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November 5, 2013

I was chatting with Nick Chirls from Betaworks recently and we talked a bit about Angelist syndicates and the incentives surrounding it. Betaworks was one of the first investors to use Syndicates on the platform in their investment with Estimote (a really cool company, BTW).

Nick reminded of an interesting perverse incentive that syndicates creates. Note, this IN NO WAY drove Betaworks’ decisions in this case, but he just pointed out that these incentive will exist almost by definition of how syndicates works. Essentially, Angelist syndicates creates an incentive to:

  1. Invest a little less
  2. Be less price sensitive
  3. Have a lower bar

Why? The answer is a) “free” leverage on one’s dollars and b) deal-by-deal carry.

On a), this drives the price sensitivity. As an investor, you are essentially now able to get more of an economic interest in a company than before on the same dollars. Thus, you are on balance more tolerant of risk (thus lower bar) and can get the same financial outcome even if you invest at a slightly higher price (thus less price sensitive). Or, another approach is to say that you can now get the same economic interest with a smaller investment (this, invest less).

The other (and to me, the bigger) issue here is the incentive around deal by deal carry. In early stage investing, deal-by-deal carry is awesome for the person doing the investing (the VC or the angel), and is pretty bad for that person’s investors. Almost no early stage funds have deal-by-deal carry. The reason is that the riskiness of early stage investing means that one has to build a portfolio of investments to be successful. Our profits in this portfolio of investments drive our carry in the fund.

But obviously, a VC or angel should be required to return their investors’ capital first before really earning that carry on the profit. However, this is not the case with deal by deal carry. You can lose money overall, but earn a nice chunk of carry along the way.

Simple example: Let’s say I’m a $10M fund. I invest in 10 companies at $1M each. If 9 completely fail and 1 makes a 9X return, I have returned $9M of the $10M. I earn no carry.

Now let’s say I’m an angelist syndicator. Let’s say I make a small investments in 10 companies, but attract $1M in syndicate capital for each of those companies. So, it’s like a $10M fund. If 9 fail and 1 makes 9X, I am able to get a carry on that 1 9X return. So, if I charge a 20% carry, I make 20% x $8M, which is $1.6M (of which Angelist takes a cut). That’s pretty awesome when my overall performance was actually a loss of capital.

Of course, because each syndicate has different investors, there is no way to force me to pay back my overall principal before taking carry. But the incentives in this situation is for me to be more risk loving overall. And if I can get really good leverage on my dollars, I could basically write pretty small checks into a lot of companies, but bank on the beautiful benefits of deal by deal carry to save the day for me.

This should come to roost at some point, because over time, syndicate members will stop following an angel who loses money on average. But this won’t happen very quickly as long as I catch a hot deal now and then. Even if I lost money along the way, but got a 20X on one investment, I think that one 20X would be enough to attract more capital behind me for a few years. Obviously, not all actors on angelist are going to do unnatural things because of these dynamics (the best definitely won’t). But these incentives definitely exist and aren’t great for a “follower” on angelist, or for any investor in any early-stage fund that gets deal-by-deal carry.

I think Nick is going to have some specific thoughts and reactions to this, so I look forward to continuing the discussion!

  • nchirls

    Rob makes some very important points here. That said, as we’ve made clear through our words and actions, we think the potential benefits of crowdfunding / syndication greatly outweigh some of the potential issues with it. It’s also important to note that the entire concept of syndication is still very much in beta and much of these issues I believe will be worked out over time.

    It should also be made clear that syndication incentives are no more perverse than the traditional VC industry.

    Here are just a few that come to mind:
    – Most traditional VCs invest very little amounts of their own capital. The large majority of it comes from LPs. In Syndicates, the lead angels are committing large amounts of their own $, often 50% or more of the overall syndicate. The same is true for betaworks as lead angel.
    – Most traditional VCs provide absolutely no returns for their LPs and instead make $ from management fees (often 2% / year). This is as bizarre an incentive I’ve seen. Syndicates charge absolutely no fees at all.
    – There is little to no transparency re: performance and returns in the traditional VC industry. Syndicates are more often than not publicly crowdsourced deals. This means each deal serves as a public notice for performance. I’m not exactly sure how to measure the “bar,” but with more transparency, I can tell you our bar feels higher two syndicated deals in.

    So those are just a few of the bizarre incentives of traditional VC. There are countless more. Syndication too has some perverse incentives, and as Rob correctly points out, it would be unwise to ignore them. Deal-by-deal carry in particular would seem ripe for abuse. For those that take syndication seriously, they would be well served to manage these incentives with care and play the long-game. For us, that means sticking to the same investment strategy with the same risk profile that we’ve used to provide 6x returns on our invested capital since betaworks was founded 5 yrs ago.

    Syndication is an incredible new tool, it will allow angel investors to potentially manage much larger pools of capital than they ever have before. And with this new power, comes great responsibility.

    • http://www.aweissman.com aweissman

      You make three points. The third (transparency) I generally agree with though there is more than used to be as a result of LPs that publish their returns,

      Your first – “Most traditional VCs invest very little amounts of their own capital” I’m not sure it accurate in all instances. A $500M fund where a GP contributes 2% is $10M of their own money. That’s material.

      Your second – that VCs “instead make $ from management fees” – well that depends on the size of the fund, but I am not sure as a general statement.

      • nchirls

        Indeed I might have been mildly hyperbolic with some of the language (as I tend to be). It is my understanding that many (maybe most?) venture funds provide little to no returns over time, underperform the S&P, and yet partners are making significant amount of $ on fees. That doesn’t feel right.

        My main point is that there are perverse incentives with every form of money management, especially when the money you’re managing is not your own. This is true for pension funds as much as it is for hedge funds as much as it is for traditional VCs and syndicators.

        What’s important, in my opinion, is being aware of these incentives and managing them appropriately if you’re interested in creating a long-term successful business and brand.

        Make sense?

        • http://www.aweissman.com aweissman

          I appreciate hyperbole!

          And understanding the incentives in any transaction are really important

          thanks for writing that

      • robchogo

        Yep, I agree with that. As someone who manages a pretty modest sized fund with a pretty big GP commit (5%+) I think we (and a number of other funds) are more closely aligned than some others.

  • http://www.startupboy.com naval

    Thanks for writing this, Rob. We’ve thought this through and here’s the best we’ve come up with:

    • Free leverage: Yes, but far less than VCs have. The average Syndicate Lead is putting in 10% of the Syndicated amount, or more. Compare to 1%-2% in VC Funds. In many cases, even this 1%-2% Capital Contribution from the VCs is in the form of deferred Management Fees, not a true cash investment.

    • Deal-by-Deal Carry: Yes, it’s more lucrative, but that’s why the average Syndicate Lead is charging a 15% carry instead of the 25% common with Seed Funds. We educate them heavily on this point. Under reasonable assumptions, a 15% Deal-by-Deal Carry is around a 20% – 22% Fund Carry.

    Now, compare to backing traditional venture. Syndicate Backers:
    • Pay zero management fees. Traditional Venture is 2% per year for 10 years! VCs can get paid even if the fund overall loses money.
    • Can hire or fire Syndicate Leads with one-click. Traditional Venture is 10-year lockups.
    • Know that the Leader has Skin in the Game (10% capital at risk)
    • Can back individuals instead of entire firms – assemble their dream team Partner by Partner
    • Can see each deal as it’s being done and drop out
    • See forced disclosure of conflicts of interest that the Lead may have (not true in Venture, which is very opaque).

    You’re also going to see a big push from us to put more detailed Track Records and Rules of Engagement online.

    • robchogo

      Thanks for the through response Naval.

      Actually, as I think of it more, the most compelling argument here for deal by deal carry is that you can get deal by deal participation too. So it’s not a blind pool as you point out, and an investor can assemble their own portfolio of managers.

      I guess the onus is on the syndicate investor to take advantage of the full power offered by the platform.

      • http://www.startupboy.com naval

        Exactly – you pay per deal, but you can opt in or opt out on a given deal. It’s the quid pro quo.

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