has never been possible before. In order for Russia to take advantage of this historic opportunity, however, the country, its leaders and its people face important an important choice on how they should proceed to develop Russia‘s economy in the 21st century and what role the nation will play in the rapidly integrating global economy.

The choices are (i) to continue to cling to an antiquated 18th century commodity model of economic development, relying on a system of highly concentrated ownership over monopoly resources and assets, or (ii) to embrace a development model based on leading the world through the creation of innovative solutions to global problems, together with other leading innovation nations. In other words, Russia could foster the development of an Innovation Economy model.

The recent global financial crisis has helped stimulate the intellectual thinking process in Russia on questions of its future development. As a result, Russia‘s leaders appear to have made the choice to push the nation to become an innovation leader. However, it is not clear if the rest of Russia‘s political and economic elite understand the importance of this choice, and the requirement that they must directly support it as well. Ultimately, it is their role to realize this incredible opportunity.

Further, the unprecedented freedom now given the people in Russia to achieve this new future is completely reliant upon each and every person taking individual responsibility for their own actions in making this dream a reality for themselves, their families and their local and national societies.

With freedom comes the responsibility to act. No passive nation can become an innovation leader.

How an American boy met a Russian spirit My personal interest in Russia started in my childhood in Florida, where my mother had the opportunity to study art and painting with a wonderful Russian woman named Tatiana Walker, a famous Russian artist who by chance was living not far from our home with her American husband.

I was raised in the U.S. and became aware of the fragile state of our species and our planet at the height of the Cold War. Every month in our school, we were drilled to prepare for incoming Soviet Union nuclear bombs which could be sent at any moment to destroy us. Each individual of that era had similar experiences and propaganda, creating a generation around the globe worried that everyone was one red button away from global destruction.

3

Kendrick White

Knowing this Russian woman in our city, and how much my mother loved and respected her, I began to wonder how and why we had come to such a self destructive moment in our civilization‘s history.

Tatiana loved her Russian culture and missed her family and homeland, but she hated the totalitarian regime of communism which stifled freedom and creativity, and was killing the Russian spirit.

Seeing Tatiana Walker, and how my family treated her and listened to her description of ancient and modern Russian culture, I began to wonder what lay at the root of such a global conflict. I decided that to learn the answer, I should study the differences between our capitalistic, free market economy regulated by open democratic institutions, and the highly regulated and controlled system of Marxist Leninism resulting in the totalitarian Communist Command Economy, a 20th century, modern aristocracy in disguise. At a young age, I decided to become an economist.

As a young American, I enjoyed a nation allowing a wide range of freedom to its citizens, and experienced first-hand the benefits of an open, free market democracy which profoundly shaped my perspective of the world.

Concurrently, I began to study different economic and political models, such as those in the USSR, Communist China, various states in Latin America, as well as various Asian countries practicing state capitalism and dictatorship.

Through these studies I became convinced that a system of market driven economics regulated by numerous democratic checks and balances was not perfect, but was the most effective system for allocating economic resources and regulating society. In such a system, citizens were motivated to work hard and become as productive as possible in the accumulation of wide-spread wealth. Global society had not yet evolved its thinking far enough to allow the creation of a more effective philosophical socioeconomic system in which individuals could manage themselves.

From critiquing Karl Marx to offering Russia assistance I completed my degree in Economics at Stetson University. My final thesis analyzed Karl Marx‘s mistaken generalized assumptions on human psychology, written during an exchange program at the London School of Economics. I returned to the United States to start a banking career at LaSalle National Bank in Chicago, Illinois.

Before long, I ―climbed the corporate ladder‖ at LaSalle Bank and ultimately built a career in Strategic Planning, Cash Management and Mergers & Acquisitions (M&A), helping the corporate owner of LaSalle Bank, ABN-Amro, to build a dominant position in middle market banking in the U.S. At the same time, I completed my MBA degree at the Kellogg Graduate School of Management at Northwestern University, through their Evening Management Program while working full time at ABN-Amro LaSalle Bank.

After completing my MBA in 1990, I wanted to shift my career at ABN-Amro to Eastern Europe. I worked to convince the bank‘s top management to send me to Russia to develop a branch of the bank in Moscow. This decision could help to bring liquidity and finance to a new generation of small and private business owners which was just beginning to develop in Russia.

4

Kendrick White

Unfortunately, the bank‘s management pointed out to me that: (i) I had never been to Russia, (ii) I did not speak a word of the Russian language, (iii) I had no connections in Russia whatsoever, and finally, (iv) it was far too risky for a western bank to develop any activities in Russia at that time!

In spite of these hurdles, and inspired by a book entitled ―Window of Opportunity,‖ written by a Harvard economist together with a young Russian economist, Grigory Yavlinsky, I took a two year ―leave of absence‖ from my work in ABN-Amro and moved to Russia. My work was part of an American technical assistance program for the city of Nizhny Novgorod, to help support the development of a prototype market economy in that region.

Seventeen years later and I am still here!

Part II Kendrick D. White, the founder and CEO of Nizhny Novgorod-based Marchmont Capital Partners, continues a series of postings sharing his thoughts of where, in his opinion, Russia should go to reinvent itself for the 21st century. In this posting he is trying to identify Russia’s most acute systemic problems.

Well-oiled ups, ill-oiled downs As an American, I lived my first thirty years in the U.S. where my world view was shaped; I experienced all of the benefits of what the U.S. economic system could offer. As an economist, I had an understanding that Russia‘s commodity-driven Command Economy was ultimately unsustainable and would eventually fail under the pressures of rising global trade and regional market integration.

I have spent the past seventeen years of my life living and working full time in Russia. I now have gained unique experiences and insight into the transition which this country is undergoing. So what have I learned?

To begin with, any traditionally-structured commodity economy in the world fluctuates through boom and bust cycles; the economy goes up when commodity prices are high and it comes crashing down and has deficits and defaults when commodity prices fall.

Many people in Russia have unfortunately misunderstood what happened in this country during the last 20 years. Many blamed the regular recurrences of the cyclical economy upon (i) the reform process itself, (ii) privatization, corruption, and in general the chaos that coincided with the start of the conversion of the country‘s commodity economy to a more market driven and diversified economy. This explanation is unfortunately too simplistic.

Since 1992, the economy has experienced a number of ―ups and downs.‖ But many people recognize that this crisis environment in Russia is not merely twenty years old, but rather that because of an abundance of oil and gas, Russia has been too reliant upon its oil-based economy for many years.

Since the mid-1960s, the Russian economy has gone up and down, its fluctuation depending on the international price of oil. In 1973 and again in 1979, with the Arab oil embargos, the increased price of oil directly led to an improved economy in the USSR. But, when the prices fell again in the 1980s 5

Kendrick White

over a longer time frame, the USSR economy also experienced a long decline leading to the ultimate default of the economy in early 1990s. So high oil prices led to good times, and low oil prices led to bad times, resulting in the final collapse of the Soviet Union and the need for radical market reforms.

This cycle has been repeated in the last twenty years. When the Asian currency crisis hit in 1997, this led to a global financial crisis which dramatically reduced global growth and therefore demand for oil. This again led to the collapse of oil prices and the second default of the Russian economy in 1998.

A commodity bias, deep-rooted and too perilous Even looking beyond the past 50 years of the oil economy in Russia, it is clear that Russia has consistently been a commodity-driven economy for centuries. For example, in the 1890s, Nizhny Novgorod‘s Yarmarka Trade Fair was the central market point where European grain prices were established.

In fact, it is probable that Russian development has been driven by commodity extraction and exports not only for hundreds of years, but for a thousand years. This dependence has profoundly shaped the Russian mentality and sociopolitical system.

While possessing these commodity resources has generated wealth for those at the top of Russia‘s aristocracy controlled power system, this socioeconomic structure has delivered much less to the rest of society.

Today, reliance upon commodities now threatens far greater damage to Russia‘s place in an innovation-driven world. The entire economy is fundamentally unstable, resulting in regular boom and bust cycles of rapid income growth followed by default as commodity prices rise and fall.

When global commodity prices are high, Russia‘s economy expands through selling its exports internationally. When global commodity prices collapse, Russia‘s economy also collapses. This creates an inherent instability which today‘s leadership in Russia recognizes cannot be sustained as the general population strives to hold onto the gains which it has worked hard to achieve. As Russia‘s growing middle class works to continuously generate wealth and improve its standard of living, this growing segment of society will no longer tolerate such an unstable, high risk economic structure.

Reliance upon the commodity economy for a thousand years has created a number of systemic problems which must be addressed and understood deeply and honestly before Russia can make any final transition to a diversified, innovation-driven economy.

As a result of the recent global financial crisis, and the particularly deep impact it had upon Russia, President Medvedev and Prime Minister Putin have fundamentally realized that their primary goal now is to set a new course for Russia‘s economic development this century which can lead to the creation of a new innovation-driven national economy.

This idea of an innovation-driven economy is the only real developmental path for Russia in the 21 st century, as all other alternatives will leave Russia excluded from any real global leadership and influence. If Russia continues to rely upon the commodity economy, its economy, culture and the country as a whole will be vulnerable year after year to global commodity crises and unavoidable fluctuations.

6

Kendrick White

Further, as the global economy moves towards innovation, any nation relying too heavily upon the purchase of Russian commodities will have little choice except to reduce its dependence upon Russia over time. This movement away from Russia will set the stage for regularly occurring conflicts of interest between Russia and others. This situation will ultimately push commodity-reliant nations such as the U.S., the EU and Japan to seek out new advanced, lower-cost innovative solutions to alternative energy sources, and new generations of power and transport systems which will be less and less reliant upon Russian commodities.

This changing geo-political situation will leave the Russian economy open to greater and greater levels of fluctuation, and increased risks of social disruptions and unrest.

Monopolization unlimited So what are the systemic problems that the Russian economy is facing, and which must be addressed for solutions?

First and foremost, a thousand years of commodity-driven economics has enshrined in the political and business culture an inherent bias in favor of creating and maintaining monopolies. State operated monopolies prevail across the entire economy.

In speaking with private entrepreneurs, it is clear that nearly every businessman has his own goal of becoming a monopolist in his sector and thereby securing monopoly profits. While there is nothing unnatural in this goal of private entrepreneurs, it is up to the role of government to regulate this process and ensure competition in a true market economy. In Russia‘s case, a dominating form of State Capitalism has resulted in widespread conflicts of interest between government regulatory bodies, which should be responsible for ensuring open competition, and state-controlled industry.

The Government‘s current plans for 2010 and 2011 show that serious efforts will be made to reinvigorate the previously-stalled privatization process. However, it is clear that a new push of stringent anti-monopoly legislation must be developed in parallel to ensure that the state controlled monopolies will not simply be transitioned into privately held monopolies.

As a traditional commodity economy relies upon mass production and export of oil, gas, grains, minerals and other natural resources, consolidated control over these sectors makes it easier to collect these resources efficiently, ship them and collect the fees. Therefore, the ownership of Russia‘s natural resources has always tended to be held in the hands of small elites, thus leading to monopolization as a form of political control over the economic system. So it was during the time of the Tsars, and so it was under the leadership of the Communist Command Economy.

The economy has now been in the process of shifting during the past 20 years from a pure command economy under the totalitarian Communist system to a pseudo-market economy dominated by a form of State Capitalism. Nonetheless, private business owners continue to believe that monopolies are the ideal form of business organization.

Unfortunately, the Government has not done enough to create legislation that stops monopolies from forming. Furthermore, it has not conducted enough business education to demonstrate to business leaders the dangers of monopolization.

High profits for the monopolists are made at the expense of the overall culture and the overall competitiveness of the Russian economic system internationally. The result is a far-reaching over7

Kendrick White

reliance upon monopoly producers across numerous economic sectors in the still semi-isolated regional economies in the Russian Federation.

Many economic problems have resulted, including the problem of single-industry cities, a huge risk of which the President and the Prime Minister are fully aware. Across the country, hundreds of cities are reliant upon a single monopoly producer. On top of this, even across Russia‘s regional capital cities where there is an abundance of various industrial enterprises, far too many monopolies dominate the local sectors.

This monopolistic local culture is highly risky in any economic environment and must be dealt with systemically in order to encourage new business formation and development to make the regional economies more diversified and competitive.

Part III Kendrick White continues identifying Russia’s most acute systemic problems and emphasizes the roles of the government—both unwarranted and mandatory.

Buy low, sell high—double-quick!

We proceed to a second systemic problem in this country. The commodity economy‘s systemic reliance upon monopolies has driven the economy to a systemically high level of inflation; it is very difficult to reduce this inflationary pressure. High inflationary levels have in turn led the business and financial community to a short-term investment mentality, seeking to lock in profits as quickly as possible.

This short-term investment strategy, in turn, has lead to a short-term transaction mentality in the business community: buy low and then sell high as quickly as possible. This philosophy is completely opposite from what is required to build an innovation economy: building fundamental and long-term business and investment strategies.

So, an economy with high levels of economic fluctuation, high levels of volatility, high levels of monopolization and high levels of inflation, results in the entire business community being overly focused upon short-term profits: how quickly can something be bought at one price and sold for a higher price.

Starting a new business, especially an innovation one, is a very risky venture. In the U.S., probably seven out of ten companies fail and go bankrupt in the first year—and that‘s in a very, very open environment. So, in Russia it is extremely difficult for a small business to start in this environment from zero and grow up. There‘s a high failure rate, which means there‘s a lot of disincentives for entrepreneurs to start businesses in the first place because they understand the difficulties—and on the contrary, there‘s a heavy stimulus to do just trading.

I recently spoke to a group of private business owners in Samara, and they told me that this has been the history of that regional economy for a thousand years. ―We have a deeply embedded trading mentality in our blood.‖ 8

Kendrick White

This short-term mindset, coupled with a rigid top-down political structure of Command & Control, has created a system whereby the long-term production facilities are initiated and financed from the Center. Then, they are placed in the regions on the orders of government officials in Moscow.

Finally, they are then left to local managers for final implementation. These local managers are primarily interested in grabbing whatever they can for themselves, their close associates, and families from the operations of the state-controlled entities.

A natural tendency has developed during the past twenty years for private entrepreneurs to develop trading companies. Import some product from Germany at price X and then sell it for three times higher the price in Russia.

Trading companies have no manufacturing costs, low administrative and operating overheads, and can be financed easily with short-term credits. An entrepreneur simply has to rely upon his own personal connections and a small administrative team which imports products at one price, pays the customs and other trading and transport fees to get the products across the border, and then sell them at a higher price.

From another angle, local entrepreneurs often buy commodities in Russia extremely cheaply through whatever personal connections they may have, and then export them to the West or East at ten times the purchase price.

A vast number of people make money in Russia this way: through quick turnover and transactions, with a mutual reliance upon various forms of corruption making the entire process possible. If an asset is owned by the State, then effectively everyone owns it, or rather no one in particular owns it, and therefore whoever controls it will always seek a means to keep the profits.

Too much of the State An additional fundamental problem which Russia faces is the high level of systemic administrative costs in this country. With so much of the economy managed by the State, a resulting extensive government bureaucracy has resulted, designed as a check and balance system to ensure that state employees do not steal resources from the government.

While a natural result of the Command & Control form of State Capitalism, this administration is also tasked with controlling private enterprise, making sure that every tax payer does not cheat and that all citizens are held accountable. Unfortunately, this current system raises the administrative cost of doing business for small entrepreneurs so high that they cannot survive the rigors of developing real production and manufacturing enterprises, which again encourages the trading mentality.

As the majority of the world‘s professional economists understand, the backbone of any innovation driven economy is the small and medium sized business, led by creative entrepreneurs driven to grow their business and increase their profits. These entrepreneurs desire as little administrative cost as possible, as their businesses constantly require additional capital to grow and expand market share.

At this point in time, political and business leaders in the Russian Federation understand: the only direction for Russia‘s long-term development is to support growth of small and medium-sized businesses.

This is essential, this is critical; and therefore today laws are being changed to make it easier for businesses, to reduce the bureaucratic hurdles, to reduce the number of checks by fire authorities, 9

Kendrick White

software authorities and what not. All these checks mean more time away from the business and more time and resources trying to settle administrative problems.

If the government reduces these hurdles, more small businesses will be started—simple as that.

Unfortunately, each of Russia‘s systemic problems mentioned, combined with the country‘s historical short-term investment horizon mentality, has led to the de-motivation of wealthy Russian investors from investing in risky, long-term innovation projects.

By their nature, innovation investments require long-term investment horizons of five, ten, fifteen and perhaps even twenty years to realize profit. This is the amount of time it may take to develop a company from a start-up to the level of Yandex. It has been a twenty-year development prospect for this company which has the potential of going public at any time.

In order to address these systemic problems, any government should fundamentally understand the critical role it plays in the socioeconomic system.

The primary role of any government tasked with regulating a market driven economic system is to reduce as much as possible the systemic risks impacting the ultimate stability of the economy. In so doing, the government will effectively encourage private investors to risk their capital on projects within that country.

The lower the risk factors, the longer the investment time horizon private investors will be ready to risk their capital.

Where the State must make a difference Governments should be tasked to develop, improve and maintain infrastructure such as water purification, roads, and telecommunications systems. All these public utilities need to be developed and maintained by the government in order to reduce risk and increase stability because investors need long-term stability more than anything.

Governments must also manage currency risk and public debt levels and therefore have an obligation in developing properly functioning financial markets and banking systems.

In this situation, the response of private investors should be - if the government is laying the right foundations, reducing risk levels, corruption and red tape, establishing the rule of law and an objective legal and free press system of checks and balances - to support their local economy with investment capital.

Unfortunately in Russia, too many potential wealthy investors very often move their money abroad due to the systemic risks prevalent in the country, which have made it difficult to invest in Russia during the past twenty years of economic restructuring.

Compounding the problem is that there has only been a period of twenty short years in which to develop a new breed of entrepreneur capable of starting and growing a new business to the point that it can be sold or taken public and thereby making its founders very wealthy.

In the West, these investors are known as ―Smart Money‖ as the projects they support going forward after the sale of their initial company can benefit from not only the financial capital which the 10

Kendrick White

investor contributes, but also the extensive ―hands-on‖ business experience which such an investor can provide to any new young start-up company.

Statistically, little money is flowing in Russia into direct investments in start-ups and early stage innovation projects. Few people with the right combination of experience and wealth can both develop and implement the necessary commercialization strategies for such projects, which are required by investors to convince them to risk.

If, however, the Federal Government continues to follow through on its restructuring of the economy and tackling the systemic risks head on, Russian and many other investors should return to invest in the new Hi-Tech Russian economy.

In parallel, however, it will be necessary for the Russian government to also dramatically improve and expand upon the system of business education in the country to develop a new generation of managers ready to work with investors on commercializing the country‘s great academic and scientific resources.

Another role of the government is to encourage new start-ups and SME development and to promote innovation commercialization within the universities so that the best and brightest minds in Russia can be encouraged to develop their scientific initiatives here in Russia.

The alternative is to export themselves to the United States or the EU or Asia or anyplace where they can obtain a high-level salary and ultimately earn commercialization income from their labors.

The historic ―Brain Drain‖ which has plagued both Russia and other countries of the former Soviet Union for the past fifty years must not only be stopped, but reversed. It is essential for the country‘s long term development to fully utilize the experience which the Diaspora has accumulated in foreign markets, critical for estimating the global market potential of Russian technology innovations.

The main role of the Government is to encourage Russia‘s top intellects to remain in Russia and develop their private business and become wealthy as a result.

Russia is not a largely populated country, with only about 142 million people. In this situation, the demographic structure of Russia is much more similar to the advanced EU or American or Japanese economies, where the society must rely upon innovation and creativity and design for its competitive advantages.

In today‘s globally integrated economy, Russia cannot position itself as a low cost manufacturing competitor to China, and it will not be a competitor to China in the 21st century. Russia should not try to position itself as an outsourcing production unit for any other country in the world. Rather, the country should be positioning itself at the highest level of the intellectual food chain.

Russian scientists and innovation entrepreneurs should be focused designing new solutions to solve global problems and then basically producing the most advanced components here and licensing these products for final assembly in other low-cost production countries such as India, China or newly emerging economies in Africa and Latin America.

11

Kendrick White

Part IV One of Wall Street’s top investment banking giants predicts Russia’s leading role in the global economic hierarchy. It’s still a long way to go, but within the current commodity paradigm it is going to be a tough row to hoe.

Goldman Sachs: Russia’s economy may rank fifth by 2050 Russia does not really have a choice except to restructure itself to meet the needs of the 21st century.

One of the greatest resources of the country is its intellectual capital.

Considering long-term trends, in the 20th century the leaders of the world were the Big Six economies. After World War II, there were a small number of mature market economies, which held the majority of power in global financial decisions, including currency regulations, banking and capitalization rules, trading legislation and so on.

Today, we have a combination of the G7 countries plus Russia and some Asian countries. Going forward, all the indicators show that the power will be held by the emerging economies, a new G20 where there will be a general balance of power between old mature economies and the new emerging economies.

With the historical position of China, which up until the 19th century was a dominant global force, it is clear that it will return to be one of the largest, if not the largest, global economy in the world.

Goldman Sachs was absolutely correct in assessing that the power in the future will be held primarily by the BRIC countries: Brazil, Russia, India and China. In the year 2050, Goldman Sachs predicts China‘s economy will be the biggest economy on the planet, almost twice as large as the U.S. economy. Immediately following the US economy will be the Indian economy, followed by Brazil.

Russia is seen to be the world‘s fifth largest economy.

Russia will be a substantially larger economy than Japan, the U.K., Germany, France, Canada or Italy, according to Goldman Sachs. But it is important to note that these statistical projections are based upon Russia‘s historical commodity economy and the continuation of the past policies of Russia, which include high monopolization rates, high concentrations of assets, resources and centralized power, low development rates for of SME business, low penetration rates of entrepreneurship in the general economy, high bureaucratic administrative barriers, high levels of corruption and so on.

Even with each of these negative trends in Russia, Goldman Sachs still ranks this country as the fifth largest economy in 2050.

How would Russia‘s economy appear if today Russia seriously created the basis for an innovation economy? What would Russia‘s GDP look like in fifty years, if Russia chooses a different path?

12

Kendrick White

This is what I project for Russia.

Russia can develop on a substantially accelerated pace of GDP growth, focusing upon the highest level of innovation and creativity, solving global problems in alternative fuels, biotechnology, nanotechnology, chemical substances or aerospace development. If Russia chooses to be an international leader in global innovation and new technology, Russia‘s economy will be a substantially higher level of growth than it is now, potentially comparable to the U.S. or India. All depends completely upon what the Russian political and business leaders choose to do over the next 20 years.

Part V A four-point plan to help Russia reinvent itself What does Russia need to do to establish itself as a leading innovation economy in the world? In my opinion, there are four basic criteria, which should be explored to determine Russia‘s competitive advantages, if any.

To create an innovation economy there must be (i) a culture of innovation. (ii) a full range of infrastructure and support (iii) a full range of financial resources (iv) a dynamic living eco-system of new open business creation which has access to capital and global know-how in commercializing new and innovation solutions to global problems.

Culture of Innovation Russia has a very strong culture of innovation. In the last one hundred years, many international innovations were created by Russian people or people of Russian descent who were educated in Russia. An academic study should be made of this position. From my own anecdotal experience, there are many innovations which came from America, Germany, Israel or Japan, which actually were ideas created by Russian national expats that left Russia to live in foreign countries where they could develop their ideas and effectively earn income from their innovations.

Russia is inherently a very creative society. It has every potential to be a leading innovator and creator of new ideas. This is a fundamental competitive advantage of Russians internationally.

I remember asking a leading founder of one of the top Silicon Valley companies who was visiting Nizhny Novgorod several years ago about how he compared software programmers from America, from China, from India, and from Russia. This is what he said:

13

Kendrick White

“Well, effectively I can say that American software programmers are some of the best in the world but they are extremely expensive and, on top of that, very capricious individuals. They are not very easy to deal with.

Considering China, our company has not experienced a high level of new R&D developments from our partners in China. However, the Chinese are extremely good at taking an existing technology and improving upon it. Furthermore, China is skilled at mass-produce products at a very low-cost. It is potentially very profitable for us to work in China.

In India, our company must create very structured sets of instructions for our programmers. We must give them the exact detail of the desired end result, when we need it, and under what budget. Indian software programmers are excellent in their work, and the job gets done at a lower-than-expected cost and on time, or even ahead of schedule. However, we do not outsource creativity or R&D work to India. We instruct them to do precise contract work according to very specific instructions.

With Russian programmers, basically we take our toughest problems, and ask two Russian programmers to come in and talk with us. They may look a little scruffy, with hair uncombed and a disheveled look. However, we explain to them our programming challenge on a blackboard, they take notes, and then leave. We do not see them for two or three weeks. I am told by my supervisors that the two have been drinking coffee for 24 hours a day and smoking cigarettes in the corridor. In three weeks, they are back in my office. They look horrible, but they explain to me on that same blackboard that the root of the problem is three levels deeper that we thought. They then conclude by explaining the solution.�

This skill is a major Russian competitive advantage in this 21st century world. The Russian education system can produce some of the best minds in the world at solving some of the toughest problems.

Russia should be using this competitive advantage to its own national advantage.

With these intellectual skills, Russia can change its image to the entire world. Russia has an opportunity in the 21st century to bring its intellect and expertise to the table at the highest level, with the Americans, English, Japanese, Germans, and others, and work at an absolutely equal level in solving global problems.

Infrastructure and Support Twenty years ago upon my arrival to Russia, infrastructure was in a very difficult condition. Even ten years ago, Russia was in a very serious predicament as far as its infrastructure. However, over the last five years, many infrastructure problems are being addressed.

There‘s a huge amount of work yet to be done, but the government today is taking the profits from oil and other natural commodity markets and reinvesting them in the development of special economic zones, new techno-parks and business incubators and municipal infrastructure, which is helping to develop the innovation economy.

As an example, the Russian Government is supporting the Russian Venture Company (RVC). This is the organization that is creating a number of programs designed to bring the risk barrier down so that private Russian investors are more incentivized and motivated to invest in Russian technology and innovation.

14

Kendrick White

The RVC now is creating a number of different funds that are able to co-invest with investors and allow investors to take a higher rate of return at the end of the project when the project is profitable and sold. This is a huge benefit to be used to motivate and encourage Russian investors to risk their private savings in supporting innovation projects.

Unfortunately, not many have taken advantage of the RVC yet, but the funds are now actively working and investing in projects. The RVC examples established over the past two-to-three years are going to be very successful and show other Russian investors the way forward.

The Russian Venture Company has also developed a number of partnerships with different programs, such as its Venture Partner program. These partnerships are becoming effective in lowering risks and encouraging private investors to take greater risks in domestic investment projects.

As another example, the Rusnano technology corporation has been created and is led by Anatoly Chubais. Rusnano is a government-owned corporation set up in 2007 to develop Russia‘s nanotechnology potential and tap into the world market of nanotechnology products.

The individuals who work in this project come from experienced background of venture capital, private equity, banking and international financial markets. They are very competent, very confident, and are developing a number of programs that are specifically addressing the systemic problems in Russia.

Russia faces a lack of business angel investors. However, Rusnano together with the RVC is absolutely supporting the development of the new RuBAN business angel network, Russia‘s first NGO set up by private (business angel and PE) investors seeking the fostering of innovation culture and looking for promising venture projects across Russia‘s regions.

The Russian Government is pouring money back into infrastructure and is helping to develop risk reduction mechanisms to encourage entrepreneurs to invest in themselves and to invest in new innovation projects.

Other examples include Russia‘s network of Special Economic Zones, which includes a specific Hi Technology zone just outside of the city of Tomsk in Siberia. Other regions are following; it‘s clear that the infrastructure is developing in this country and will soon reach a critical mass.

A Full Range of Financial Resources Regarding the range of financial sources, Russia has not yet completed the development of a strong financial system in this country. Specifically, business angel investors are too few to establish a solid foundation on which the rest of the system must develop.

A number of professional venture capital fund managers cast about for projects around the country, as well as many world class private equity funds based in Moscow. Additionally, international and domestic banks and many other financial intermediaries are active; all built on top of some very effective and useful government technical assistance programs, such as the Bortnik Fund.

But to effectively build an innovation economy, there must be numerous Russian investors at the earliest seed capital and start-up phase: money coming into projects before the commercialization strategy is really understood for those products. Business angel investors nurture young, aggressive 15

Kendrick White

innovators and scientific minds that are creating new innovation ideas. But those innovation ideas need business experience in order to succeed.

Business angel investors bring to the table money, of course, but most importantly their experience.

Russia faces another systemic challenge here, as the first generation of business angel investors who developed their career in the market economy, creating their own businesses from scratch, are just maturing into Smart Money angel investors, ready to morally and financially support the next generation of innovators.

Only a handful of such people exist in Russia today. They must be encouraged with incentives and Western know-how to properly channel their own experience and wealth back into Russia‘s emerging new innovation economy.

Numerous wealthy individual Russian investors exist in the nation, who made their money through any combination of privatization, real estate, or commodities trading deals. Others became wealthy riding the topsy-turvy swings of the Russian stock markets, or perhaps simply by being in the right place at the right time and having the right government connections.

Whatever the case, while many who have made substantial wealth through lucrative transactions, few who have made serious money by building businesses from the bottom up, with bootstrapping and 24/7 work routines.

Smart Money experience is not profound yet. Only today are the first generation of entrepreneurs – individuals that started their business twenty years ago, grew that business, found investors, found strategic partners, developed the production of their products to sell in Russia or export into the world, and then maybe sold their companies - investing in the next generation of projects.

This should be a cyclical process, with each new generation of successful entrepreneurs investing in a next generation. Because the number of such individuals is far too small in today‘s Russia, an answer must be developed which uniquely addresses this Russian problem.

The Russian Venture Company and Rusnano are working on developing earlier stage seed funds and infrastructure funds to bring earlier stage money into companies. The government has already experimented with such approaches, such as the Bortnik Fund. This well-known fund was a pioneer in Russia, and its concept should be repeated a thousand times around the country. Each major city should have fifty different funds operating in competition with each other and stimulating the young generation of innovation entrepreneurs to create new ides in which the funds can invest.

Unfortunately, Russia is still very far away from this vision. A typical city in the United States - such as Chicago – holds hundreds of different investment funds focused upon different areas of technology; private equity, venture capital, and of course, business angel investors. The same type of financial structure is repeated in New York, Boston, the Silicon Valley, all across the U.S., the Euro zone, England or Japan.

Mature economies must have a very deep and rich financial infrastructure in order to remain competitive and attract the best and brightest from around the world to come, live, work, and get rich.

Russia is only beginning to develop this system. To succeed, the country must work harder to improve its competitiveness and retain its ―best and brightest‖ in Russia.

16

Kendrick White

Nonetheless, the system today is like ―night and day‖ compared to its appearance five years ago. The country is laying the right foundation for attracting Russian investors to come into this market and risk their investment capital in early stage technology. Over the next twenty years, the evidence should show if this system is working correctly.

A Dynamic Living Ecosystem of New Open Business The next stage on the path of commercialization is to assure business developers understand commercialization strategy.

The process begins by developing a first prototype; then identifying another investor to help move to a next level prototype; then testing and validation and market studies to develop a business plan to attract a Private Equity investor to secure credit from banks; then acquire higher levels of private equity funding to continue expanding; and ultimately moving to an Initial Public Offering (IPO) to go national or international with product sales.

The overall process may take five, ten, fifteen, maybe twenty years from start-up to IPO. However, any major global company today probably went through this exact same process, such as Google, Apple, Yandex, Facebook, or Cisco Systems. The path each company took is clear and understandable. A business angel investor‘s main responsibility is to help the leaders of the invested project fully understand this process and prepare for it properly.

An investment project‘s commercialization strategy is like a roadmap. For a journey from Moscow to Vladivostok, one would not jump in a car and leave without a map. A map is needed to make decisions as to where to turn left or right, or where to get gas or other help along the way. Without that map, one cannot explain the journey to anyone else.

Likewise, if an innovator cannot explain to an investor the development process of the project or the new innovation of his young company, the investor is not going to invest. So, a path to commercialization is simply a mechanism to explain to an investor how the company will develop from one stage to the next.

Hi-tech innovation entrepreneurs won‘t be able to do that unless they understand their market. As a business angel I advise you: be market-driven. When the first investor listened to Sergei Brin speak about his Google idea in a caf?, what did the investor do? He gave Mr. Brin a check for a hundred thousand dollars because as a Smart Money investor he understood the difference between just a change and a market disruption.

In order to understand the market impact of your product, you must understand who‘s going to buy your product. Is your product a niche industrial product? Or are you going to develop a license on a new evolutionary change? Know the market potential, be aware of your valuation—and be prepared to explain the path to commercialization to each and every level of potential investment along the way.

For example, angel investors place much importance on the innovator‘s motivation to work 24/7 to develop the project. The angel investor may make an investment decision based on his intuition.

As the project progresses, a professional private equity firm is not going to base its decision upon an investment officer‘s intuition; the firm is going to conduct due diligence. The firm will want to look 17

Kendrick White

at cash flow statements and financial projections; it will read the 200-page business plan to understand if all the risks in the proposition have been addressed.

If the company approached a public offering, hundreds of pages of documents on financial due diligence, accounting due diligence, international reporting, etc. are required.

At every level of the company‘s development, the innovator must be prepared to speak to that level of investor. This is the path to commercialization, and this is what business angels need to explain to innovators.

Part VI Angels and seed capital: too few, too little, but the wind’s changing The statistics developed by the Russian Venture Capital Association demonstrate that fully 80% of the money in Russia is already dedicated to restructuring and expansion. Less than 20% is allocated to early stage financing, seed stage and start-ups.

This disparity explains why the concept of business angels is so important. In the U.S. in 2007, before the crisis, a review by the Economist Intelligence Unit revealed that approximately 250,000 business angel investors existed with accumulative investments of an estimated $30 billion in startups and seed funding. This is a statistical indicator of an innovation economy. In Russia, the figures are still very, very small.

I helped to start my first business angel club in 1987 in Chicago with friends from my graduate school. We pooled together our money and started investing in the financial commodity exchange in Chicago. We experimented with different investments, and at one point we accumulated $10,000 and bought a new seat on a new 24 hour currency trading exchange. It was a brand new innovation in finance. We rented the seat for six months to a currency broker for $5,000/month. Half a year later we sold that seat for $100,000. We took a risk and we made a profit.

So with much experience, I can see that Russia is now developing several business angel networks, such as the group Private Capital based in Moscow, and the Unions of Business Angels in Russia (SBAR) in Moscow.

In Nizhny Novgorod, the Start Invest business angel club is run by Eduard Fyaxel, and was ranked last year as one of the leading, if not the leading business angel investor in Russia. Today, the new formal professional association for angel investors, called RuBAN, the Russian Union of Business Angel Networks, has been launched and is led by Konstantin Fokin.

Russia is creating a new generation of VC funds focused on seed capital and early stage expansion.

The range should start from $25-50k investments and go up to a $3-5m, and possibly up to $10m.

Beyond that there are many professional fund management firms in Moscow actively looking for projects that need up to $100m. In this large scale range there‘s no problem sourcing finance for sizable Russian projects.

18

Kendrick White

The problem is for the early stage projects, which simply require $25-50k to make a prototype, or move from unit production to serial production. I think, between the Russian Venture Company and Rusnano the diversification of the ranges has already begun. I strongly believe that this will encourage a new generation of private investors to enter the market.

Untying Russia’s IP knot If a Russian innovator with a PhD in mathematics feels he can never become wealthy in Russia but sees many incentives and a higher salary for him to move to the Silicon Valley, what should he do?

Stay in Russia and remain poor, or move to America where he knows he can become rich through his hard work and knowledge?

The nation needs to do its utmost to encourage its bright young minds to stay in Russia and make their business in Russia. But these brilliant individuals must be free to connect and communicate with other like-minded people. The university system is the first place where people should begin to feel this freedom.

The fundamental law that was approved last summer, #217, is absolutely critical for the future of Russia. It focuses upon defining rights in ownership over intellectual property developed at a state university.

For the first time in Russia‘s history the law says that the project developer at Russian universities (individual and/or group/lab) has a share of direct ownership of the project and IP behind its technology alongside the university as an entity. Prior to that whatever was created by and within a university was undivided federal property.

Also the law allows the setting-up of innovative SMEs by and within Russian academia, with private investors being part of new companies.

Intellectual property is the key, and any person should have the right to hold on to his property and be a part of a company that develops based on his technology. The individual must a direct ownership of the technology.

Universities should participate; in fact, professors, laboratories, student bodies and universities as entities should all share in the development of a new company and have shareholdings in it.

Unless ownership in the intellectual property is clear, no person or entity will feel confident that money could be made with that project.

Unfortunately, as an investor I saw many examples of brilliant technology coming from the education system of Russia. However, when I asked the question ―Who owns the intellectual property?‖ as a potential investor wanting to own a percentage of the technology, I was informed that the intellectual property was owned by the federal government. Immediately, I stopped my investment due diligence because I thought: ―Why should I invest in the technology if I‘m not going to own it?‖ As an investor, I should have the direct ability to own a percent of the intellectual property, and have the option to sell it upon exit.

19

Kendrick White

―Why am I going to develop another Google if I‘m not going to own it? Why should I look for financial investors if I cannot guarantee them they will become owners of the company?‖ an innovator has the right to think. I hope the new law will serve to solve this dilemma.

Part VII Innovation clusters: international experience Finally, the development of innovation clusters is very important. Many people talk about this concept; it‘s quite a hot topic in Russia. Innovation clusters are in fact the key to developing an innovation economy in Russia. It‘s that simple.

The new law 217 has enabled Russian universities to become the nuclei of such prospective clusters – in the same vein as in the U.S. universities provide the core of clusters there.

A review of any successful innovation cluster in the United States, such as Silicon Valley, Silicon Alley or Silicon Hills (Austin), reveals there is an open creative environment in each. In order for Russia to create the same type of creative environment, it must allow people to believe they can become millionaires.

In the U.S., a typical innovation cluster is a university surrounded by laboratories, techno-parks, business schools, business angel clubs, banks, VC and PE funds. The entire system is open. The entire system is geared towards encouraging collaboration. This is the fundamental concept.

If Northwestern University is developing a new drug to fight cancer or Alzheimer‘s disease, it will be working in collaboration with other laboratories around the world to solve the problem.

As a solution is near, a corporation is formed. Who are the owners of the corporation? The owners are the innovators, the lab, Northwestern University and its professors. The corporation is not 100% owned by one person. It is a shared ownership of the people working on the project. Of course, the initiator of the project has more shares; others may have less but they have a direct ownership. Each owner can attract investment in the company or in the technology. Eventually, they may either establish a company to produce product, or they may license the intellectual property for products, or they may sell the technology outright.

From Silicon Valley…

An innovation cluster is designed to solve a specific problem. Silicon Valley is a great example. It began during World War II when the U.S. government set up a number of large corporations to focus upon defense and production for the war efforts. Consequently, a number of prominent companies arose.

After the War, the government encouraged these companies to develop ‗Chinese walls‘ between their civilian work and their defense work financed by R&D money from the government at such companies as Boeing, McDonald Douglas and Northrop Grumman.

20

Kendrick White

Each of those companies had a defense arm working on government contracts. At the same time the firms were given the right (and encouraged) to use this defense technology on the commercialization side to make better refrigerators, microwaves, drugs, etc. The companies could sell these products throughout the world.

The commercial side of the business thus helped lower the expense of R&D and ultimately lower the cost of government subsidy to the defense side of the business. It is an absolute natural program.

In Russia, such a program does not exist. In Russia, government companies work on defense, and private companies that are completely separate from the government work on commercial projects.

This is not the most efficient way to run the system.

Russian industrial leaders should examine how the Japanese or American or EU systems work and how corporations receive R&D dollars from the government and subsidize development of new technologies, and then identify different uses for the technology both for the defense side and the commercialization side.

Silicon Valley developed exactly in this way. As the companies grew, the founders began working less and less in the companies on a daily basis. With significant business knowledge and experience, they became business angel investors and started investing in other new companies. As examples, Bill Gates, Steven Jobs and many other corporate founders now invest in many different companies.

Both corporations and individuals subsequently have invested in dozens of new start-up companies.

There are legendary VC investors such as Pitch Johnson or Guy Kawasaki or other Silicon Valley investors who passed their knowledge to dozens of new companies over many years.

This process is the foundation for an innovation cluster. The process acts as a magnet to attract the best and brightest people in the field to come there, live there, study there, work there and establish new companies there. ‌to Silicon Alley and beyond Silicon Valley became known for its Information Technology (IT). Another cluster, Silicon Alley, a corridor surrounding MIT, Harvard and other universities in the Boston-Massachusetts area, knew it was behind Silicon Valley in IT, so it chose to make biotechnology the focus of the cluster. Many biotech firms emerged from Silicon Alley.

Chicago understood that it was not the leader in IT or biotech, so there was a fundamental effort by its leaders more than twenty years ago to focus upon creating an innovation cluster for nanotechnology. Chicago persuaded the federal government to sponsor and finance the nanotechnology fabrication center in Evanston, Illinois, within the territory of Northwestern University. A major $200m facility focused on nanotech was initiated in Chicago at the request of regional business and political leaders.

Over the last 20 years, Evanston, Northwestern University, the University of Chicago and others created an innovation cluster. Now, surrounding this geographical region are investors, techno- parks, research centers, laboratories, business schools and so on.

This is a very good example of how a region determined to develop itself.

21

Kendrick White

But you also have areas in Utah; you have Detroit, Michigan.

There are now clusters developing all over the world, based on this model.

Basically, South Korea is developing a massive innovation cluster focusing on hi-tech, innovation, technology, logistics, transport and infrastructure.

There‘s one in Singapore; you have many areas developing on the Chinese coast.

You now have massive effort on the part on MIT to work in Latin America to develop in a wide range of Latin American cities innovation clusters that are going to feed new innovations and products into the American market, for example.

Not everybody knows about all these things and they are not highly publicized as Silicon Valley but there‘s general understanding that this is absolutely obligatory to create an open culture, an open ecosystem where innovators meet with academicians, teachers, business students, investors.

They have necessary platforms to do so, from cafes and campuses and restaurants to state-of-the-art labs. On top of those are business incubators, business accelerators, technology transfer centers, proof-of-concept centers, all the way to techno-parks.

The key idea is to build infrastructure that facilitates all these various people‘s meeting in an open way, exchanging ideas, and to link innovation clusters between themselves. Collaboration is the key thing.

Each innovation cluster should define exactly what its most important, historically proven strengths are. That may be defined by the local political elite, by the local universities, or by the local business community. In any case, it should be then aggressively promoted through PR. When I talk about innovation clusters that‘s what I‘m talking about. In order for Russia to develop its own network of innovation clusters it‘s important to understand these principles. Nobody is telling Russia that it has to follow some particular model, but this is a model that the entire rest of the planet has adapted, and I would encourage Russia to at least consider adapting it.

Skolkovo: pioneering Russia’s way to innovation clusters Russia‘s not sitting on the fence. It is getting pro-active, and the world is watching the progress of what President Medvedev announced earlier this year as ‗Russia‘s Silicon Valley,‘ a government priority. A $2-3.5bn innovation cluster is expected in Skolkovo just outside Moscow.

Of course, the president‘s wish to develop a highly prominent innovation cluster next to the Kremlin is quite understandable. The key thing is not to create a closed society in Skolkovo. This would be the greatest mistake imaginable.

The advantage of Silicon Valley is that all sorts of different aspects of the society co-mingle together.

Wealthy individuals with millions of dollars may sit side by side with college students drinking coffee in a Starbucks. That makes Silicon Valley such an open system.

If the Skolkovo innovation cluster is closed and requires a restrictive entry regime, then it won‘t develop results. It should encourage open integration; people should come and go there very freely.

22

Kendrick White

Of course, only certain people will open their companies there; of course, only certain people will have to be qualified to buy houses and live there. Companies will have to compete and fulfill certain criteria to open up in that particular place. That‘s understandable.

But at the same time there should be very strong logistics infrastructure and transport to allow free movement of people back and forth, and there should be attractions to attract people to go there: some specific shopping centers, restaurants, cultural centers.

I feel, in the 21st century the concept of design is going to be what differentiates simply low-cost mass production vs. high value-added, high margins in science and innovation. It‘s the designer products, how you feel about the products.

What‘s the difference between a typical PC and an iPad? Why is iPad selling one new computer every two seconds since its launch? There‘s a reason for that: it‘s design, emotion. And this has created the most valuable company in the tech world, Apple Corporation.

I think it would be very intelligent for Skolkovo to incorporate a very open design environment and cultural center that would attract many visitors. They might not live there, but they may create there freely.

It‘s very important to use Skolkovo as an example for the rest of the country to follow. It would be absolutely essential to link in Skolkovo together with other innovation clusters around the country.

The key to making Russia an innovation economy is to encourage collaboration and integration between these innovation clusters.

I strongly believe Russia needs to create that. For cluster areas I obviously view Tomsk, Novosibirsk, Kazan, Ekaterinburg, Samara, and, of course, Nizhny Novgorod, a prime target to make one of the top innovation clusters in the country.

With its oil industry in Nizhny, the Lukoil refinery in Kstovo, with the submarine factory, the aircraft factory, with the chemical processing of Dzerzhinsk, wood processing in Pavlovo, pipe and metal manufacturing in Vyksa, the Nizhny region has a huge industrial base. And in order for this industrial base to develop, at the center of Nizhny Novgorod should be an innovation cluster, which feeds new innovation solutions to those industries.

Russian industry needs to invest in itself Russian industry needs to invest in itself; this is my main message. In the U.S. or EU, commercial investment in R&D is significant, up to 30% of revenue in the telecom sector for instance.

Companies globally reinvest continuously in R&D and themselves.

In Russia, the amount of reinvestment in R&D is less than 1% of Gross Domestic Product (GDP)!

Statistically, Russian companies are not investing in themselves. However, the government is now encouraging industrial owners who were able to take over their companies through privatization to start investing in their assets.

I believe by the end of 2010, Russia may join the World Trade Organization (WTO).

23

Kendrick White

If the Jackson-Vanik amendment is finally lifted and the U.S. pushes for Russia‘s accession, this will create a new wave of competition from global companies that want to come and work and compete in Russia.

Russian companies must be prepared to compete. If the company is a monopoly, there is not much motivation for it to invest in itself, but if it faces competition, there will be no other choice. This is a fundamental change that is occurring in Russia. Those companies investing in themselves are going to win the market and outstrip foreign competitors.

Each region in Russia should understand its competitive strength and weaknesses and create its own strategy; this is a key point. The region should begin feeding innovation to its own industrial base. If Russia chooses to do this, it can be a leader in the 21st century, a leader in solving global problems.

Prosperity will be brought to the Russian people.

Part VIII We continue discussing Russia’s new innovation economy, which can put Russia on a completely different development track. This is an important time in Russia’s history. It is the time, in which Russia needs to search for Smart Money. What does that mean?

If you look at a sophisticated innovation cluster in other parts of the world, there are people there who have made new businesses again and again and again. Over the past 50 years there have been many serial entrepreneurs. People who started their first business 40 years ago are today obviously very sophisticated as they‘ve been through this cyclical process many times.

Therefore, just looking at a new project they can quickly understand the impact that this new technology may have on a wide range of markets, both domestically and internationally. They will be promptly able to determine the scope of change that can occur with this innovation, and this can give them a very quick understanding of the value of the project.

Inventiveness and market illiteracy: a gap still unbridged I think Russia has an innate competitive advantage, which is creativity. But there‘s a very serious problem here.

In its latest report a leading national business association, OPORA Russia, shows that Russia ranks very highly as an innovation initiator, but it ranks very low in all global comparisons as far as its ability to translate new innovative ideas into commercial products.

There‘s obviously a fundamental disconnect between the academic world and the innovators, between academia and investors.

I would like to give innovative entrepreneurs some insights into how they should think about the work they are involved in.

It‘s so important to understand who needs your science and technology and the basic fundamental research that you‘re doing. Why do they need it? Who cares? If you don‘t know the answers to those 24

Kendrick White

questions, if you‘re only doing this research because someone above you told you to do so and you didn‘t ask him why, if you don‘t believe this is important and will change the world, then why work on it? Why spend time on it?

Most innovators that I‘ve ever met love what they are doing, but they don‘t always know how their science will be applied. This is a question mark at the back of their heads.

Why? Because their teachers didn‘t explain to them the existing market principles that can use those innovations. Because academicians themselves are not serial entrepreneurs—unlike many Smart Money investors/university professors in the United States who are. They can quickly understand market applications, and they actually give tasks to their students to think in those terms.

What will your science bring about?

Science should not be an abstract toil of work to spend time on just for the sake of spending time on science; it should rather have a purpose. Solving commercially-driven problems could be one.

We have a global problem with some disease, or water, or ecology. People in laboratories around the world apply themselves to solve those problems. They are driven to work in collaboration with other like-minded people, and they want to make products to sell, which the humanity will benefit from.

Over nearly 18 years in Russia I‘ve met hundreds, if not thousands, of innovators, students, professors who would come to me when I worked for the EBRD, for example, and present projects.

They would say, ―I have an idea, this is a very exciting scientific theory.‖ I usually asked if that was a technology aimed at triggering an evolutionary change, a revolutionary change, or it was going to completely disrupt the market. Unfortunately, very often people looked at me, having no idea what I was talking about. ―I don‘t know. This is just science. I have worked on this project for many years, and it is a project to purify water.‖ My question was if that was an improvement of existing technology, or whether the project was based on a completely different approach to solving the problem that many had been working on, which is revolutionary, or if the person had been working on solving a problem that nobody even knew existed yet, which is disruptive.

Looking for a license buyer or altering the world?

If you‘re thinking in terms of changing the basic rules of the game, then that‘s something disruptive.

Here‘s an example: you have at the top of the hierarchy IBM, Microsoft and Apple, and you introduce a company like Google. What happens? The move changes all the market players. People begin to alter the way they work with technology and interact with it.

As Microsoft grew, it overcame and completely changed the market position of IBM. As Apple has grown and introduced a new product that is intuitively much more attractive to different people, this has changed the dynamics with Microsoft and how people interact with machines and software. And now that Google has established itself as one of the clear global leaders, it is disrupting the entire structure; it is introducing new technologies, which will again change the entire market.

25

Kendrick White

If a technology is evolutionary, it‘s going to have a certain value because someone may want to buy the license. Some existing companies that work in that field may see this as a better way of doing their job. This is a value of that.

For a revolutionary product, this also may involve a company buying the license for that, but theoretically, investors may say that this is a project they would like to support from the beginning to the end because that company, introducing this revolutionary change, may become a market leader.

An evolutionary technology doesn‘t necessarily become a market leader; it may be bought, and the value has a certain price range. A revolutionary idea may have a much higher value, so if your idea is truly revolutionary the value of your project may allow an investor to say, ―I‘m not going to invest just $200-500k in your project. I will invest much more and take a smaller position because I understand your firm can become a global leader.‖ The same is true for a disruptive technology. A sophisticated investor may view it as potentially changing the world, and therefore an expected value for him may be rapid significant growth. If your idea is a disruptive technology, and you‘re able to convince the investor that this is a disruptive technology, you‘ll get higher valuation.

In this world your objective as the innovator is to sell your idea as expensive as possible. Any investor‘s natural motivation is to spend as little as possible and get as much share as possible for your company. This is a natural conflict of interest.

To the degree that you understand the market implication of your product you can increase the value of that idea. If you don‘t know the market capability, and a mature Smart Money investor comes in, he‘ll simply buy your idea very cheaply. And you‘ll never even know.

Part IX We continue discussing Russia’s new innovation economy, which can put Russia on a completely different development track. A key issue for an innovator eager to monetize his or her ideas is where the ideas can be applied.

A small world riddled with big problems Two hundred years ago it took weeks to simply send a message from one part of the world to another. Today you can send an SMS between Beijing and NY with smiles and info instantaneously. Our planet is now very small, and we can better understand it.

And not only is it small from a communication standpoint between two human beings. Things that are happening ecologically in one area of the planet have an impact on another. In the past, when information couldn‘t flow, people didn‘t know, for example, that a tsunami occurring in the Pacific had an impact elsewhere around the globe. Today we can watch it unravel on a real-time basis because information flow is transparent and instantaneous.

26

Kendrick White

We must understand that there are many microeconomic, climatic and other problems that our small planet faces, which we cannot solve alone as individuals or countries. We have to work together in a collaborative manner, to bring the brightest minds of the world.

Among major problems are waste disposal, global warming, water purification, diseases, wars, scarce resources, food production, genetic disorders, etc. There are richer parts of the world, and there are poorer parts of the world. As a species we should begin to look at how we can raise our level on this planet. If we‘re rich in natural resources, or in intellectual creativity, we should apply that knowledge and that wealth to solving the above problems.

There‘s no lack of riddles to riddle. The key thing is to look at your technology, your science and innovation that you‘re developing and understand where it‘s applicable on this planet.

See where your science fits best You should break down problems into specific categories. You can look at human problems, such as pandemic diseases, the search for longevity, reduction of the process of ageing, hunger, malnutrition, population growth, demographic issues.

You can look at global problems such as lack of pure water, waste disposal, agricultural output, limited resources, global warming.

As our planet gets more and more consumer-oriented, as the emerging markets grow, populations swell, liquidity increases, people buy more products; we have more wastes to dispose of, more plastics, batteries, chemicals, acids. What do we do with these things? We cannot as a species continue to accumulate these types of waste products and just dispose of them into the ocean or rivers or landfills. We need to think of new ways to dispose of those products without harming the environment. So this is a major area where people can apply their scientific innovations.

If we look at economic problems, these are efficiency, industrial productivity, cost controls, resource allocations, infrastructure development, etc.

Everywhere in the world where human beings exist they have the desire to consume products. They can see on television what other people in other countries consume and they want to have the same things. There‘s a constant requirement to expand our logistical and distribution presence on the planet, which necessitates ever-improving ways of transporting products, whether by rail or road or ship or air.

Look at the problems of just the quality of life. We have a number of systemic issues that revolve around the type of political systems, religious systems within we guide ourselves. As any particular society improves its quality of life, it wants to have a higher meaning of life.

This is related to space travel, for example. What is the meaning of our species on this planet? Should we try and travel to Mars? Should we do another expedition to the Moon? Talking about the quality of life, we also talk about aesthetics, entertainment, communication, education.

There are many human beings that don‘t have the benefit of sight, or hearing, or mobility, but they are also people on this planet and they want to improve their lives. Maybe, it‘s very interesting for them to get connected through the Internet and live in virtual worlds where they could run and jump as any other.

27

Kendrick White

Your particular science or innovation may deal with any of these things: interplanetary travel, communication, etc. There are lots of issues that can drive us, lots of avenues to channel your energy.

As an innovator you need to think who needs your innovation, and where it is applicable.

Part X How many brilliant ideas just died in labs or minds finding no path to the heart of a venture investor!

Why? Because those innovators simply did not know the value of their ideas.

For an investor, your drive is key As a VC investor I‘m interested in understanding what your motivation is, why I should invest in you and your projects, and why you feel it‘s something important. Of course, every innovator thinks what he‘s doing is important. But I want to know why YOU feel this, and why YOU want to spend your time on this.

As a scientist you may want to better understand nanotechnology, medical or biotechnology, energy efficiency, space or telecoms. Your interest may just be the advancement of science itself.

But maybe your motivation comes from market demands and as an entrepreneur, your want to apply the right science to solve a market problem.

Maybe your motivation is moral; you want to help the world, your fellow species; you might want to work on a specific project because deep in your heart you feel it‘s the right thing to do, which your God wants you to pursue.

Or you simply want to become a billionaire. That‘s also a good reason.

If you tell me as an investor that you‘re just given this research as an assignment, if you don‘t make me believe why YOU believe in this project, if you can‘t show me that you can convince other people why they should believe in you—then why should I believe in you and risk my money on your innovation?

When you begin discussions with any investor, you should first and foremost understand yourself.

What do you want to accomplish with your project? This is the most important thing an investor looks for at this early stage. As an investor I‘m investing in people, not technologies. I want to invest in people ready to solve a global problem and have a high level of ambition, and that to me is much more important than the scientific background.

If you‘re able to explain that to an investor, this will help you establish a better valuation for your project.

Avoid cocooning and study your subject 28

Kendrick White

As part of your research into whether your idea is evolutionary, revolutionary or disruptive, you need to investigate the market.

It is completely open to you. Go to Yandex, Google; search, look around. For example, you can find, in two minutes, a very important statistics on the projections of global warming between 1990 and 2100. It‘s just there! If your project deals with global warming, you‘ll find all sorts of stats on what‘s going to happen.

You may find different versions of it, or even conflicting or contradictory statistics, but information is there. You should find it, digest it and understand it.

You can think of your technology and begin to search for who else is working on that. Maybe someone else is working on the same idea but from a different angle; maybe it‘s a competitor to you, maybe it‘s a collaborator. You need to reach out and find out what other people are doing, what other laboratories and universities around the globe are working on.

This healthy competition and collaboration are part of science advancement. Unfortunately, Russia has been very isolated from this process, but it doesn‘t have to continue to be.

This isolation is the reason why there‘s such a low level of commercialization of technology: because the Russian scientists are working on their own, in their own laboratories in Tomsk or Novosibirsk or Nizhny Novgorod and they are not really sharing their information with other people. They are not able to expand their knowledge fast enough to keep up with the market.

I‘ve seen a lot of interesting innovations that just died in laboratories because other laboratories in Japan, Germany, the U.K. or America simply developed their ideas faster and got them to the market.

Whoever comes to the market after doesn‘t have any value.

It‘s a global competition: who comes fastest to the market. Who comes fastest is one working in collaboration with other people to speed up the process.

To understand a commercialization strategy you can analyze all the aspects in the form of a Power Point presentation. You can show yourself what the scope of the market is, who needs this, who else is working on it, and based on that you can prepare a proposal to an investor.

Then a sophisticated investor will see that you‘ve done your homework.

A Bible of your market If you don‘t know the value for your idea, how can you negotiate maximizing that value with an investor?

Maybe you have a new revolutionary technology that will change the business process for the production of very specific automotive components. BUT: your buyers are twenty large original component manufacturers in the world. What‘s the value of your product in this case?

You can find that the value is to simply sell the license at a maximum price you can to one of those twenty, because if you want to sell each of them your product, then once you sold it to them, where‘s the next buyer?

29

Kendrick White

You may have invented a new endoscopic piece of surgical equipment. The buying market may be ten hospitals on the planet, or it might be 500,000 different dental offices.

The value of your product may change the way dentistry works. In this case an investor may find this project disruptive and capable of reshuffling the whole market. The value of that idea may be much larger because you may be able to develop a production facility in your region and begin to supply global markets.

If you don‘t know who‘s going to buy your product, how can you begin to estimate the value? Is your product worth $1 or $50m?

Knowing all that you can begin to negotiate it with an investor in a sophisticated way—and believe me, he will respect you for that.

Part XI Russia is innately a very creative society. But the key fundamental gap right now is to take innovative ideas and move them into commercial markets.

A long but righteous road With any typical project you start with an invention.

Then you start promoting this invention in international publications.

Then you have to work on the proof of the concept: is it really marketable?

Then you should identify investors to help you make a prototype.

Once you‘ve made the prototype, you have to start testing and validation in US markets, European markets, Russian markets, Asian markets to verify that your products are going to be accepted by regulatory agencies in the different countries.

Then you should apply for patterns.

Then you have to start market studies.

Then you have to begin to look for more money to expand because you want to go from unit production to serial production when you will need an experienced management team.

Then you need to develop your macro-business plan to begin to look for credits from banks and serious PE for expansion strategies.

Once you have that, you need product development; you will need to begin working on marketing, promotion, branding, market positioning, and adjusting how the product looks to make it improve constantly so that it stays ahead of competitors‘ or copycats‘.

30

Kendrick White

Terra cognita: learn and adapt So, there‘s a whole range of steps from waking up in the middle of the night saying, ―I have an idea that‘s going to change the world!‖ all the way to having a manufacturing plant supplying the produced product through a distribution system to buyers around the world.

And every step has been already taken by someone else.

Other companies have already gone through this process of commercialization. It‘s not as if you were starting a process no one knows of; you can find other companies to examine how they have done it.

How was the iPod introduced? How was Apple Computers developed? How was it that Nokia overcame Motorola?

You can look at case studies of company after company of how they rose and fell; how they developed themselves, restructured themselves and expanded themselves.

If you‘re developing a pharma product, investigate the pharma market. Who are the leaders in the world? What are consumer preferences? What are the trends?

And then you can begin to develop your own strategy for your innovation.

They did it One good case study is Imalux Corporation developed in Nizhny Novgorod nearly 15 years ago.

This company developed its technology here by innovative scientists; it was then commercialized into the American market. The first financing it got was from Russia‘s Bortnik Fund, a $100k loan back in 1996.

Then the company got an additional $30k from the Nizhny Novgorod Incubator Center for Technology Companies and then again, in 2000, another $151k from Edison Biotech Center.

Then they went on to get additional testing at the CCF. Then they hired a CEO. They got additional grant financing from CRDF in 2001 for $230k. Then they got a grant for $542k in 2002 to continue to develop the commercialization of the product in the United States.

It then got in 2004 FTA approval, and in 2005 they raised $20m to expand this product in the US market.

This is a great success story. The capitalization of the company rose at every new stage. The investors continued to back the company and prepare it for each new stage. This was a normal commercialization strategy.

Unfortunately, in Russia there historically have been very few sources of capital for early stage and seed companies. We in Marchmont feel that this situation is starting to change.

31

Kendrick White

Through programs backed by the Russian Venture Company and Rusnano there are new funds coming out, including the Venture Partner program developed by the RVC. These programs are designed to lower the risks for private angel investors to enter the market.

In a nutshell…

Most importantly, when you think of an innovation project, you need to bear in mind that it is a longterm process. That‘s why you have to be motivated to work on it day and night over the next five, ten, fifteen, maybe even twenty years.

See how long it has taken Yandex to get where it is now. It received its first seed capital by an American in 1989. Today it is a large global company ready to compete head to head against Google in the global search markets.

If you‘re involved in innovation, it‘s unlikely that conquering markets is going to happen overnight.

Russia is innately a very creative society. But the key fundamental gap right now is to take innovative ideas and move them into commercial markets.

You need to be able to convince investors what projects are going to win the market and what projects aren‘t. To the degree that you can convince them your new technology is going to be revolutionary or even disruptive you can attract a higher valuation for your intellectual capital.

I encourage you to go forward. If you believe in yourselves, you‘ll be successful.

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 Russia‘s 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.

I‘m not going to comment on the moral implications of this; Russia‘s history is what it is. But it now must change dramatically in order to embrace a market economy.

Today‘s 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. There‘s been too long a period of non-investment.

32

Kendrick White

This aspect of Russia‘s 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 there‘s 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 company‘s 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.

It‘s 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 there‘s 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 it‘s 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; there‘s a market interest and buzz about this product; and the time horizon for 33

Kendrick White

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 more—$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 it‘s 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 you‘re 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 you‘re 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 Association‘s website, you‘ll basically be able to find the listing of all the different investment funds operating in Russia, and you can see who‘s 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 managers‘ 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.

34

Kendrick White

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 don‘t 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.

35