To resolve the challenge of turning Russia into a leading country for innovation, the Kremlin should first understand the reasons why Russia’s home-grown start-ups are leaving for the West.

Viktor Vekselberg, president of Skolkovo Foundation, chairman of the directors' board of Renova Group, speaks at the Startup Village international conference of startup companies and investors. Photo: RIA Novosti.

For a different take read: "Russia's startup migration could help repair relationship with the US"

As more and more Russian start-ups relocate to the West, there have been growing concerns about the permanence of this trend and its potential effects for the Russian economy. What, then, are the reasons behind these young companies moving out of Russia and what does it mean for the future?

First of all, it is worth taking a look at what an emerging company, often in the high-tech sector, needs in order to grow and capture or create a new market segment. Creative ideas combined with managerial talent and a small pool of qualified staff are essential at the initial phase.

Next comes the seed funding round, in order to move from the idea to the implementation, when a given product can enter the market. There are also important advantages related to the location of a given start-up.

Proximity to other start-ups enhances the exchange of ideas, helps in building networks, and eases access to potential investors. Often, proximity to customers is very important in order to be able to realize the potential of a given market segment. Finally, stable market conditions are essential for strategic planning.

What is Russia’s innovation potential?

Now, let’s see how these factors compare in Russia. 

With a relatively high number of researchers, especially in the sciences, a high number of patent applications, and the like, there seems to be lots of human capital for start-ups in the Information and Communication Technologies (ICT) field or ICT-using fields. And indeed, this market has been expanding.

For example, the Russian online retail sector, which often uses newly developed applications, expanded by 10-15 percent in 2014 in dollar terms. During 2010-2013, the e-commerce sector (which has been the main destination for venture capital investment in Russia) attracted nearly $1.3 billion.

On top of venture capital investing in local start-ups, the Russian government provides seed money and grants, predominantly in the more technical market segments. As TNW News writes, the Russian government financed almost 40 percent of seed deals and one-fourth of all start-up early stage funding in 2013.

When thinking about the market potential, it is enough to mention that in 2010 there were nearly 260 million Russian speakers globally, 137 million of which live in Russia. About 68 percent of the population uses the internet, which falls just a bit short of the densely populated and highly developed euro zone, according to the World Bank World Doing Business 2013 database.

Only half as many people is connected to the broadband in Russia as in the euro zone, but given the geographic size of the country, the Internet penetration rate is still impressive. On top of that, Russia has one of the highest rates of mobile penetration in the world, which shows the extent of the market potential.

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A broader look at Russia’s macroeconomic situation

The picture gets blurred when one reflects on whether the Russian economy is governed by a stable and predictable set of rules. The general business environment does not seem to be very conducive to sustainable economic growth.

Russia ranks 62 out of 189 countries in the World Bank 2015 Ease of Doing Business rating. It does not look that dramatic as it is still higher than the regional (Eastern European and Central Asian) average, yet certain regulations hamper business development.

For example, companies willing to sell beyond national borders may find doing it very difficult, as compared to conditions in many other countries. Moreover, the perception of corruption is still very prevalent, as Russia ranks 136 out of the total 174 countries in the Transparency International Corruption Perception Index, which puts it among the most corrupt countries in the world.

Moreover, the unfavorable macroeconomic situation does not provide lots of grounds for optimism. The Russian economy by and large is still dependent on fluctuation in oil and commodity prices and has been suffering from economic sanctions.

Russian gross domestic product (GDP), after practically stagnating in 2014, ended the first half of 2015 with a broad-based contraction of 3 percent. The decline of real incomes and, what follows, consumption, has been larger than earlier expected.

The high cost of credit has hampered business investment. As a result, the growth of the e-commerce sector (still the most important tech sector in Russia) has been slowing down considerably in 2015. Attracting venture money became more difficult in 2014 and 2015 as opposed to earlier years.

In comparison to this fluctuating business environment, the U.S. or the UK markets offer more mature conditions to develop an enterprise. The potential pool of venture capital or the average funding from “business angels” is considerably larger than in Russia, even in good times.

The proximity to other ventures in tech clusters like those in California, New York or London, plays a very important role, too. Some of the start-ups from Russia would have gravitated to those innovation hubs anyway, as a natural consequence of their development.

The Russian market continues to offer large untapped potential. However, new companies do respond to the same overall conditions as more mature companies. In order to grow, they require stable economic conditions.

Currently, with the Russian economy sliding, the start-up sector is affected, just like any other sector of the economy. The balance of economic push and pull factors resulted in the net outflow of some new, innovative undertakings out of Russia.

The primary reasons behind this outflow are an unstable environment, uncertain future, and decrease in demand (both regionally and nationally). Even the availability of highly skilled Russian ICT specialists, researchers and government seed money do not seem to offset it.

On the contrary, the pull factors of global start-up clusters are as attractive to Russian firms as they are to entrepreneurs coming from elsewhere. As a consequence, at the moment there are good reasons for Russian start-ups gravitating towards these global clusters. As long as the overall macroeconomic prospects in Russia do not change, this trend is unlikely to be reversed. In this context the Russian government’s incentives seem to work for some but, overall, may be outweighed by grander promises elsewhere.

The opinion of the author may not necessarily reflect the position of Russia Direct or its staff.