In Turkey, entrepreneurs and VCs are still waiting for their big payday

ISTANBUL – Tantalizing investors and innovators at the crossroads between Europe and the Middle East, Turkey has emerged as an entrepreneurial hub. The past five years prove this, with companies churning out billions of dollars worth of e-commerce, gaming, mobile, and software platforms and products.

Deloitte, an auditing, consulting and financial advisory firm, valued Turkish merger and acquisition deals in the e-commerce space at $29 billion in 2010. When VentureBeat reported on the Turkish e-commerce scene last year, we reported that the market accounted for $16.3 billion in revenue for all of 2010. Since then it’s grown even further: Turkish e-commerce market was $19.7 billion for 2011, and through September, it accounts for $17.7 billion this year.

Yet the breakthrough many in Turkey’s entrepreneurship space are waiting for seems distant. Many in the private sector, particularly investors, worry that even though there are many bright and promising Turkish entrepreneurs, there aren’t enough venture capitalists to back them. Indeed, venture capital in Turkey sits on a razor’s edge, with only a handful of funds available for thousands of startups. The next few years will determine whether that edge cuts lucrative returns to solidify Turkey’s place as an innovation hub or whether it bleeds dry, rendering the county an eternal emerging market.

Impatient capital

Last year venture capital godfather Kleiner Perkins, along with Tiger Global, injected a surge of optimism into the Turkish startup scene when it invested a combined 26 million into Trendyol, a Turkish version of Gilt Groupe, an online flash sales site. Other investments by Amazon, eBay, and Intel Capital into several e-commerce sites — online flower and chocolate marketer Ciceksepeti, online auction clone GittiGidiyor, and daily deals namesake Gruponya — has fueled the sentiment that Turkish venture capital has arrived. But as with any venture capital investment that must wait out the possibility of successful exits, only time will tell. Time is exactly what has many worried.

The Turkish economy, which has grown at an average between 5 percent to 7 percent over the past five years, is slowing down. The International Monetary Fund expects the country to grow by 2.3 percent in 2012, a dramatic drop from the 8.5 percent it grew last year. Turks want returns today, which is why e-commerce clones dominate much of the country’s startup scene. Online copycats have a low barrier to entry, have already demonstrated proof of concept, and can be easily “flipped.” Therein lies the danger, as Cem Sertoglu, an Istanbul-based venture capital partner with Earlybird Ventures, points out.

“E-commerce is cheap to start but expensive to keep up because once it gets going it requires a lot of backend operations and logistics. Building a website is easy. Getting the product out is costly,” Sertoglu says. He notes that it takes an average of $25 million to bring an e-commerce company to full scale. That is why, he notes, it is sometimes the “big established retailers” such as Macy’s and Nordstrom that dominate the online market, not the “upstart” flash-sales sites or pure play ventures.

Despite having “a strong payments system,” a sophisticated banking structure, and a credit card penetration rate of 62 percent, Sertoglu is skeptical that many of Turkey’s e-commerce platforms will succeed against eventual entrants who hold strong supply-chain positions. However, noting that “the number of people who have ever completed a commercial transaction online in Turkey is around 5 million, a mere 10 percent of Internet users,” he remains, “overall bullish” on Turkish entrepreneurship and, thereby, Turkish venture capital, noting that even if some e-commerce companies fail, the Turkish tech scene is strong and promising, especially with a highly educated talent pool and reverse brain drain coming back to the country.

Jose Romano, an investor with the European Investment Fund (EIF) and the head of the Istanbul Venture Capital Initiative (IVCI), agrees. He says that e-commerce is not where “the true potential of Turkey lies.” He is more interested in “catalyzing” what he calls the “third generation” of business models that take advantage of technology transfers from universities and that have been “built locally and can expand in the region and globally.”

Uncharted territory

Turkish e-commerce showed its first visible signs of distress in August when the German-based tech “clone factory” that reproduces successful Internet sites in many countries, Rocket Internet, shut down its 400-person operation in Istanbul.

Turkey has seen less obvious indications as well. Skype cofounder Niklas Zennstrom last year made Istanbul the European headquarters for his venture arm, Atomoco. It has not made a single investment in a Turkish enterprise, choosing to act as a base for its existing portfolio companies such as Fab, Rovio, and Wrapp that are interested in launching in Turkey.

While other marquee VCs have shown interest in rolling out a presence in Istanbul, including Accel Partners and Intel Capital, they have not made a lot of active investments here. Back in 2010, a former Silicon Valley hand and major player in Turkish angel investing told me he thought all of this was “tire-kicking.”

“Quite a bit are interested in the (Turkish) Internet business but most of them are afraid of making investments,” this investor told me.

So too are banks who have hesitated to extend capital to small and medium businesses Larger, more established family conglomerates have avoided taking on equity, refusing to yield their corporate governance to outsiders. The result has been stunted Turkish capital markets and deal flow.

Turkish investors and entrepreneurs have no sense of how venture capital investments end. We’ve seen a few exits from angel investments in Turkey, but few of any serious significance.

“We’re seeing the first chunks of wealth made from the Internet,” says Earlybird’s Sertoglu, who himself saw returns from angel investments he made in Yemeksepeti.com. “But no one has made it really rich.”

Despite having a capital markets board that oversees the Istanbul stock market, investment banking and private equity, the lack of laws regulating venture capital and outlining tax incentives for investors in Turkey only fuels investors’ fear.

Nonetheless, venture capital has managed to lay down roots in Anatolia.

Sowing VC seeds

The Turkish government has, for the past decade, extended credits to small business owners and awarded research and development grants for technology projects with the support of the World Bank.

The global financial body helped to establish the independent Turkish Technology Development Foundation (TTGV) in 1991. Though headquartered in the Turkish capital, Ankara, TTGV’s mission has been to support “technological innovation activities in Turkey.” It has provided $300 million to 950, largely R&D projects, carried out by 800 companies. It also contributed to the establishment of investment firms, Is Girisim and Turkven, both of which launched in 2000. Though largely focused on private equity for established companies in need of later stage growth capital, Is Girisim and Turkven have made combined investments over $3.5 billion, in predominately larger buyouts of brick-and-mortar companies. While both are on their third funding rounds, neither has yielded significant returns.

What they have done, however, is create a precedent for others to start funds. In 2000, Access Turkey Capital Group established a venture arm, iLabs. The Istanbul Venture Capital Initiative (IVCI), a EUR 160 million fund of funds launched in 2007.

IVCI director Jose Romano describes it as being a “catalyst to advance the development of the [Turkish VC] industry.” It has inspired a number of largely European and some Turkish investors to set up investment funds. IVCI has not given any money to any venture capital firm.

212 Capital Partners is the latest risk-taker to dive into the Turkish entrepreneurship. Launched this year with a first round fund raised among Turks totaling $30 million, it is eyeing early stage investments in tech startups in e-commerce, gaming, and software applications.

“What we’re trying to do is more entrepreneur-friendly,” says Ali Karabey, a general partner at 212. His idea of entrepreneur friendly is “providing equity where there is no debt” and transforming the Turkish entrepreneurial landscape that, as Karabey describes, is made up of either small firms that rarely scale or large conglomerates that dominate industry verticals. He and partner Numan Numan are trying to mitigate risk and jumpstart deal flow, which is woefully absent in Turkey.

“The risk appetite of investors [in Turkey],” says 212 backer Emre Kurttepeli, “is not one you’d find in Silicon Valley.” In Silicon Valley, he notes, “you have a certain amount of money that gets dispersed into anywhere between 50 to 100 investments and maybe five of them makes a return.” In Turkey, investors are all about collateral and hard numbers. Early stage and seed funding that rely on projected valuations is an uncomfortable concept for these financiers already frustrated with a valuation and due diligence process that depends on weak accounting and auditing practices. It is not uncommon for a Turkish company to keep up to three sets of books.

Projected valuations are tricky and have become a controversial topic in the Turkish startup scene. “The Turkish market has become a bit frothy,” Pamir Gelenbe, an investor with Belgian-based Hummingbird Ventures, recently said in an interview. “Frothy meaning the valuations are starting to creep to unreasonable levels.” He notes that he and his colleagues “find it more difficult to find attractive deals from a valuation stand point.” Another venture capitalist, who asked to stay anonymous, echoed the same point, noting that Turkish entrepreneurs are overvaluing their companies.

Jose Romano chalks this up to the “hype” in the Turkish market. “There have been successful experiences of very strong individuals raising large funds, so many people think this is normal. Just because the economy is doing well and Turkey is in the emerging-country pot, they try to do the same,” he says. Romano is split on the advantages and disadvantages of this. He says it is a disadvantage “because these things take time and many people will be disappointed with the high expectations that have been raised with no results in the short-term.”

“It is an advantage because it brings forward the concept of entrepreneurship, more discussion, more talent, more people coming in from abroad to share experiences, and more money looking for deals,” Romano says.

Going big

Everyone agrees that there is plenty of money in Turkey. The challenge is to couple it with risk. Romano says that one thing that the Turkish VC landscape needs is “strong local limited partners.”

212’s Ali Karabey agrees. “The future of venture capital is on us,” he says and then pausing for a moment. “Big things will develop here. They will be so, so big that we’ll forget about all the problems that we had before starting.”

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