Russian start-up Zvooq sues internet giant Yandex for $29mn for breach of contract

Russian start-up Zvooq sues internet giant Yandex for $29mn for breach of contract
Russian start-up Zvooq sues internet giant Yandex.
By Ben Aris in Berlin November 22, 2016

Leading music streaming site Zvooq is suing Russian internet behemoth Yandex for $29mn for alleged breach of contract and accuses the New York-listed company of destroying the delicate investment climate in Russia for technology start-ups by exploiting its market power.

Zvooq is part of Dream Industries, founded in 2009, and offers streamed music to subscribers. The company also owns Bookmate.com and a co-working and events venue. It has a combined revenue of some $10mn a year, according to the co-owner of Dream Industries, Dmitry Kostygin.

Zvooq was in talks with Yandex, which was considering becoming a strategic investor. But things went awry after Yandex decided not to go ahead and hired away key Zvooq senior staff members to work for its rival Yandex.Musika service.

Zvooq, which means “sound” in Russian, opened its books to Yandex and introduced its representatives to the management team. It was in talks with other strategic buyers at the same time, but these deals were killed when several key managers walked off to join Yandex.

“Zvooq Ltd announces that it is initiating legal proceedings against Yandex Llc, the Russian search giant. The plaintiff claims compensation for losses of $29mn incurred on basis of breach of Non-Disclosure Agreement (NDA) signed by the Parties in February of this year,” Zvooq said in a statement on November 16.

Zvooq is accusing Yandex of unfair competition. Before opening acquisition talks, the two companies signed the NDA in February 2016 as part of the initiation of the due diligence process after Yandex showed interest in becoming a potential investor in the company.

At the insistence of Zvooq's shareholders, the NDA included a non-solicitation clause that stated Yandex was obliged “not to offer jobs to any of Zvooq’s employees nor to encourage the dismissal of the employees within a six month period of signing [the NDA]”.

However, in the spring of 2016 the Zvooq’s marketing director Varvara Semenikhina joined Yandex in an identical position as marketing director of Yandex.Musika, owned and operated by Yandex, which competes directly with Zvooq. Zvooq’s chief technology officer Konstantin Ryabinin was also hired by Yandex a few months later in July and is now Yandex’s search projects manager.

“Varvara was a key employee of Zvooq. She joined the team in July 2014 as traffic manager and grew to position of CMO [chief marketing officer],” Victor Frumkin, Zvooq’s co-founder and CFO, told bne IntelliNews. “She was intimately involved in development and implementation of all newly conceived and as yet unrealized business methodologies – including marketing methodologies for app promotion across different user acquisition channels, mechanics developed exclusively in-house for conversion of free users into paid subscribers, and all details of agreements with distribution channel partners and customers.”

Russia’s Spotify

Zvooq was Russia’s first legal-only and mobile-first music streaming service, with a catalogue of over 25mn tracks. Similar to Spotify, users can listen for free without restriction to any music, including new items and daily personal recommendations, while fee-paying premium subscribers can download music high quality to their devices for subsequent offline listening, ad-free.

Zvooq worries that Yandex will gain an unfair competitive advantage by gaining access to all of its plans and relationships going forward. “Upon Varvara’s arriving in Yandex.Music, all related know-how and methodologies were apparently immediately implemented to the benefit of Yandex.Music and resulted in markedly improved performance to Yandex.Music,” Frumkin claimed.

Zvooq immediately noticed a decline in traffic as Yandex.Muskia rolled out a number of changes that are in many cases identical to featuresthat  Zvooq already sported, right down to identical messaging in adverts: in September 2015 Zvooq had an ad that read “Music for behind the steering wheel”, while an identical strap line appeared on Yandex after Zvooq’s marketing manager started working at the company in the middle of 2016. Several other distinctive Zvooq design features started to appear on the Yandex music site at the same time.

Yandex spokesperson Asya Melkumova told Russian daily Vedomosti: “We have received notification of the [Zvooq] law suit and are extremely surprised by this lawsuit.” She went on to deny any wrongdoing or breach of agreements, and promised to refute the accusations in court. In a comment, emailed to bne IntelliNews on November 24, Melkumova cites Semenihina saying: "You can quote me on that - there was no solicitation. Zvooq and I agreed that I would leave long before I sent my CV to Yandex."

Zvooq has filed a complaint with the District Court of Limassol, Cyprus in what will be the first of its kind lawsuit, if it goes ahead. Cyprus, as stipulated in the NDA, which deals with these sorts of claims and disputes under English law, was the chosen jurisdiction.

 

Deal breaker

The claim is for $29mn, as that is the amount of equity value that Zvooq believes it has lost from Yandex’s hiring away key staff at a crucial time. Zvooq was not only talking to Yandex about it becoming a strategic investor, but several other companies at the same time.

Yandex is huge. It is not only the largest internet company in Russia by a long chalk, it is the largest and most valuable internet company in all of the European continent. Yandex floated on Nasdaq in May 2011, raising $1.3bn to give it a market capitalisation of $11.2bn. Its nearest rival is Mail.ru which IPO’d on the London Stock Exchange (LSE) a year earlier with a market capitalisation a tenth of the size. Yandex’s stock price has suffered since then due to the current economic and political brouhaha, with its market capitalisation falling to $5.9bn as of November 21.

Russian tech companies are hot and telecommunications, media and technology (TMT) remains one of the few really vibrant parts of the Russian economy. The IPOs of Yandex and Mail.ru have piqued the interest of international tech investors, who hope to find another Yandex, which made its early investors and owners a fortune at the IPO in 2011. But there is a lack of trained talent in Russia, making the smaller companies that raise their heads above the parapet run the danger of having their best people poached. In 2012, several of the leading companies in the sector, including Yandex, software engineering company EPAM and anti-virus legend Kaspersky Labs, entered into a gentlemen’s agreement not to pinch staff from each other, but the agreement was not legally binding.

Zvooq was in the active stage of negotiations with various interested strategic parties on a potential transaction and it was actively negotiating via a process run by M&A advisors LDA Jupiter out of London and Alfa Bank in Moscow. “As consequence of Yandex's breach and subsequently inflicted significant material damage to the company, Zvooq did not conclude any transactions at that time,” the company said in its statement.

Tech climate killer

The Kremlin is keen to capitalise on one of the few really valuable resources it has other than oil: its human capital. President Vladimir Putin personally kicked off the drive to make the most of a scientific and engineering legacy that put the first man into space, with a string of initiatives such as the state Rusnano holding company, which supports and promotes investments into hi-tech with some $3bn under management.

However, apart from Yandex there are few other large hi-tech companies in the Russian market, but a lot of small start-ups. Because the gap between the top and bottom of the market is so wide, start-ups have very few options for an exit or subsequent rounds of funding. While the tech giants in the US compete for the best and most innovative start-ups, often paying billions of dollars for two-year old companies that catch their eye and sometimes acquiring a company a week, in Russia start-ups have less than a handful of options for raising money.

A few oligarchs have invested in start-ups, but these are usually on the basis of individual decisions made by high-net-worths, or “angels” as they are known in the trade. Russian tech development also suffers from the absence of venture capital funds specialising in tech start-ups.

The upshot is that instead of paying tens of millions to buy up exciting start-ups that have managed to establish a business and have several million users or more, the big players simply come in and hire away the key staff members, buying the know-how and relationships in the process, for a fraction of the cost.

“Yandex’s breach of contract with Zvooq continues to exemplify unfair competition and bad business practices of the Russian search giant,” said Frumkin. “We initiated the lawsuit because we believe that unfair competition and bad business practices affects the entire online industry in a negative way, and its a fragile one in Russia in these times. A free and open market works effectively only when basic rules of fair competition are complied with by key players… If basic rules of corporate conduct and market principles are not upheld, if commitments of signed agreements are not observed, only companies with close political ties and moral absenteeism will remain alive in markets like Russia. Yandex's actions are unacceptable, and should not be left unpunished, because they illustrate to the world that Russia is a country with a yet immature business culture with high risks for investors.”

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