Why did Azerbaijan force the creation of venture capital legislation? Analysis by Caliber.Az

Azerbaijan is searching for new forms of financing for innovative entrepreneurship and start-ups. Along with preferential crediting by means of state funds, loans and grants by international specialized structures, the possibility of financial support of local high-tech IT companies, scientific production structures, and software businesses by means of private investment funds are being studied. For this purpose, the country has accelerated work on the development of a draft law on venture funds, the adoption of which is expected this year. The next step in this direction was the creation of the Technovate Angels Club investors club in the country, which was recently announced by the Minister of Economy of Azerbaijan Mikayil Jabbarov.

The history of modern venture investing dates back to the inception of digital technology and the Internet at the turn of the eighties and nineties, and this form of financing finally took shape in the 2000s, during the dot-com era, remembered for the crazy jump in the value of global IT companies' shares. And while venture capital was a tiny and relatively new form of investment in the 1990s, totalling only $7.6 billion, the global venture capital market reached $584 billion in 2021, according to Japan Times estimates, effectively doubling compared to the previous year.

What are the advantages of venture capital funding and why are such investments most in demand for the development of high-tech and the creation of the startup ecosystem? Venture investments (venture - risky enterprise) are investments in a developing high-tech business or a startup, the success of which is not yet known. That is, such investments allow you to get a quick profit in exchange for funding, but given the huge risks, a venture fund can lose everything.

In the case of normal investments, the investor expects a stable, but not super-high income; however, the bankruptcy risks of such a company are usually much lower. Well, venture investments, depending on the ability of a high-tech project to find the right business model to scale up and become a major market player, can bring investors profits, sometimes thousands of times higher than the investment.

The average period of investors' stay in such projects is about five years, and if the business is successful, the venture capital funds usually sell their stake in it later at a huge profit. Some co-investors in Zoom, Uber, Slack and Airbnb did the same when these companies took off. For example, two investors invested in Google, each with an investment of $100,000, and the company's current capitalization exceeds $1 trillion.

Of course, it is still quite rare for such superprofits, but in general, the average return of venture capital is significantly higher than that of traditional lending structures. Thus, according to the Cambridge Associates US Venture Capital Index, which tracks the results of about 1,800 U.S. venture capital funds, the average return on venture capital investments is 14.34% per annum over the past ten years and 34.43% per annum over a 25-year period. Over the same period, the S&P 500 index of the largest companies showed 10.17% and 9.6% revenues, respectively.

In Azerbaijan, which has started to develop the startup ecosystem relatively recently, there is still very little experience in the commercialization of experimental hi-tech developments and software solutions. Until recently, high-tech projects implemented in the country were mostly of applied, research nature, carried out mainly in the framework of state support and international donor grants. More recently local start-ups began to seek support from international vendors and make the first steps towards attracting contract orders from leading companies in the US Silicon Valley and other world centres of the IT industry.

Nevertheless, in recent years the dynamics of development and the number of startups operating on the basis of incubation and acceleration centres at universities and research and production structures have noticeably improved in the country. Incubation and acceleration centres, programming schools and a number of other specialized structures formed at a number of universities, ANAS and state agencies act as a driving force here. The most active of them are the incubation structures Barama, NewSpace, AppLab, YouthInc and Tech.az, etc. Moreover, since last year, support to innovative businesses is also provided through fiscal preferences: SMEs that received startup certificates are exempted from income tax and tax on income from innovative activities for three years.

Nevertheless, attempts made in recent years to create some analogues of specialized venture capital funds and target investors (so-called "business angels") in Azerbaijan have not been successful. Such steps, in particular, were taken in 2018 when the country was negotiating the establishment of the High-Tech Investors Club (a kind of analogue of a venture fund), the members of which were planned to become local IT companies. Among the potential founders of the Club were the names of well-known Azerbaijani companies operating in the field of ICT - Sinam, BestComp, Neuron Technologies, Azercell, Enginet, Hesab.az and a number of other structures. The Club's activities were planned to be aimed at the commercialization of promising startup projects through equity participation in them.

Another attempt to create a venture capital fund in Azerbaijan was made in May 2019: a memorandum of understanding was signed between the Ministry of Communications and DAAL Venture Capital. The focus of DAAL Venture Capital was to invest in startups operating in the field of financial technology, but so far there is no information about the implementation of any specific investment projects.

In the post-pandemic period, efforts were also made to attract international investment funds to the country. In particular, a year ago agreements were signed with Turkish venture fund BoğaziçiVentures, which plans to provide $5 million to accelerate Azerbaijani start-up projects. In turn, the Turkish GOSB Technology Park and the Innovation Agency of Azerbaijan signed a memorandum "On cultural and scientific cooperation", which provides for joint implementation of acceleration programs, technology transfer and creation of a joint Park of High Technologies. Last July, the largest Israeli venture company OurCrowd and Azerbaijan Investment Company (AIC) also signed an agreement on attracting capital and know-how in the development of the high-tech sphere. OurCrowd specializes in investing in startups operating in the field of artificial intelligence, transport, energy, healthcare, security, etc., and its experience in the commercialization of startups' experimental developments and incubation centres can be used in Azerbaijan in the future.

Nevertheless, the process of attracting international capital to develop the startup ecosystem in Azerbaijan is not an easy task: both due to the fact that local high-tech business is still at the stage of formation, and due to the lack of fiscal regulation, mechanisms of preferential lending to the IT sector, lack of special legislation and other incentives to attract such investments. Moreover, it is necessary to work out incentives to attract "business angels" and further move to venture to finance, as venture funds finance start-ups not at the stage of creation, but at the stage of their infancy.

On the other hand, in Azerbaijan, private investors are still very cautious to participate in such undertakings, as venture financing is associated with a high or relatively high degree of risk, because, as a rule, 70% of projects do not bring a return.

Therefore, today the main efforts for the development of the private investment market in Azerbaijan are aimed at the creation of a specialized legislative framework. "In 2022 Azerbaijan may adopt a bill on venture capital funds. Experts of the State Agency for Public Services and Social Innovations under the President of Azerbaijan, the SME Development Agency (KOBİA), the Ministries of Economy and Digital Development and Transport were involved in drafting the document," KOBİA Board Chairman Orhan Mammadov said recently. The new law "On Ventures" will help expand the instruments of financing and development of the startup sector, innovation and technology industries, and work on the formation of a venture fund with the participation of government agencies in the country is underway.

Apparently, the state's activities in the development of private investment funds are also supported by the country's business community.

"Technovate Angels Club, which unites trustee investors, was launched in Azerbaijan," Economy Minister Mikayil Jabbarov wrote on his Twitter page. The minister stressed that the club was based on the best international practices, noting that such platforms are a new and interesting opportunity for the development of the startup ecosystem, a useful initiative to improve the business and competitive environment in Azerbaijan.