galatime.com - Kaushik Gala

Note: The views & opinions expressed in these essays are strictly my own, and not those of any entity I may be associated with as an employee, consultant, promoter, investor, etc.

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Which distribution channels will you use?

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Technology Entrepreneurship in India - Raising Capital

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Due diligence - A necessary evil

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› Oct 2011: Equity Risk Premium for India

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› Nov 2010: Technology investment in India - WATER

› Aug 2010: Technology enterprises in India - 3 avatars

 

Risk Capital for MSMEs

› Mar 2010: Risk mitigation for investors in MSMEs

› Mar 2010: Why don't (Indian) MSMEs get risk capital?

› Feb 2010: Angel investing - Will it work for Indian MSMEs?

› Feb 2010: What's so special about innovative MSMEs?

› Feb 2010: Where do Indian/NRI (V)HNIs invest?

› Feb 2010: Funding options for innovative MSMEs in India

› Jan 2010: Innovative MSMEs in India

Angel Investing - Will It Work for Indian MSMEs?

(Last revised 23-Feb-2010, Send comments to galatime@gmail.com)

(Thanks to Right Side Capital for their 'research' links)

In developed countries, a major source of risk capital for startups is angels. An angel investor is an individual that uses his or her own cash to invest in early stage companies. For a primer on angel investing, refer to this note.

To get a sense for how large a role angels play, note that angel funding runs at ~ $25B per year in the US. This is more than the total amount invested by venture capitalists. If you look at number of companies funded, angels bet on 25x+ more startups than VCs. Of course, even this pales in comparison with the funds (savings, friends & family) invested by founders (~ $300B/year).

On average, professional angels in the US make investment returns of 25%-30% per year. There is of course a huge variation, depending on skills, luck, timing, sector, etc. But the averages seem fairly stable for most angels/angel networks, both in US & UK.

Researchers who have studied angel performance (Kauffman, NESTA have come up with key success factors:

  • Importance of due diligence (not too much, not too little)
  • Sticking to familiar sectors/industries
  • Avoiding management control, but expecting regular reports
  • Keeping follow-on rounds to a minimum (aim for early exits)
  • Focus on early-stage, pre-revenue investments
There is also strong evidence in favor of regulation such as tax breaks for angel investors. For a tech/Valley centric view of 'good' angels, see Paul Graham's essay.

The overall market is labeled as 'informal' venture capital. In the US/UK, this market was usually anonymous, fragmented and disorganized. To address this, people tried business introduction services, computerized match-making services, 'pitching' events, newsletters, databases, government funded intermediaries, etc. - usually with limited success.

Research on this market indicates that broking / introduction services that hook up angels with MSMEs work best if:

  • Structured as impartial, trustworthy not-for-profits respected by the local community
  • Narrow geographic focus, with links to local informal networks
  • Subsidized by local/regional government or donors/sponsors
  • Preferably levies a fixed 'registration' fee instead of success fee (~ % of capital)
  • Caters to a broad/large range of angels & MSMEs, with quality control
  • Use of due diligence and lead investors to weed out 'lemons'
  • Well organized & adequately funded marketing program
  • Entrepreneurs pitch directly to investors

Will it work in India?

The flood of (US) VC firms to India has been followed by home-grown angel networks that seek to emulate the success of Silicon Valley angels (eg. Mumbai Angels, Indian Angel Network, etc.). The emphasis is on 'tech' startups for the most part, with investment amounts in the Rs 30 lakh - Rs 3 crore range.

While it is too early to comment on the investment success of Indian angels, note the following:

  • Angel investors in India do not get any tax breaks.
  • The due diligence process and investment agreements tend to be onerous on the founders.
  • Both the deal flows and the angel investment portfolios are tiny; professional angels probably fund < 50 startups per year.
  • Angel/VC backed success stories (seed to IPO) remain elusive. Exits are usually via M&A.
  • Given that angel/VC investing is basically a portfolio game, the average angel investment in an Indian tech startup is bound to lose money, given how few startups any given angel invests in.
  • Social/cultural issues such as lack of trustworthiness, cynicism about founders/promoters, perverse behavior driven by tax/labor laws, etc. worsen the scenario.

Bottom-line: Angel investing in Indian tech startups is likely to have limited success, on average.

If tech startups in India face such hurdles, what are the prospects for innovative MSMEs? Are angel investors even a viable option?

I think that in India, quantity matters as much as quality. Forget cutting-edge technology, patent portfolios, management with branded degrees, etc. Get away from weeks/months of due diligence, business plans, investment agreements as thick as books, LP-funded lunches with VC associates and all that jazz. A large-scale angel investment approach is the only solution to bridge the huge gap in (Rs 20 lakh - 2 crore) risk capital for thousands of MSMEs.

Of course, any large-scale model will involve organizing the angels in a fashion which allows pooling of funds. This starts getting close to the VC model, with angels as LPs.

But - the VC model in the US is largely broken (most VCs had negative returns in 2000-2009) and is likely to end up as a combination of humongous funds (eg. KPCB, Khosla) and a bunch of 'spray & pray' funds (= small amounts, numerous investments).

The recently launched firm Right Side Capital is turning the VC model on its head: fast due diligence & turn-around, minimal management/BoD interference, 100-200 investments/year, seed stage, low transaction costs, etc. Note that with smaller investment amounts, RSCM can tap into angel investors as their LPs, instead of the usual pension funds, endowment funds, etc. [Note: I have no idea who their LPs are, but would love to find out.]

If this is happening in the US (which is blessed with a huge deal flow and exit options), is it any wonder that the traditional VC model doesn't work in India? With Indian VCs investing in 3-5 deals per year on average (I still find this hard to believe, btw), how the heck are they going to make 40%+ p.a. for their LPs? Hence their transmogrification to PE investors / mutual fund managers.

It is obvious that what India needs is an adapted version of the Right Side Capital model, which accounts for:

  • Poor deal flow of 'tech' startups, but huge deal flow of innovative MSMEs.
  • Investor concerns w.r.t. control, transparency (information asymmetry), exit routes, etc.
  • Promoter concerns w.r.t. interference, investment terms, transaction costs, etc.
  • Lack of (favorable) regulation & tax policies for angel investment.
  • Constraints on 'portfolio management' service providers.
  • Opportunity costs for angel investors (eg. real estate).
  • Low levels of trust, awareness of angel/VC models, etc. amongst MSME founders.
  • Variety of angels (especially w.r.t. source of wealth) with different notions of 'risk'.