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!