Entrepreneurial activity and innovation are imperative for sustained development and growth in any economy. Despite its nascent status as a capitalist nation,Russia’s economy by many measures is fairly advanced. In 2012, the country’s GDP was eighth in the world, at just over US$2.0 trillion. Its population of 143 million is well-educated, with a literacy rate of 99% and nearly 70% enrolled in post-secondary education. Russia also boasts the largest Internet market in Europe, with 59.7 million users, and an astounding 230.5 million mobile phones, or 1.6 mobile phone numbers per person.

Despite these figures, however, private investment in early-stage business projects in Russia is still about US$300 million per year, roughly 1/70th that of similar investment in the U.S. According to the Global Entrepreneurship Monitor, only about 5% of the Russian adult population is engaged in early-stage entrepreneurship, the lowest level among countries with a comparable GDP per capita. The abundance of natural resources — such as oil, gas, coal, and timber — and the economy’s resulting dependence on these commodities for export earnings have led to a natural resource curse, whereby most public and private capital is funneled to support those industries, at the expense of nearly all other sectors of the economy.

In Russia, this is exacerbated by the fact that state ownership is present in 81% of the top firms, which places the country third in the category behind only China and the UAE. To sustain short-term economic growth and satisfy the country’s recent fast-growing consumer market, where GDP per capita has grown about 13% annually from 1999 through 2010, politicians continue to funnel outsized portions of capital to these natural-resource-related industries.

Moreover, with very little foreign or domestic competition, Russian manufacturers do not see a reason to innovate, further increasing inefficiency and putting a strain on long-term economic development. For example, in 2011, overall R&D expenditures by businesses in Russia represented just over 1% of GDP, compared to expenditures of about 3% in the U.S. Furthermore, the number of researchers in Russia has decreased nearly three-fold since the late Soviet period. In addition, due in large part to its geographic vastness, isolation and political and economic barriers with other nations, very few industrial products (outside those used for natural resources) enter Russia’s borders. As a result, with no internal demand for innovation, much of the nation’s industrial technology has become dangerously outdated and inefficient. In fact, many industries continue to use legacy Soviet-era equipment and machinery. Finally, political instability, the economic crash in the 1990s, and a general lack of opportunity caused a “brain drain.” It is estimated that 1.25 million people emigrated from Russia in the first decade of the twenty-first century alone.

A Startup Incubator Is Born

In 2010, recognizing this overall void in innovation and development spending, former President and current Prime Minister Dmitry Medvedev established the Skolkovo Innovation Center just outside Moscow. Billed as Russia’s version of Silicon Valley, Skolkovo calls for a 400-hectare (1,000-acre) site with 25,000 permanent residents, business and engineering schools, housing, a Technopark, and mass-transit connections, all to be completed by 2020. This complex is a hallmark of Medvedev’s efforts as president to wean Russia off natural-resource commodities and nurture a knowledge-based economy. The Technopark, in particular, serves as a startup incubator that supports its residents in developing products with the end goal of establishing them in the Russian and global markets.

In 2011, overall R&D expenditures by businesses in Russia represented just over 1% of GDP compared to expenditures of about 3% in the U.S.

Today each startup at Skolkovo falls into one of five clusters that the state deems essential to innovation: information technologies, energy-efficient technologies, nuclear technologies, biomedical technologies, and space technologies and telecommunications. According to the Skolkovo Foundation, which oversees the Innovation Center and Technopark, during the first half of 2013 resident companies generated about 4.6 billion rubles (US$145 million) in revenues and submitted 204 applications to register intellectual property.

Once admitted through an application process, residents enjoy benefits such as highly subsidized rent and reductions in payroll and value-added taxes. They also have the opportunity to apply for monetary grants from the Skolkovo Foundation, but many choose not to because of the significant additional reporting requirements. International participants in Skolkovo Technopark are also afforded easier access to work visas.

In reality, the residents’ incentives go beyond mere finances. Vladimir Bernstein, CEO of Board Maps, in the IT cluster, came upon Sberbank, which he hopes will become an important client, through a Skolkovo contact. Pavel Smirnoff, CEO of Optogard, in the nuclear-technology sector, hopes to gain access to Russian railroads through another Skolkovo connection. Optogard, which uses a unique laser-plasma system to increase the strength and durability of metal surfaces, also utilizes Skolkovo’s vast array of hardware technology and the advanced testing center — both of which are freely available to all residents — to analyze various metal surfaces. Another founder, in the Energy cluster, who prefers to remain anonymous, wound up at Skolkovo by accident, but loves the culture of innovation, frequently attending meet-and-greet events to network and share best practices.

Residents of Skolkovo can retain their benefits for either 10 years or until they exceed an annual revenue of 1 billion rubles (US$31 million) — whichever comes first. This allows time for proper R&D to build and test the product but may also serve as a moral hazard.

Another concern is how Skolkovo Technopark plans to reconcile the need for innovation with commercial viability. Skolkovo recently hosted StartupVillage, an Entrepreneurship and Innovation Conference, whose goal was to connect startups with investors, tech companies, and experts in their respective fields. The first-place winner was the eTrike from Bravo Motors, a business in the energy-efficiency cluster that focuses on research to extend the life of rechargeable batteries in electric cars. It received a 900,000 rubles (US$30,000) prize and was named best Russian startup by Forbes. Bravo Motors’ main challenge now is to raise 42 million rubles (US$1.4 million) for field testing and initiating production. As an anonymous source close to the matter says, the success of Skolkovo will not be measured by companies like Bravo Motors. Rather, “the success of Skolkovo should be assessed on the basis of whether it manages to create a huge and successful business like Yandex [Russia’s largest search engine] and Mail.ru [Russian email].”

Operating within the current Russian investment climate presents another challenge. The current legal system is still developing and lacks important elements, such as fundamental protection for minority shareholders. As a result, many companies choose to incorporate in Luxembourg or Cyprus and hold overseas bank accounts. Businesses also seek to partner with international firms to share expertise, which is often lacking within Russia; and many seek international clients. Consequently, the benefit to Russia and its economy is diluted, and these startups are effectively Russian only in name. Outside of adequate access to capital and legal uncertainty, the lack of concrete corporate governance and the dearth of qualified people echo over and over as the main problems these startups face.

Since 2012, Skolkovo’s name has been mired in a number of widely publicized criminal cases involving its executives.

Sergei Sedyh, who has been involved in three startups at Skolkovo, questions whether companies in Russia can truly innovate and create a disruptive breakthrough. He describes the investors’ general sentiment as, “if they haven’t already done it in America, it probably won’t work,” and adds that “Russia is an investment desert.” He also worries that the government is using Skolkovo as a political puppet for its own ends.

Misspending and Illegal Payment Allegations

Since 2012, Skolkovo’s name has been mired in a number of widely publicized criminal cases involving its executives. In February 2012, the Investigative Committee, a top law-enforcement body, said it was investigating the misspending of 3.18 billion rubles (US$106 million) the government had provided to Skolkovo. The committee also announced that it had opened one criminal case against two Skolkovo managers over the alleged theft of 21.6 million rubles (US$720,000), and a second case, accusing Skolkovo vice president Alexei Beltyukov of allegedly making illegal payments of 22.5 million rubles (US$750,000) to opposition lawmaker Ilya Ponomarev for preparing a series of lectures about Skolkovo. In total, three ministers in Medvedev’s cabinet have been fired or forced out since October 2012, most recently Deputy Prime Minister Vladislav Surkov, the government’s chief of staff. Announcement of his resignation in May 2013 came after he publicly criticized the criminal investigations into the use of state funds at Skolkovo, which he had overseen.

Skolkovo is widely regarded as an endeavor of former president Medvedev. While current President Vladimir Putin’s public comments about the project have been largely supportive, his enacted policies have been mixed, and his administration recently reversed certain preferential treatments for the center. Gleb Pavlovsky, an ex-Kremlin adviser who heads the Moscow-based Effective Policy Foundation, says that “the idea of the project itself is anathema to the leadership because of its special status and independence. Without Medvedev able to protect it, it can’t survive.”

Beyond the shameful publicity that highlights the country’s political instability, these events have led to hesitation among multinational corporations looking to invest in Russia. Many prominent global corporations — including Alstom, Intel, Microsoft, Samsung Electronics, and Siemens — originally backed Skolkovo and pledged nearly 15 billion rubles (US$500 million) in investments. Conor Lenihan, a former Irish science minister tasked with attracting foreign companies to Skolkovo, notes that the center offers “alignment with a flagship project and a safe harbor where [the corporations] can locate R&D and receive protection for their intellectual property.” However, with the current instability, many investors can still withdraw their financial support, especially if the projected state funding does not materialize.

Direct government involvement creates a number of questions about conflicts of interest regarding independence and financial control, as well as interpretation of the law.

The environment of political uncertainty compounds Skolkovo’s fragility. The Technopark and innovation center are almost exclusively government-funded and are administered through Federal Law No. 244-FZ. The Skolkovo Foundation, whose board of directors oversees the Technopark, claims to be independent of the government. However, this direct government involvement creates a number of questions about conflicts of interest regarding independence and financial control, as well as interpretation of the law. Article 10, for example, states that, as of January 2014, all business residents must be physically present in Skolkovo. However, construction of the facilities is not complete. As a result, some of the startups are worried about their logistical ability to comply with the law.

Gleb Daviduk, managing partner of iTech capital, a private equity firm that invests primarily in technology companies in Russia, is optimistic about Skolkovo, noting, “the Russian startup scene seems largely to have been spared by corruption. In the digital sphere, greedy civil servants don’t know what to look for — or where. This helps the industry to stay below various radar screens.” He believes all attempts at innovation are good and that Russia needs Skolkovo, no matter how inefficiently it is run. Skolkovo does not need to work for results specifically, he adds, but for the sake of being there to promote innovation.

Viktor Vekselberg, the Russian oligarch who heads the innovation center, points out that government involvement is unavoidable. He notes, “When it comes to innovation,Silicon Valley appeared thanks to the government…. Let’s not have illusions about this. It appeared in the first instance thanks to serious contracts from the military-industrial complex. And to this day,Silicon Valley — don’t try to twist things around — still relies heavily on the state…. Wherever you look, if we take other examples, the state always plays a dominant role. Singapore: The state plays a dominant role in an analogous project. India: huge involvement of the state.”

For at least the near term, the Russian government has reaffirmed its commitment to Skolkovo. In August 2013, the Duma allocated 502 billion rubles (about US$15.5 million) through 2020. According to Vekselberg, this action demonstrates the government’s “faith in the future of the Skolkovo project.” According to the foundation’s estimates, by 2020, the Skolkovo project will help establish 1,000 startups in Russia, which will contribute 213 billion rubles (US$7.1 billion) to the Russian economy. Vekselberg notes that “In total, efficiency from investment in the project needs to be calculated by 2030, when it reaches full operating capacity. According to preliminary calculations, the project will contribute up to 1.5 trillion rubles to GDP.”

By virtue of a rotund bureaucracy and the large role state-owned enterprises play, every Skolkovo resident relies on the foundation for access to one branch of government or another — be it Russian railways, state-owned Sberbank (Russia’s largest commercial bank), or a regional government office. It is the magic ingredient in Russian entrepreneurship and is ubiquitously termed the “administrative resource.” As Vekselberg notes, “It is true that in Russia it is difficult to get anything done without state support.” It remains to be seen how the state will follow through on its commitment to Skolkovo and innovation in general, but Russia needs its continued development in order to avoid the Dutch disease of overreliance on natural resources.

This article was written by Eugene Bord and Natalya Guseva, members of the Lauder Class of 2015.