Improving Ukrainian SMEs’ Access to Venture Capital: Implementing EU Regulations
Summary
This policy brief emphasizes the urgent need for Ukraine to reform its legislative framework for venture investments to support the development of small and medium-sized enterprises (SMEs) and innovation. Despite the existence of a legislative framework for collective investment institutions in Ukraine, it is deemed insufficient for fostering SME growth and innovation, as highlighted by international assessments like the OECD SME Policy Index. The brief suggests that Ukraine’s venture investment market, functioning within its legislation, requires thorough evaluation to assess its effectiveness.
Recommendations include intensifying legislative changes to align with EU Regulation 345/2013 on European venture capital funds, focusing collective financing institutions on SME and innovative business development, and ensuring comprehensive implementation of EU legislation related to collective investment institutions. The brief also advises limiting tax incentives to venture funds that invest specifically in SMEs and innovative businesses, ensuring a targeted approach to fostering economic growth and innovation. This approach is seen as crucial for enhancing the accessibility of non-banking financing for SMEs and improving the overall innovation landscape in Ukraine.
Introduction
The development of entrepreneurship and industrial policy is key for the economic resilience and reconstruction of a country. However, Ukraine still demonstrates a modest level of readiness in this area for EU accession, and the pace of progress remains limited. Thus, the question arises of how to activate reforms and mobilize resources for the country’s survival and development. One such measure is the legislative regulation of venture investments to support Ukrainian small and medium-sized enterprises (SMEs). Specifically, this refers to the implementation of EU Regulation 345/2013, which concerns venture capital investment in SMEs.
The issue of access to financing traditionally remains one of the main challenges for SMEs in Ukraine. Before the war, raising financial resources was a serious problem for more than half (57.4%) of Ukrainian entrepreneurs (according to the results of the USAID Municipal Competitiveness Index – 2021 research[1]). Ukrainian businesses typically rely on their own funds, borrowed money from acquaintances, friends, or relatives, and only partially on bank loans. Meanwhile, there remains a gap in legislation regarding the activities of venture funds in Ukraine, which could be an additional source of financing for innovative SMEs.
According to a UNECE assessment, Ukraine remains one of the European countries with a weak system of support for innovative activities. In particular, the country has limited access to financial resources for the development of innovative activities. Existing venture funds predominantly invest in startups in the information technology sector, but there is insufficient investment in research and development[2]. According to the OECD SME Policy Index assessment, in 2020, Ukraine received one of the lowest scores among the Eastern Partnership countries in the “venture capital” dimension, scoring only 1.66 points compared to the average score of 2.26 for the entire region.[3]
How are venture investments regulated in the EU?
EU Regulation 345/2013[4] of 17 April 2013 (also known as the EuVECA Regulation) was adopted to simplify access to venture capital in all EU member states. A pan-European instrument like this was expected to unify and simplify the work of venture funds, which remained dependent on the legislation of individual member states. Previously, the provisions of the relevant national legislation on financing institutions were regulated solely by Directive 2011/61/EU of June 8, 2011, regarding managers of alternative investment funds (Alternative Investment Fund Managers Directive or AIFMD[5]). It should be noted that the relevant directive was adopted in response to the global economic crisis of 2008, after which the G20 countries made efforts to increase the transparency of the financial system. Accordingly, the new regulations imposed higher requirements on the management of such funds. The EuVECA Regulation complemented the legislative framework.
The EuVECA Regulation concerns managers (legal entities that manage the fund) of small venture funds that meet several criteria[6]:
- Assets under management must not exceed 500 million euros,
- Managers must be established in the EU,
- Managers are subject to registration in their home country according to Directive 2011/61/EU,
- They manage “qualified venture capital funds” (by definition, this is a joint financing institution, 70% of whose capital falls on “qualifying investments”).
In the portfolio of “qualifying investments,” primarily small and medium-sized public companies from SME Growth Markets (at least 50% of issuers in the market are small or medium-sized enterprises) can be included, as well as private companies with fewer than 500 employees (excluding funds, credit institutions, investment firms, insurance companies, financial holding companies, etc.[7])
After 2013, the European Commission made amendments to the EuVECA Regulation, in particular, expanding the range of “qualifying investments” and managing companies. These changes were made considering the feedback from stakeholders and the low effectiveness of the regulation. In September 2015, it was reported that only 34 funds were registered in EU member states according to EuVECA. However, after the amendments, the number of registered funds increased to more than 400 units by the end of 2021[8]. Thus, today Ukraine has the opportunity to implement a regulation that has already been modified/improved after a decade of trials and errors among EU countries.
It is important to emphasize that the EuVECA Regulation is one of the initiatives aimed at creating a single EU Capital Markets Union (CMU). At the same time, the common capital market should improve SMEs’ access to non-bank financing. The text of the EuVECA Regulation itself identifies strengthening the growth and innovation of SMEs as the purpose of its adoption. Such a goal also corresponds to the needs of Ukraine, whose business lacks financing and innovation. Therefore, legislative regulation of venture investments in Ukraine may increase the interest of European funds in the country.
It should be considered that EU legislation consists of a broader framework of legislative acts that covers both all collective investment institutions in general and alternative institutions (venture funds), social entrepreneurship funds, etc.
What legislation exists in Ukraine?
De jure, a legislative framework for the operation of collective investment institutions has long been functioning in Ukraine. The relevant law is the Law of Ukraine “On Collective Investment Institutions” №5080-VI, adopted on July 5, 2012. The law has received minor amendments several times, but overall it still does not meet the needs of developing small and medium-sized enterprises and innovative activities, as pointed out by experts and international partners.
Among the shortcomings of the law on collective investment institutions, we see problems with the breadth of its application and terminological base. Unlike the EU, where issues of collective investment institutions are regulated by a number of regulations and directives, the Ukrainian law sets only general legislative frameworks. However, it is important to consider that the relevant legislative framework is also relatively new for EU countries, as it was introduced about a decade ago. This could serve as a certain justification for why Ukraine has not yet taken the necessary steps in this area.
In Ukrainian legislation, there is also practically no adequate legal definition of “venture fund” and “venture capital” that meets the needs of supporting innovative SMEs. Unlike the EU, there are no simplified requirements for small funds working with small and medium-sized businesses. In addition, there are no similar requirements for “qualifying investments” that would compel investment specifically in certain sectors of the manufacturing and high-tech business. Instead, Ukrainian legislation (the Tax Code) offers tax benefits (including a profit tax exemption) for collective investment institutions, which creates a field for tax abuses, but does not have a stimulating effect on the development of entrepreneurship and innovation.
The state of venture investments in Ukraine
Available statistics collected by private companies[9] indicated a gradual increase in the volume of venture investments in Ukraine. In 2021, venture investments in Ukraine amounted to $832 million, a record increase of more than 45% compared to 2020. However, in 2022, the volume of investments in Ukraine decreased by 74%. On one hand, the situation with investments was negatively affected by the full-scale invasion of Russia, and on the other hand – by the reduction in the volumes of venture financing worldwide[10]. Due to the modest volumes of total investments, the main part of the investments usually falls on a few Ukrainian companies. In particular, in 2022, 4 companies received 62% of the total funding. Therefore, Ukraine needs growth in the venture investment market.
Traditionally, the main investments are directed to companies developing software and online services, but there is a lack of attention to technological manufacturing, which will be important for the country’s recovery and renewal. According to UNECE’s assessment, Ukraine remains one of the European countries with a weak system of support for innovative activities. In particular, the country has limited access to financial resources for the development of innovative activities. Existing venture funds predominantly invest in startups in the information technology sector, but there is insufficient investment in research and development[11].
It is difficult to talk about the role of Ukrainian legislation, as companies are mostly registered abroad and operate in the legal framework of foreign countries. Available statistics reflect the development of companies of Ukrainian origin, but often only A small proportion of their employees work in Ukraine, and their headquarters are located abroad. In view of this, the growth of venture capital investments in Ukraine has been occurring not due to, but despite, the Ukrainian legal framework, as the influence of global markets is greater.
It’s difficult to speak about the role of Ukrainian legislation, as companies are predominantly registered abroad and operate within the legislative field of foreign countries. The available statistics reflect the development of companies of Ukrainian origin, but often only a small part of their employees works in Ukraine, and the main offices are located abroad. Given this, the growth of venture investments in Ukraine occurred not thanks to, but despite the Ukrainian legislative field, as the influence of global markets is greater.
In 2014, the Ukrainian Venture Capital and Private Equity Association was created, which, according to the latest data, included 50 participants with a total investment volume of $1.5 billion. However, only about half of the participants are actually representatives of funds, while the others represent consulting and legal companies, innovation support infrastructure, international organizations, and financial institutions, etc[12]. However, European funds and organizations constitute only a tenth of the association’s members, while American ones make up more than half. Perhaps legislative changes could activate the activity of European funds in Ukraine.
What is Ukraine already doing?
In July 2019, the Cabinet of Ministers approved the Strategy for the Development of the Innovation Activity Sphere up to 2030[13]. Among the problems identified in the Strategy for the functioning of the innovation environment, we also see “insufficient development of venture financing in Ukraine and problems with legal protection of foreign investors’ property.” Accordingly, the strategy envisaged that it is necessary to:
- Stimulate the activity of the venture business.
- Simplify the participation in a venture fund of an individual investor by reducing the amount of funds necessary to purchase securities of such a fund.
- Work on the issue of introducing English and/or American jurisdiction in Ukraine to resolve corporate issues in courts for startups and venture investors (positive examples of the existence of such jurisdictions exist in the UAE and Kazakhstan);[14]
Despite the declared tasks, the corresponding measures were not included in the action plan for the implementation of the Strategy for the Development of the Innovation Activity Sphere for 2021 – 2023 (adopted in December 2021).[15].
In March 2021, the government approved the National Economic Strategy up to 2030 (NES 2030), which defines strategic goals for the development of the Ukrainian economy. Until the start of the war, this document could give a general idea of the government’s priorities for the development of the economy, in particular entrepreneurship and industry. The authors of the strategy included the growth of venture financing in the NES 2030 target indicators (for the strategic goal “Stimulating the development of innovations”). An increase in funding for Ukrainian startups from $510 million to $5 billion was expected. This is one of the few clearly defined numerical indicators of the strategy’s implementation. The goal was ambitious, but the document does not contain an action plan with defined deadlines and funding, and therefore there are no specific measures regarding venture investments in Ukraine.
The development of collective financing institutions was included in the Strategy for the Development of the Financial Sector of Ukraine until 2025. One of the indicators of the strategy’s implementation is to raise Ukraine’s position in the IGC World Economic Forum rating for the component “Availability of venture capital” to the top-60 (it was the 80th position in 2019). However, due to the full-scale war, a new Strategy for the Development of the Financial Sector[16] was approved. The new document includes the measure “expanding the use of alternative mechanisms for attracting public funds for venture investing and financing” within the development of capital market infrastructure[17]. The National Securities and Stock Market Commission (NSSMC) is responsible for the implementation of the measure.[18].
The tasks of the new Strategy for the Development of the Financial Sector involve classifying the relevance of individual measures according to two focuses – “focus of resistance” (short-term measures to ensure stability and prevent the deterioration of the situation in the financial sector and economy) and “focus of recovery” (medium-term measures to start transformations for future reconstruction and economic growth). However, the development of venture investing is an example of measures that combine the two focuses. Thus, improving SMEs’ access to venture capital (as well as to other alternative sources of financing) is an important step for supporting the economy’s resilience and for improving recovery prospects.
What are the recommendations?
Given the experience of EU countries and the current state of collective financing institutions in Ukraine, it is recommended to:
- Intensify the implementation of legislative changes that implement EU Regulation 345/2013 on European venture capital funds.
- Focus the activities of collective financing institutions in Ukraine on the development of SMEs and innovative businesses through the implementation of EU Regulation 345/2013.
- Conduct an evaluation of the functioning of tax incentives for collective financing institutions and monitor their effectiveness in the context of stimulating venture financing.