Rise of angels and syndicates — Is venture capital turning into a commodity?

I was sitting with one of my relatives recently, he is at a senior position of one of the world’s largest banking firms. Given the fact that I have worked in the Indian start-up ecosystem for close to 7 years, we do end up discussing what is happening in the sector. However, this time the discussion took a different turn, rather than just discussing about the fringes, he actually told me that he had invested in 3 start-ups at varying stages via a syndicate and he is currently exploring more.

Then I ran into a friend, a senior from school, who works with Amazon. He was in discussions with startups to invest in them along with some of his relatives, who were themselves in senior positions across companies.

Finally, I came across these kinds of posts on social platforms — the coming together of 3 industry veterans who have opened up a small fund to invest across startups and a group of ex-Facebook employees coming together to fund startups.

All this piqued my interest and I decided to take a more thorough look. I go on Google and do a random search on angel investments in India and there you go — Angel investments have gone up 24% to 341 deals in 2020 from the last year!!

Naturally, you tend to wonder what is happening, who are these new angels, why the rush all of a sudden, will these new syndicates add real value and so on…Earlier syndicates were mostly HNIs coming together from one city and they even named their syndicate after the city; Mumbai Angels, Calcutta Angels and so on.

Something else was brewing here now. So I start to dig a little deeper…

Here is what I found….

First, who are these new angels and why the recent rush to this sector?

Well, if you skim through various sources of angel investors and their listings such as this one by Unicon Baba — you will find that most of them belong to two categories:

HNIs from the service sector — These are people at senior levels in the corporate sector

• These high salaried HNIs are sitting on a huge pile of savings and now have enough to take more riskier and bold bets.
• They have seen the evolution of the startup ecosystem and now have developed enough knowledge or sources of knowledge to understand and put their money in the system.
• There might be the case of FOMO amongst this community with the media outlets constantly pumping news of newly minted millionaires and massive funding rounds and stories of people who have made it big.

Former/Current employees of successful startups — These are people who have either earlier cashed out from their startup ventures or cashed out their ESOPs from bigger startups. Mostly they belong to startups like Flipkart, Paytm, Freecharge and the likes, who have made employees millionaires via their stocks. These angels typically invest in startups opened by their former colleagues, wherein they have a better idea about the individuals and teams they are investing in.

• This lot is a part of the ecosystem and the biggest advantage they have is the access to deals, the knowledge of how the ecosystem functions, their network of people within and their domain knowledge.
• They themselves have seen the upside and do want to miss out on the next wave of billion/trillion dollar companies.
• For both the players, it is also about belief in and support for causes — propagating a certain sector, mostly in medical and environmental fields.

Now this raises a very important question, with so many players entering the market with wallets full of cash — ‘Is capital becoming a commodity?’

In a podcast by the Indian Silicon Valley, Karthik Reddy from Blume Ventures agrees partially to this point, wherein he believes that capital has become a commodity but mainly for experienced, well connected and former entrepreneurs. Else, despite the increase in the number of funds and angels, the funnel at the top also continues to increase, thereby increasing the competition for that available capital. Basically, the average increase in availability of capital has been accompanied by an increasing rate of startups demanding venture capital.

But the next question is whether they are adding any kind of value or not to the ecosystem.

Again, Karthik from Blume has a point that the value that you provide as an angel or as any fund lasts only till the next round. Therefore it becomes imperative that you bring some extra value to the table as opposed to just capital.

This is more pronounced at the angel stage. While the amount of money deployed can be substantially huge at later stages, the number of such funds are still limited in comparison, therefore capital in itself acts as great value. At the angel stage though, the number of such angels are much more giving rise to choices for the right entrepreneur.This gives rise to the concept of ‘Smart Capital’,wherein the founder is going to determine what extra you bring to the table.

• Do you bring some kind of domain expertise?
• Are you seen as an expert in your industry for you to become an evangelist for the product/company?
• Are you an industry leader that your investment acts as a signal for bigger funds for later rounds?
• Do you have connections in the industry where sales are supposed to happen?
• Are your networks wide enough for getting the best talent and advice on board?

Therefore, angels need to ensure that for them to get the best deals and maximize the probability of higher returns, they need to provide more than just capital, or let’s say they need to provide ‘smart capital’.

Duality is an inescapable fact of nature, with something good comes something bad. So while the good does come with a rise in angel funding, they do give rise to negative points as well.

Wrong Signalling

To begin with , venture capital represents more of a pyramid structure, you have many angels at the bottom who have the smallest fund size and as you go further up, the number of venture capital firms decrease with an increase in fund size.

Sourcing the right deals to invest in is a major pain point for the venture capital firms at any stage and this problem is more pronounced for the angels. Here, they are mostly betting on the founders and the team. This problem is less pronounced as you go higher up the ladder as the businesses mature and more data points are available to make educated bets.

In this kind of a structure, the angels act as the supply chain and provide a steady deal flow for the firms at the next growth stage. While angel mostly bets on the founders and team, the next stage firms also do not usually have much data to rely on, they also more or less have to do with betting on the founder, team and whatever little promise the business has shown so far.

Here, the possibility does arise that an angel might push for and oversell his investments to the firms at the next stage to maximize his or her probability of returns. I am not implying that the next firm would not be doing their due diligence, but given that the business is still relatively young, the chances of this happening might increase.

Funding of companies which are not suitable for VC capital

Venture capital firms dont aim for 2X or 5X returns, they aim for companies which can give you 100 -1000X returns if not more. Therefore the idea is to look for and invest in companies which have that potential for outsized growth.

However, due to a glut of capital, very often companies which are otherwise profitable but not suitable for the VC model get funded. A very good example of this happened with food outlets in 2015–16. A lot of them got funded with nothing coming out of them. It was only later that the business models evolved to make them more suitable for VC funding such as cloud kitchens or simply ramping up store fronts all across the country.

To end it up, I came across something, which has bewildered me so far. While I read it in the context of cryptocurrency, it might add some value to this article.

Indian SMEs currently lack access to financial capital, which is to the tune of $250–500 billion and closing this gap is essential to India becoming a $5 trillion economy by 2025. There are 2 primary reason for this financing gap:

1. Lack of physical collateral which hinders these SMEs from raising capital from the banks. This problem is enhanced and reinforced by the lack of information regarding these small SMEs thereby increasing the dependence on physical collateral for releasing loans. No physical collateral with the companies and hence no loans for them by the banks. More like a chicken and egg problem.
2. Lack of sufficient capital within the banks to provide capital. Pools of capital are short even if they wanted to disburse loans. Currently only 25% of the loans disbursed are to these SMEs.

Now the first problem is being solved by something known as ‘Information Collateral’. Close to 10 million SMEs are registered on the GST portal and the data collected by this portal with respect to invoices, purchases and so on provides a close to accurate reading of the particular company and the industry in general. Now this information can be used to give out loans instead of dependency on physical collateral.

How does it matter here?

The angels can come together and tap these SMEs for generating returns and their investments can be backed by the informational collateral being generated by GST data collection. While the angels are focussed on billion dollar outcomes and as individual companies, they may be small, but combined together and investing in a portfolio of such companies, you are looking at higher levels of return. Not sure if it is the right analogy, but this sounds something on the likes of Thrasio.

Also, with technology being implemented at a rapid and innovative space across traditional industries, angels might be in for massive returns there too in the long run.

For example, the fast casual Mexican food chain Chipotle has seen the value of their shares grow by 34x since 2006. The increase in value has been brought about by adding a technology layer to their ordering and distribution system. In 2020, their digital business grew 174% year on year and recently they announced that their digital sales account for more than half of their total revenue in a quarter. Also, they have invested in autonomous delivery systems and if that works out, a traditional food chain is automatically transformed into a tech business with valuations and returns on VC lines.

In this scenario, angels can add that extra ‘value’ in terms of introducing and adding tech layers to the traditional businesses whereby both the business and the value of investment grows at increased rates.

Diverting some amount of this capital to SMEs reduces the burden on banks. This automatically reduces the second pain point to a certain level — this is an additional pool of capital which plugs in the financing gap for SMEs.

Ending it with some philosophy

While it is great that HNIs are coming in and adding value, it is imperative for them to understand and play the long term game, wherein not only do they benefit in terms of money, the society too benefits and evolves in the right direction.

Photo by Shane on Unsplash