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Development of Small Innovative Companies in Sarovto Serve the Russian Market

Vladimir I.Zhigalov *
All-Russian Scientific-Research Institute of Experimental Physics

This paper discusses practical experience amassed mainly since 1996 in the development of small innovative companies in the city of Sarov (formerly Arzamas-16). The city is the site of an important research and production center, the Russian Federal Nuclear Center—All-Russian Scientific-Research Institute of Experimental Physics (VNIIEF), which employs 18,000 people. Also located in Sarov is the Avangard Electromechanical Plant, employing about 3,500 people.

There is a rather high concentration of scientific and technical potential in the city, which provides favorable conditions for the development of innovation-oriented business. In terms of its potential, VNIIEF is comparable to a complex of several dozen research institutes with a fairly wide range of specialties. This facilitates the development of innovative business on many fronts, ensuring broad commercial diversification.

To provide incentive for the development of small companies, the enterprise VNIIEF-Conversion was established in 1996 on the basis of a joint decision by the Russian Minister for Atomic Energy and the Gover-nor of Nizhny Novgorod Oblast. The founders of the enterprise were VNIIEF, the Russian Ministry of Atomic Energy (Minatom), and the governments of Nizhny Novgorod Oblast and the city of Sarov. In the years since its establishment, VNIIEF-Conversion has functioned as a business incubator, working with various partners to form small companies in different spheres of activity using attracted investments.

* Translated from the Russian by Kelly Robbins.



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Page 57 Development of Small Innovative Companies in Sarovto Serve the Russian Market Vladimir I.Zhigalov * All-Russian Scientific-Research Institute of Experimental Physics This paper discusses practical experience amassed mainly since 1996 in the development of small innovative companies in the city of Sarov (formerly Arzamas-16). The city is the site of an important research and production center, the Russian Federal Nuclear Center—All-Russian Scientific-Research Institute of Experimental Physics (VNIIEF), which employs 18,000 people. Also located in Sarov is the Avangard Electromechanical Plant, employing about 3,500 people. There is a rather high concentration of scientific and technical potential in the city, which provides favorable conditions for the development of innovation-oriented business. In terms of its potential, VNIIEF is comparable to a complex of several dozen research institutes with a fairly wide range of specialties. This facilitates the development of innovative business on many fronts, ensuring broad commercial diversification. To provide incentive for the development of small companies, the enterprise VNIIEF-Conversion was established in 1996 on the basis of a joint decision by the Russian Minister for Atomic Energy and the Gover-nor of Nizhny Novgorod Oblast. The founders of the enterprise were VNIIEF, the Russian Ministry of Atomic Energy (Minatom), and the governments of Nizhny Novgorod Oblast and the city of Sarov. In the years since its establishment, VNIIEF-Conversion has functioned as a business incubator, working with various partners to form small companies in different spheres of activity using attracted investments. * Translated from the Russian by Kelly Robbins.

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Page 58 In the following text, the basic activities of the aforementioned enterprises are described briefly, including their specializations in the innovation area and the opportunities on which they have attempted to capitalize. Employing about 120 people, Titan is a company that develops new approaches to the processing of metals and alloys. By studying the physical and chemical properties of metals and modeling the various technological processes involved, the company is attempting to create items with preestablished mechanical durability characteristics. The items are treated over different temperature and pressure ranges using vacuum technologies. The most significant results are being obtained in work with phase shift materials. About 10 patents have been obtained for research results in this area. Very interesting results have also been obtained in research on titanium alloys, materials that are currently promising not only for aviation but also for the automobile, chemical, and medical industries. The company has recently begun serial production of a number of products made from titanium and aluminum alloys. Small contracts have been signed with a number of Western European countries. In addition, the company's design group is working on original designs for road-building equipment on orders from the Russian Federation Road Foundation and is participating in various competitions and trade shows in this area. Sarov Cellular Communications is a company that is developing and introducing mobile communications technologies in the Nizhny Novgorod area. In 1997 it completed a project to provide a cellular phone network for about 1,000 subscribers in Sarov. With its business developing in a profitable and favorably predictable manner, the company is trying to develop capabilities for manufacturing mobile communications equipment. VNIIEF-Conversion Industry is a company that specializes in introducing new technologies in the construction industry. Its main “test site” is the southern part of Nizhny Novgorod Oblast. This particular company initiated and developed a number of new production facilities, including an asphalt plant and a mixtures plant, both of which are equipped to comply with environmental protection regulations and ensure high production standards. The enterprise is profitable and has good characteristics for further growth. The Rehabilitation Center is an enterprise that concentrates its activities in a number of areas associated with the development of medical technologies. The main area involves the development of prophylactic and diagnostic tools, such as telemedicine. Development of efficient modern tools for medical diagnostic consultations is one of the company's most interesting problems. In collaboration with U.S. and Italian specialists, the firm is considering plans to establish a telemedicine center in Sarov under its auspices. In 2001 the enterprise opened a laparoscopy

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Page 59 center that performs laparoscopic surgeries in cooperation with Central Medical Facility-50 of the city of Sarov. The Ecological Technopark is an enterprise that is developing resource-conserving technologies connected with environmental protection and accident prevention and cleanup. The focus of the company's activities in this area is currently a project on wood processing. The technological process of the enterprise, on the one hand, is waste-free and, on the other, guarantees that the products manufactured will be of high quality for the consumer. The enterprise is currently completing the investment stage, and by the end of the year, actual production will be under way at projected capacity. In addition, the enterprise manufactures small batches of specialized vehicles to order. In particular, it produced a special emergency squad vehicle based on the “Gazelle” to serve the needs of the Russian Ministry for Emergency Situations. The technopark is also preparing to produce vehicles to collect and purify sulfur hexafluoride gas, which is used as an insulator in high-voltage switches. Imperial is a company that was founded jointly with the local church authorities to make wine. HydroApparatus is an enterprise specializing in the production of new types of equipment for use at electric power plants, with its customers including Unified Energy Systems of Russia, among others. HydroApparatus has launched the small-scale production of hydraulic drives for electric switches. The Testing Laboratory is a project aimed at developing special services for the testing and repair of equipment and sensors that monitor water and heat usage. In connection with the growing importance of resource conservation in Russia in recent years, a great deal of monitoring and control equipment has begun to be installed. Such equipment requires constant testing and maintenance. The implementation of this project will meet the needs for such types of services in southern Nizhny Novgorod Oblast and a number of adjoining regions. RosBioProduct is an enterprise that is attempting to develop a unique tagging technology to meet the needs of the food industry. The company is currently in the stage of attracting investments for the project, so its products are not yet on the market. AirUnion was established jointly with the Kazan Aviation Institute. It specializes in developing light aircraft. To date, the company has produced two series of delta-wing vehicles used in the tourism industry and in agriculture. Some of these machines have already been sold. In addition, the company is developing a small two-seat plane with a very short running distance before takeoff. Prospects for introducing such aircraft on the Russian market appear rather promising. Sarov has an airport, which provides a unique kind of test site for testing and demonstrating such aircraft.

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Page 60 Brilliants of Sarov is an enterprise that manufactures and sells jewelry under the auspices of a factory that processes diamonds and other precious stones. AST is a transportation company operating in Russia and internationally. VNIIEF-Energy is a company that develops and installs energy-saving technologies. Specifically, these include special systems for facilitating multirate operating modes for various users. VNIIEF-Conversion Business Center is an enterprise specializing in the trading of petroleum products. The Center for Gas Mixtures is a company that manufactures, transports, and stores special highly pure gas mixtures, in particular, for laser applications. This enterprise employs specialists from the VNIIEF laser division. Besides making highly pure gases, the company has also begun producing special tanks that ensure the stability of the gas mixtures during transportation and storage. VNIIEF-Conversion serves as an incubator for all the aforementioned companies. It should be noted that each project is of an individual nature, with its own particular characteristics, drawbacks, and competitive advantages, and each one is at its own specific developmental stage. Summary information on all of the above-mentioned companies is presented in Table 1. Now I would like to discuss the history of VNIIEF-Conversion and its current operations. VNIIEF-Conversion is an open-stock company that operates as a commercial organization. If there is a real demand for an incubator in a region, such an organization may exist only in a commercial form if no governmental or municipal grants (reliable financial support) are provided. This implies that consultations would have to be on a paid basis, as would assistance to emerging companies in compiling business plans and searching for funding sources. Such an organization might pursue other commercial activities simultaneously, to support its own balance of payments. Certainly some startup capital is required at the beginning of operations. This is provided by the stockholders as a contribution to the organization's initial capitalization. Actually there are several ways in which such an organization can maintain its self-sustaining status, including paid consultations on business plan development. As a rule, payment is made during the project implementation stage, that is, the services are provided on credit over a set period of time. paid legal consultations. Typically, emerging companies employing 10 to 30 people cannot afford to keep a lawyer on staff, though they do encounter needs for legal services in the course of their operations. As a rule, all legal services to these companies are rendered by the legal group

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Page 61 TABLE 1 Small Innovative Companies in Sarov Name Market Competitive Advantages Difficulties Status Sarov Cellular Communications Stable, regional Developed service infrastructure Limited nature of market Past break-even point; now profitable Titan Nizhny Novgorod region, all Russia Highly qualified specialists available Profound market research required for correct strategy Past investment stage; sales near to break-even Industry Regional and highly competitive Highly qualified specialists available Limited nature of market Past break-even point; now profitable Rehabilitation Center Regional Unique technologies Solvency of the market Embraces two projects: one is past investment stage and near break-even; the second is in the investment stage (telemedicine). Ecological Technopark Regional, with sales potential New technology with good consumer qualities Production arrangements and staffing Past investment but not yet at break-even Imperial Russia Strong competitive positions (a strong partner) Correct product assortment policy required Past investment and in first sales HydroApparatus Russia, China Unique technology Strong competitors, niched market In investment stage connected with production start-up Testing Laboratory Regional Licenses obtained, experienced personnel Need to expand range of services Investment stage; first sales expected in March 2002 RosBioProduct Russia Possibility to preserve technology Uncertainty in volume of orders Investment stage AirUnion Russia, International Experienced partner Insufficient knowledge of market Near break-even; more investment required to develop several areas of activity

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Page 62 TABLE 1 (continued) Name Market Competitive Advantages Difficulties Status Brilliants of Sarov Russia Reliable partner: ABP Sales and distribution system required Investment stage AST Russia, International Good base Insufficient number of vehicles to fulfill lucrative orders Break-even VNIIEF-Energy Russia Unique technology Insufficient commercialization of technology Investment stage VNIIEF-Conversion Business Center Regional Experienced personnel Expansion required, lack of investments Recoupment Center for Gas Mixtures Russia Unique and reliable technologies Sales expansion and special market research required Investment stage; initial sales

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Page 63 of VNIIEF-Conversion based on a special agreement stipulating prices not higher than those of other organizations. consulting in accounting. A number of VNIIEF-Conversion employees serve as auditors for some companies on a paid basis. overhead services on fulfillment of contracts with temporary creative collectives operations in the stock market profits from shareholding in companies On average, VNIIEF-Conversion has about 35 employees, while all the companies embraced by the incubator employ about 500 people. The experience of the incubator has shown that such an enterprise can be self-sustaining.Table 2shows the company's annual profits, which allow it to invest in a number of other enterprises. In 2000 an innovative technology center was established under the auspices of VNIIEF-Conversion. Its main purpose is to develop funding for investment projects using its own means and attracting funds from other sources (international foundations, state financing). In practice, it deals with developing commercial product prototypes that may be offered for market evaluation. This refers to ideas that are premature to be immediately put into production on any sort of scale, as their potential consumer qualities must first be assessed. That is, a working model must be created and the technology must be tested. This is not a matter of conducting any sort of scientific research, but rather of determining certain consumer qualities of the product using well-known technical designs and processes for that purpose. Working out all the details in this manner sometimes requires a sum on the order of $50,000 to $200,000, but this money is at high risk of producing no return. The fate of such a prototype could take one of three paths. It might be licensed to another organization, investments might be sought under the creating organization's business plan to initiate production, or the prototype might not elicit any interest whatsoever. This issue will be discussed in more detail in another presentation. It should be noted that several new independent companies are operating and developing in Sarov, with their business being connected in particular with developing software products (e.g., the company STL, in TABLE 2 Annual Profit Figures for VNIIEF-Conversion

Year Profit (in rubles) 1997 2,192,000 1998 2,076,000 1999 3,142,000 2000 4,171,000

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Page 64 the area of computer services), equipment for the oil and gas industry, and so forth. The experience of creating new enterprises has proven in practice the importance of the formula Management + Market + Capital. An error in one of the elements leads to a failure of the whole project. A balanced approach should be taken in upgrading all components of this system. All projects encounter essentially the same problems in their developmental stages, but they must overcome them in accordance with their specific situations. Otherwise, bankruptcy awaits them. In this regard, an incubator plays an extremely significant role in enhancing the viability of new companies in the following ways: consulting at flexible rates monitoring company activities providing access to additional resources The main difficulties new companies encounter and the typical mistakes they make are as follows: poor knowledge of the market in which they need to sell their products low consumer qualities of products and, as a result, low competitiveness insufficient funding due to errors in business planning poor management lack of access to suitable funding sources (lack of collateral) This point is illustrated using examples from the development histories of several companies. The key role of the project manager should be noted. Even if you have found funding and your product is long-awaited at the market, there is still no guarantee of success. “Bad” management will create a situation in which you do not have enough money, the price of your product is unacceptably high, and so on. At present, Sarov Cellular Communications is a successfully developing company that recouped investments made in it after three years of operation. However, the early operations of the company were far from problem-free. In fact, the company was saved by the systematic independent monitoring of its activities by VNIIEF-Conversion. This point is illustrated using the concept of net present value (NPV). Figure 1 presents the expected and actual net present value of the company. An analysis conducted in the second half of the first year showed that costs were actually continuing to rise, in contrast to what was expected, namely that investments in the project would end and expenses and in

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Page 65 Image: jpg ~ enlarge ~ FIGURE 1 Expected and actual net present value of Sarov Cellular Communications. come would begin to balance out thanks to sales growth. An additional loan was taken out at the bank to cover the unpredicted expenses. The analysis showed the presence of excessive personnel, unduly high salaries, and abnormal expenses for company operations (payments for contracts, services, etc.). A financial manager was appointed for a six-month term, and working jointly with VNIIEF-Conversion specialists, he developed a detailed financial plan, implementation of which was closely monitored. For example, salary costs were cut by about one-third. Income exceeded expenditures, and the company paid off the expensive loan and even returned all investments by the end of its third year of operations. Notably, this is the only mobile communications project in Russia with 100 percent Russian capital. This is a practical example of “curing” the disease of unacceptable management. In general, difficulties in financial management are typical for small companies headed by leaders with technical backgrounds. Even a company like STL, which has such a strong partner/customer as Intel, sometimes needs consultation on tax matters. Another difficulty associated with the required market research and financial planning arises when orders come on an irregular basis, even if a company has a strong partner. One characteristic example is a project involving the development of equipment for servicing facilities using sulfur hexafluoride gas as an isolator. The strong points of the project include the availability of personnel specializing in gas purification and the

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Page 66 fact that the customer is the rather well-known firm Unified Energy Systems of Russia. Because of the irregularity of the orders received, it is extremely difficult to provide for the constant operation of the production facilities, and therefore, diversification into several other commercial product lines is required. That is why the company is currently seeking opportunities for working with gas mixtures for other client companies. Poor access to funding sources is one serious obstacle to successful business development. In the project dealing with road-laying machinery, which requires rather long-term funding due to specification processes and the related major testing program, there are a number of difficulties that are substantially slowing the pace of development efforts. An analysis of many projects performed by the Economic Department of VNIIEF-Conversion, both within the incubator structure and on other projects, revealed that business planning mistakes connected with insufficient estimates of required funding (investment resources) manifest themselves only during the project implementation stage. Typically, mistakes involve incorrect estimations of operating capital required for marketing and product certification. In other words, such mistakes are made with regard to operating capital projections; to be more precise, usually the money turnover time is estimated incorrectly. We have encountered some projects in which operating capital was not taken into account at all. Sometimes, accounting for this factor during the course of the analysis leads to a situation in which a project may reach a point of no return on investment. Operating capital borrowed at bank interest rates leads to a negative differential in the financial lever. In a substantial number of projects, the amounts required for operating capital are even greater than those needed for equipment purchases and other capital expenses. If no help is available in the form of cheap supplemental loans, such a project may die quickly. As for the projects connected with the incubator, such a situation occurred at the Imperial company. Basically, not accounting for money required for product certification and marketing substantially transforms the project implementation process. The Titan company is to a significant extent oriented to producing goods for the Western market. The quality of the company's products and the capabilities of its plant meet Western standards. Its products have been exhibited at several trade shows in Western Europe and sales are being made through intermediaries, but the enterprise has no direct market access due to its lack of ISO-9000 quality certification. Not accounting for that factor is forcing the firm to seek additional funding in the amount of approximately 5 million rubles. Insufficient knowledge of the target market in which the enterprise must sell its products is characteristic of practically all the new companies to a greater or lesser degree. As a result, the initial assortment of products and their prices very often differ from those stated in the business plan.

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Page 67 We view the making of initial sales as the main task of all projects. In fact, such sales make it possible to augment initial practical experience in the market and refine not only tactics but also, at times, even the business development strategy itself. Certainly the concept of business development should take into consideration current trends towards the shorten-ing of product life cycles, which dictates the need to respond quickly to changing conditions. This leads to a situation in which an investment stream is required for the development of new versions of existing products. In a number of cases, profits have been insufficient to support this process or provide for effective support for new products. In particular, perforators for the oil industry are one example of a product that needs to be modernized by improving its consumer properties. The experience gained in developing small innovative companies to serve the Russian market indicates a need for creating truly self-sustain-ing incubators, in order to address regional development needs. To make an innovation project successful, the following elements are necessary: monitoring of company activities, not only to provide a certain control over the honesty of the company director but also to facilitate analysis of the reasons for nonprofitability and to ensure that corrections are made in a timely fashion detailed business planning and independent expert assessment (of a real and not merely formal nature) access to funding sources for new business activity, as such activity involves a high degree of risk. High interest rates make it impossible to develop this sector; therefore, assistance is needed from state and international foundations. assistance to small businesses in developing a culture oriented toward product licensing. To that end, special protective and incentive measures should be developed. Within the scope of their competencies, the Legislative Assembly of the Russian Federation, the Russian government, and local authorities can certainly promote the development of small innovation-oriented business in the market environment. Finally, it is worthwhile to stress two potential ways of stimulating the business development process: 1. From our perspective, tax incentives are needed for innovation-oriented business, as this will help attract private capital to this particular sphere. Primarily, this should cover value-added taxes and profits taxes. 2. State-supported innovation funds targeted to specific industries must be created and supported. This will enable the industry-based science and production sectors to play an active role in the development and practical introduction of innovative products.