A Q&A guide to venture capital law in the Russian Federation.
The Q&A gives a high level overview of the venture capital market; tax incentives; fund structures; fund formation and regulation; investor protection; founder and employee incentivisation and exits.
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This Q&A is part of the PLC multi-jurisdictional guide to venture capital. For a full list of jurisdictional Q&As visit www.practicallaw.com/venturecapital-mjg.
There is little specific regulation in Russia concerning private equity in general, and venture capital in particular. Laws regulating investments are outdated and of limited use, and the government has not taken any steps to revise and update general legislation regulating investments recently. The legal definition of private equity is far from accepted standards and venture capital remains undefined.
The Law on Investment Funds (No 156-FZ, 29 November 2001) regulates mutual investment funds and incorporated investment funds established in Russia. It severely restricts funds' activities, often making them unsuitable for venture financing.
The Federal Service for Financial Markets (FSFM) has defined venture financing as investments in high-tech, or similar companies connected with significant investment risks. However, this definition does not provide a clear distinction between venture capital and private equity. In addition, the definition had not been reflected in legislation and thus may be applicable only for the transactions on the financial markets.
The lack of regulation significantly complicates venture capital activity, although it does not prevent these transactions from taking place.
Definition of joint investment activities is provided in the recently enacted Law on Special Investment Partnerships, which comes into force on 1 January 2012. However, the use of this definition will be most probably limited to the sphere of the said law.
Venture capital is relatively new in Russia and its early development is heavily linked with international financial institutions, such as the European Bank for Reconstruction and Development and the International Finance Corporation. For several years, venture funds organised by these institutions were the sole source of special purpose venture financing. Venture capital funds of international and foreign origin are still one of the main sources of venture financing, while the number of local venture investors remains low, especially after the financial crisis. Russian banks and public companies have been slow to provide venture investment in recent years. However, large finance and credit corporations (for example, Gazprom, VTB, Finam, Rosno Allianz) still maintain their own venture funds, which provide moderate investment.
Investment funds incorporated under Russian investment legislation, including mutual investment funds and incorporated investment funds, often cannot provide sufficient venture financing, due to legislative restrictions and their internal regulations. Pension funds do not invest heavily, as they face similar restrictions to investment funds and pension system deficit. After a major decrease of available funds in 2008, pension funds became very sensitive to investment instruments and now tend to invest into steady assets, rather than provide venture financing. However, all these funds are theoretically able to provide financing for venture companies.
The state can invest in the national economy through specifically created state investment funds. In 2000, a state Venture Investment Fund was established. Later, the Russian Venture Company (RVC) received substantial financing from the state to distribute between ten to 20 venture funds. The RVC is modelled on the Israeli Jozma programme, as a fund of funds providing financing to private funds on a 50:50 basis. From 2010 to 2011, RVC has financed several venture funds, including in co-operation with large foreign venture investors. Recently RVC published a document called Fields of activities for RVC in 2011-2013, providing for expansion of RVC investment activities, including on the venture capital market.
Most companies attracting venture financing are small or medium-sized companies engaged in innovative, high-tech research and production, such as IT companies or telecommunication companies. They are usually early-stage companies offering or intending to offer new products and services.
Companies can be organised as limited liability companies (LLCs) or joint stock companies (JSCs). Depending on the form of the company, the investor may receive a participatory interest or shares in the company, both representing its stake in the company, but having slightly different legal regimes (see Question 17). LLCs and JSCs can conduct any activities not directly prohibited by law. However, a special licence is required for certain types of activity (see Question 9).
The Law on Commercial Partnerships, which has just been enacted, will come into force on 1 July 2012. Commercial partnership is a new form of a commercial organisation and it is expected to be a perfect structure for the management of private equity investments.
Special investment partnerships will also become available soon (see above, Venture capital and private equity). However, a special investment partnership is a mere contractual entity and cannot be formed as a separate legal entity.
Investments in venture capital continue to represent an insignificant part of total investments made in Russia. However, state support of the sector inspires large businesses to devote a part of their capital to venture investments, which makes the future of venture investments in Russia look optimistic.
The most popular areas of venture financing are:
IT, particularly software.
Telecommunication and media companies.
Niche retail business, particularly online (for example, children or health and beauty).
Services, including financial.
Investing in manufacturing companies is less popular.
There are a number of positive developments concerning the venture capital market, including the following:
Development of specific legal regulation of the relationship between general partners and limited partners under a partnership agreement (until recently, partnerships have not been used at all). Creation of the commercial partnership is also an important step in this respect.
Development of infrastructure (for example, technology parks such as Skolkovo (see Question 2)).
Improvement of banking system and greater availability of leverage.
Attraction of competent management in venture investment.
In recent years, the government has consistently stated its concern about the underdevelopment and low amounts of venture financing in the country. As a result, several organisations were formed to provide state financing for start-up companies (for example, the Russian State Corporation for Nanotechnologies). In addition, some special state venture funds have been established (for example, since October 2009 there has been a new venture fund, fully financed by the RVC, with capital of RUB2 billion (as at 1 November 2011, US$1 was about RUB30)). More state venture funds are planned.
The Law on Skolkovo Innovation Center (Skolkovo Law) was enacted in 2010. Under this law, start-up companies conducting research and development located in the area of the Skolkovo technology centre benefit from significant tax and other incentives (see Question 3, Skolkovo incentive).
These measures will support start-up companies, and it is hoped they will incentivise the development of the venture capital industry.
The Law on Special Investment Partnerships and the Law on Commercial Partnerships are also an important development. However, piecemeal regulatory innovation in the absence of the general system perspective is unlikely to solve the main problems of the venture financing industry in Russia, even in combination with state financing for start-up companies. Nor does it do much to incentivise private investors.
There are no special tax incentive schemes to encourage investment in venture capital, apart from various tax benefits granted to companies domiciled in Skolkovo (see below, Skolkovo incentive). However, the Tax Code of the Russian Federation (Part I - No 146-FZ, 31 July 1998; Part II No 117-FZ, 5 August 2000) (Tax Code) can provide some basic benefits in relation to some taxes (for example, income tax) to the parties to an investment transaction (see below, Income tax and Investment tax credit).
This is the only general tax incentive scheme in Russia. To benefit from this system, the company must meet the following conditions (Tax Code):
The company's income in the first nine months of the financial year does not exceed RUB15 million (this figure is subject to annual revaluation).
The company is not prohibited from implementing this system under the Tax Code. The following entities, among others, are prohibited from using the simplified system of taxation:
non-state pension funds.
The simplified system of taxation may be very useful for the purposes of venture financing, particularly in early stages. However, as investment funds cannot apply for it, it is usually an option for target companies.
Under the simplified system of taxation, the payment of the corporate income tax, the tax on the property of organisations and the uniform social tax is replaced by the payment of a uniform tax, computed in accordance with the results of the economic activity of an organisation in the relevant tax period.
The organisations using the simplified taxation system are not subject to value added tax (VAT) either, except for the VAT payable on importation of goods into the customs territory of the Russian Federation.
Income received from contributions to a company's charter capital or within the framework of target financing does not incur income tax (Article 251, Tax Code). Therefore, investments in a target venture company are not taxed if they come from either:
Direct financing (that is, there is a direct connection to the financial markets as indicated by the borrower issuing securities directly on the market).
Contributions to its charter capital from its shareholder(s), including holding companies.
Under the investment tax credit, the target can (within certain limits) decrease its payments of certain taxes for a period of time, by gradually repaying the debt and accrued interest in the future (Article 66, Tax Code). To apply for an investment tax credit, the company must meet one of the following requirements:
It must be involved in research and development, or in the technical upgrade of its own creations (for example, upgrades aimed at employing disabled persons or environmental protection).
It must commission or itself be involved in:
creating or upgrading technologies;
developing new sources of raw materials.
It must provide an important contribution to the social and economic development of a region or provide important services to the general public.
Russia has double taxation treaties with many countries, providing potential tax benefits for foreign investors. Local investors can also enjoy these benefits by including a company incorporated under the law of these countries into the structure of an investment transaction. This is an important consideration, as most venture investors acting in Russia use structures and instruments based on foreign law. The benefits provided by double taxation treaties are not directly related to venture financing or private equity investments, but they can be used by investors.
The Skolkovo Law relaxes regulation of accounting, tax, customs, foreign labour force and certain other aspects of business administration. In particular, an innovative company domiciled in Skolkovo has a right to get tax holidays of up to ten years.
To benefit from this regime, a company must be recognised as a participant of the project Skolkovo, which is confirmed by the respective record in the register of project participants. To become a participant, a company must satisfy the following conditions (Skolkovo Law):
It must be registered in Russia.
Its chief executive officer (CEO) must be permanently located in Skolkovo.
A company's charter must provide that the company can perform only research and development activities.
Throughout 2011 several companies benefited from this regime. However, this is not enough to assert a significant influence over venture financing in Russia in general.
The first venture capital funds were organised and fully funded by international organisations. Later, a number of private foreign funds were established. Local financing still plays a small part in the amount of overall investments.
While private foreign financing, local financing or a combination of the two are common, state financing (at federal and regional levels) is also available (see Question 1).
International and local venture capital funds mostly receive funding from private and corporate investors, and the level of such funding exceeds credit funding.
Funds with different structures, financial sources and management have different objectives in relation to:
Acceptable investment targets.
The way the investments are made.
In particular, Russian-based investment funds generally have more limited means of making investments, and less to invest compared to foreign funds, although the targets of investments are mostly the same. If a Russian-based investment fund is established as a mutual investment fund or incorporated investment fund, it has fewer options for investing, due to a number of limitations imposed by the FSFM on these funds' structure of assets.
Long-established foreign investment funds, with more complex structures and higher funding can be more risky. However, they currently have a considerable advantage over local funds, in relation to the levels of investment and rates of return.
In practice, venture funds generally invest independently. This is because venture financing in Russia is mainly undertaken by large foreign funds that are able to provide all necessary finance. However, joint financing with other funds or strategic investors is more common when attracting a new investor at a later stage in the next round of investments. Venture funds sometimes co-operate in finding potential targets. In this case, they finance independently, but exchange information concerning targets.
Throughout 2011, there have been several cases when Russian-based venture funds elected to co-operate with other funds to raise funds, which is a positive development for venture financing in Russia.
It is possible to establish a representative office of a foreign company, and use it as a vehicle for venture capital funds. The representative office is deemed to be a separate department of the foreign company, rather than a separate company. However, due to insufficiency of regulation and procedural difficulties relating to establishing and maintaining representative offices, most investors, including foreign investors, prefer to establish separate Russian-based companies and use them as investment vehicles.
A company can be incorporated as an LLC or a JSC. As there is currently no legal distinction between public and private companies, the choice of structure does not significantly affect the way investments are made.
Another option is to use a mutual fund. Mutual funds are regulated by the FSFM and are mandatory for managing state funds. However, for major investors that are capable of participating in managing targets, this is less convenient than JSCs and particularly LLCs, due to the number of requirements and restrictions concerning mutual funds.
Special investment partnerships and commercial partnerships will be available from 2012 only so for now it is difficult to estimate their popularity. Potentially they may be very useful for venture financing. However, it often takes some time after the law becomes effective to amend it, so it can have the effect that was initially planned.
Foreign venture capital funds operating in Russia aim to invest in start-up and early-stage companies with unique research and development projects, which allow them to:
Gain market power.
Begin providing returns within a short period of time.
The life of a fund is usually five to seven years, possibly with one or two one-year extensions. Investors seek 25% to 35% internal rate of return (IRR) or above. For example, in 2008 one of the largest foreign venture funds declared IRR on several projects as high as 70% per annum, which resulted in considerable profits for investors. In 2009, IRRs have significantly decreased, to a maximum of 20% to 25%, and for many funds this parameter was negative throughout 2010. In 2011 it has slightly recovered; for example, IRR on several ROSNANO projects was 25-35%. However, these figures are rather an exception.
A fund usually exits a project after four to five years. However, it is not currently possible to provide detailed figures concerning timing, financing at each stage and returns of domestic venture projects, as venture financing is still undeveloped, and the general economic situation is unstable.
Generally no special licences are required.
Licences may be required in limited circumstances, including the following:
Some professional participants in the stock market, including brokers, dealers and depositaries must obtain special licences. However, in most cases, funds do not operate on stock markets with assistance of an intermediary. Therefore, the fund or its promoter, manager or principal(s) do not require a licence.
Russian-based mutual and incorporated investment funds investing in venture companies must have a licence for securities management. Certain requirements also apply to their management team.
As venture funds are not specifically regulated (see Question 1, Venture capital and private equity), they follow the general rules regulating companies making investments. Fund vehicles must comply with general corporate legislation, including all restrictions provided for Russian companies on:
For example, advertising restrictions on Russian-based mutual investment funds and incorporated investment funds include:
Restrictions connected with sources of funding, investment instruments and other restrictions, provided mainly by FSFM regulations.
Advertising regulations under Article 28 of the Law on Advertising (No 38-FZ, 13 March 2006), which aim to ensure the full and accurate disclosure of information about the fund and its activities.
These requirements can be imposed on foreign investment funds acting in Russia.
For foreign venture funds, relations between the investor and fund are regulated by the law of the jurisdiction where the fund is established. Therefore, they can invest in Russian targets without any changes to the relationship.
Domestic mutual and incorporated investment funds are regulated by:
The Law on Investment Funds.
For incorporated investment funds, the fund's charter and investment declaration.
For mutual (unincorporated) investment funds, the rules on trust management.
Since incorporated investment funds must be JSCs, their investors are their shareholders. They can therefore participate in the fund's management and protect their interests in the way provided by the Law on Joint Stock Companies (No. 415-II, 13 May 2003).
The rules on trust management for mutual investment funds are intended to provide investors with substantial protection, through extensive responsibility and accountability obligations for the fund's managing company.
Since it is usually not feasible to secure obligations from the target, venture capital funds provide equity financing, particularly in the early stages.
Equity financing also has the advantage of allowing funds to nominate their own managers to the governing bodies of targets. Funds can therefore gain control over the company, and obtain reliable information about the company's activities.
Although equity financing is a priority, sometimes the targets apply for debt financing from the venture fund. This is usually to cover operating costs, or to receive bridge financing during the fund's decision-making period. Debt financing in this form is usually done in combination with basic equity financing.
Debt financing is increasingly popular for seed investments (the first contribution towards the financing of a new business) or angel investments (financing provided by a high net-worth individual for a start-up). These early-stage investors intend to replace the debt provided by them with equity at later investment stages.
Until recently, investors would consider investing in a simple licence or patent with little development or commercialisation. However, funds are now largely investing in companies already generating income or making a profit.
This demonstrates a considerable change in how capital funds are assessing risk, and sustainability is becoming much more important. Instead of evaluating intellectual property (IP) or the basic ideas of the founders, investors are looking for:
A developed and well-supported business plan.
A proven and tested business concept.
An able management team.
Generally, investors and venture capitalists accept as little risk as possible.
There are no strict rules on the venture capital fund's share in the target's capital, within the framework of the financing. However, this matter is dealt with through agreements between the fund and the founders of the investee company.
When considering potential investments, venture capital funds closely examine the target's business plan, and compare it with current market trends to estimate the company's prospects. If the conclusion is positive, the fund carries out a due diligence exercise, which includes the following:
Technical due diligence. Irrespective of what stage the project is at, technical due diligence is the most important part of this process.
Legal due diligence. This covers IP matters and, where the target has existed for some time, its documentation and legal history are also subject to thorough legal due diligence.
Financial due diligence. This is carried out for existing targets.
Management due diligence. The fund assesses the current management of the company, as its capabilities will be crucial in establishing long-term success.
A shareholder agreement regulated under foreign law is usually used as the principal legal document, transferring participatory interests or shares in the target to the fund (represented by its vehicles), in exchange for future financing. This is because share or asset purchase agreements under Russian law are generally of limited use, since it is practically impossible to contractually include any conditions, other than those related to the sale and purchase. For example, representations and warranties (as they are known in common law jurisdictions) are not recognised in Russia, and the courts would most likely consider this part of an agreement unenforceable.
The Law on Joint Stock Companies came into force not long ago, with provisions regulating shareholder agreements between the shareholders of Russian JSCs. Following the changes to the Law on Limited Liability Companies (No. 14-FZ, 8 February 1998) effective from 1 July 2009, LLC participants can also enter into participant agreements, similar to shareholder agreements. Similar regulation was enacted in relation to closed JSCs (see Question 17).
These agreements can, among other things:
Regulate voting issues.
Include pre-emption and first refusal rights.
Cover other matters of co-operation between shareholders or participants.
Due to the recent introduction of the amendments, there is still very little information concerning execution and practical use of these agreements.
Therefore, many investors still seek to have the transaction governed by foreign law, for example, by using a holding company registered outside Russia. While it is theoretically possible to include provisions concerning further financing in the purchase agreement, the parties to a private equity transaction still usually have additional and detailed shareholder agreements regulated by foreign law.
Share purchase agreements governed by Russian law (used if the investor acquires existing shares) contain provisions on:
The subject matter of the agreement.
The level of consideration.
Mutual rights and obligations of the parties (including completion mechanics).
Arbitration, if the parties to the agreement intend to submit their disputes to arbitration.
Generally, venture investment transactions also include changes to the target's constituent documents. The target must also usually execute certain documentation required by the investor as a result of legal due diligence, for example, to transfer IP rights to the holding level.
Although significant changes were made to corporate legislation concerning shareholder agreements (see Question 15), those agreements are still of limited use. Therefore, the parties to a venture investment transaction, even if they are both Russian, still prefer to perform the deal through a foreign special purpose vehicle (usually offshore), and submit the agreements connected with the transaction to foreign law (usually one of the common law systems). This is the only way to execute a comprehensive and effective shareholder agreement, and to set out future obligations relating to further financing and the operation of the target, as well as mutual representations and warranties.
The form of equity interest taken by a fund depends on whether the target is an LLC or a JSC:
LLC. An equity interest in an LLC is represented by a participatory interest, which is not recognised as a security. The participatory interest provides rights to:
participate in the company's management;
receive a part of company's profits.
In specific cases, the participants of the company can grant a participatory interest holder additional rights, similar to those given to a shareholder by preferred shares (for example, rights connected with the management of the company and distribution of profits).
JSC. JSCs issue ordinary and, if necessary, preferred shares, which can be either distributed among a limited number of shareholders (closed JSC), or placed and traded publicly (open JSC).
Shareholders holding preferred shares cannot vote at shareholder meetings, except in limited cases (generally, matters of restructuring and matters directly related to preferred shareholders' powers) (Law on Joint Stock Companies).
The target's charter must provide a fixed amount or rate of interest to be paid to the holders of preferred shares, and define which part of the company's assets will be delivered to them in case of the company's winding-up. The charter may also allow for the conversion of preferred shares into ordinary shares, in which case the order of any conversion must be set out.
If the company fails to pay interest to its preferred shareholders, they obtain voting rights, effective at the first shareholder meeting after non-payment of interest.
The management structure of Russian companies differs from the Anglo-American model. The role of the board of directors in Russian private and public companies is less important, while the shareholders usually control the company's activities. Therefore, it is more important for the fund to:
Have a major shareholding in the company, in the form of a controlling or at least a blocking stake.
Have to approve the company's general director (CEO).
In addition, new companies are usually established as LLCs and closed JSCs, which may have no board, provided the management is performed through shareholder meetings and a general director.
LLC participants and JSC shareholders can create contractual restrictions on share transfers in the target, which form part of the investment documentation.
The following actions are also available to JSCs and LLCs:
Restrictions can be imposed in the constituent documents of the Russian-based LLCs on the ability of participants to transfer their participatory interests.
Even if no additional restrictions are set out in the constituent documents or participants' agreements, shareholders of closed JSCs and participants of LLCs have pre-emption rights for any shares or participatory interests offered to a third party that is not a shareholder or participant of the company.
Due to lags in the regulation of pre-emption rights and the lack of practical implementation of the participants' agreements, it is still highly recommended to incorporate all restrictions in a comprehensive shareholder agreement regulated by foreign law, preferably from a common law system.
Russian corporate legislation does not recognise drag-along and tag-along rights. While these concepts might be recognised by the courts in the future, under the freedom of contract concept, currently, the only guaranteed way for the investor to receive this type of protection is to be a shareholder of a foreign holding company, solely owning the target in Russia (see Questions 15 and 16).
LLC participants and closed JSC shareholders can agree and implement into a target's foundation documents various rights of minority participants concerning the sale of their participatory interests, for example:
Fixed sale price of participatory interests.
Criteria and ways to determine the sale price (including net assets and net profit of the company).
This makes an LLC or a closed JSC a convenient instrument for minority shareholders, where they can effectively secure their interests.
Statutory pre-emption rights are provided for LLCs and closed JSCs (see Question 20). However, considering the limited flexibility of these provisions, and the impossibility of sufficiently regulating the parties' relationship in an agreement, it is advisable to incorporate pre-emption rights in the shareholder agreement of a foreign holding company (see Questions 15 and 16).
No consents of official bodies are required for the approval of investment documentation. However, there are regulations concerning the requirement for documentation to be executed and submitted to certain regulatory bodies by Russian-based mutual investment funds and incorporated investment funds. At the same time, various corporate consents from the investor of a target or of the founders (if they are represented with legal entities) may be required in accordance with applicable legislation and the respective foundation documents.
Generally, the fund bears its own costs. However, there are no restrictions on the costs of foreign venture capital funds being paid by any other entity or individual. It is not uncommon for costs to be met out of the fund's investment when the investment is completed. If not, it is usually the management company of the fund who covers the costs.
It is not common to grant shares and options to employees, except at the highest levels. Employees are usually incentivised through bonuses, which may be connected with efficiency or length of service. However, management can be granted options for up to 15% to 20% of shares on a fully diluted basis.
Founders commonly have shareholdings and occupy top management positions in venture companies. They are therefore directly motivated to be successful and to increase capitalisation of the company.
Employees' bonuses are subject to general payroll tax at a flat rate of 13%.
As most venture investors acting in Russia are foreign or international venture funds, they generally implement the same conditions of financing and protection as used in other countries. This also means that all the usual contractual instruments used to ensure founders' commitment can be used for Russian-based foreign venture companies and their respective founders.
Founders' lock-ups are quite common and can be structured under Russian law. Good leaver and bad leaver provisions are usually structured under foreign law, since shareholder agreements regulating these issues are most commonly regulated by foreign law.
A venture capital fund's stock in an unsuccessful company is primarily realised through a sale or buyout.
However, if the unsuccessful target is an LLC, the investor may have an additional option under the Law on Limited Liability Companies. If included in the charter of the target, this option provides that in exchange for the investor's equity stock, the company can, within a set period of time, deliver to the investor a part of its total assets in an amount pro rated to the investor's shareholding, in kind or the cash equivalent. The participant of an LLC can use this right at any time. If there are no investors willing to buy the equity stock and a management buyout is not possible, this type of exit can become a valuable tool for the investor. The exit repayments are exempt from taxation as part of the initial contribution by the investor to the company, so the investor does not have to pay income tax in Russia for the amount of gains up to its effected contributions (see Question 3, Income tax). However, the investor is still subject to taxation if it sells its equity stock in the usual way. If the investor owns substantial equity stock, such an exit can seriously affect a company.
A venture capital fund holding equity stock in a successful company usually has a wide range of options to realise its investment, including:
An initial public offering (IPO).
A management buyout.
A leveraged buyout.
A sale to a strategic investor.
The most commonly used exit is a sale to a strategic investor, due to the:
Currently limited opportunities for international IPOs.
Under-developed stock market.
Lack of private equity transaction regulations.
Domestic IPOs do take place, and their number is expected to grow in the future, with the further development of infrastructure and the securities market.
An exit strategy is usually contractually built into the investment, particularly by including it in the shareholder agreement, or any similar instrument used to regulate the parties' relationship.
The investors must consider any provisions in the target company's foundation documents, which could delay or make impossible a desired exit strategy (for example, a restriction on selling a participatory interest in an LLC, if the investor wishes to sell those participatory interests to the strategic investor).
Qualified. Russia, 2002
Areas of practice. Corporate M&A; private equity/venture capital; employee benefits.
Qualified. Russia, 2004
Areas of practice. Corporate M&A; private equity/venture capital.