Advisory Capital
Stowe Boyd has an interesting post on the idea of advisory capital (as opposed to venture capital).
Stowe observes correctly that many tech startups don't need nearly the amount of startup capital that they used to need to build a business. We all know the reasons for this so I won't get into them. Stowe mentions a few of them in his post anyway.
And Stowe goes on to point out that many VCs won't or can't get involved in companies unless they can invest millions of dollars ($3 million to $5 million are the minimums for many top tier venture firms).
And so he concludes that many tech entrepreneurs will not be able to tap into the venture capital market for the things that VCs bring in addition to money - advice, counsel, oversight, relationships, etc.
Stowe suggests that industry insiders who have the knowledge, relationships, and experience can fill the gap. He suggests that entrepreneurs take the notion of an advisory board one step further and put a few strong advisors in the role of VCs. Put them on the board and give them meaningful stakes in the business (but certainly less than VCs would get) in order to get the advice, counsel, oversight, and relationships that VCs would otherwise provide.
I think Stowe is right that advisors have a growing role in the startup equation for many of the reasons that he articulates. But I think it isn't possible to completely replace the role of the VC for a couple of reasons.
1 - Unless you have capital at risk or some other form of "skin in the game" like sweat equity, you cannot and will not feel the thrill of victory and agony of defeat that binds the VCs and entrepreneurs in startups. Capitalism works for a reason. Greed and fear are powerful forces. I have worked with many "independent directors" over the years. And they are often incredibly good directors who add value in all sorts of ways. But they don't feel it in their gut the way the entrepreneur does. VCs, particualarly the best ones, do feel it in their gut. And so they are there for the entrepreneur when they need it most, joined at the hip with the risk/reward belt.
2 - There is a growing market of angel money that is sophisticated and acts a lot like VCs. There are even "super angels" like Pierre Omidyar, Mark Cuban, and the like who can invest as much or more than most VCs in a deal they like. These angels bring most of what a VC firm can bring to the table if they so choose and can write smaller checks. I'd suggest before entrepreneurs give equity to advisors for no cash, they think about angels instead.
The bottom line for me is that cash at risk is a critical part of the relationship between the entrepreneur and their VCs. It provides the foundation for all the other roles that the VC plays - advice, oversight, connections, etc. Without it you won't get close to what you get with a VC.
February 23, 2006 02:00 PM, By Fred Wilson
Tags: advisors directors vc
Comments (12)
I also think there's a vast underestimation in the Web 2.0 community of how much capital it takes to make a scalable, profitable business, not just a product or a feature. Capital is even more important if you're trying to build an actual mainstream consumer product, not a product targeted at the 500K worldwide digerati. You can blog and buzz your way into the hearts of the digerati, but you're not going to break out.
If you can't get your business to cash flow neutral, including support, scalability and sales, you're playing with fire. If you're not cash flow neutral, you are dealing with potential acquirers from a position of weakness. The longer they wait, the weaker your position will get.
Posted by ELS , February 23, 2006 02:59 PM
Structured correctly, the advisor can have enough skin in the game to make it worthwhile:
1. Define the role upfront, but not necessarily the entire compensation package- create upside for the advisor. This includes a required time commitment and performance reviews.
2. Don't put the advisor on the board- ultimately this role is to be an asset and a resource for management, not a representative of the shareholders nor any group of shareholders.
3. Find an advisory capitalist that only does this and only works with a small number of companies and only works in this manner- that puts cash at risk.
It's also a mistake to be an advisor capitalist on the board as an independent director
Posted by Charles Smith , February 23, 2006 04:45 PM
Agreed. Having skin in the game is very important in the entrepreneur/VC relationship. Without the investment of money from VCs the relationship probably changes and this change may not be in the best interest of the entrepreneur. If changes in the VC model do need to be made, I would not recommend taking out the capital portion of the relationship.
Posted by Eric Olson , February 23, 2006 04:56 PM
I agree, it's all about risk/reward. If an advisor or consultant is not taking a significant risk then their expectation of upside should be limited. I feel that people overvalue their ideas and concepts, and forget that executing is typically the really hard part.
Posted by Neil Jensen , February 23, 2006 06:45 PM
I think the venture capital industry can be horizontally delaminated just like any other industry. I agree that angels are an alternative to VCs for small investments but don't think that companies which don't need cash should raise it prematurely just because they need advice and connections.
In other words, think Stowe is on to something. Posted on it here: http://blog.tomevslin.com/2006/02/disrupting_the_.html
Posted by Tom Evslin , February 23, 2006 07:00 PM
In regards to Charles Smith's comment, there is a real danger in assigning structure to a relationship with and advisor being paid in equity because if the performance goals that are tied to equity bonuses can be related to a monetary value in anyway, the bonus will constitute a pricing event, which can have all kinds or nasty tax consequences.
Generally speaking I think the Advisor Capitalist camp underestimates how difficult it is to find someone who is talented, motivated and passionate enough about a company they didn't co-found to forgo salary. There just arn't enough independently wealthy people who can fill these roles. So the Advisor Capital model can work well for some, but it doesn't really have the legs to threaten the venture model.
Posted by Andrew Fife , February 24, 2006 05:45 AM
Not that I know what I am talking about but the adviser capital idea is the wrong competitive strategy for nascent fund managers and bad for venture capital in general. Advice is important, but producers are not in the business of telling directors how to shoot movies.
The fact that vcs compete on the basis of value add is testament to how immature the vc market is and how far it has to go to become less of an anomaly in the global financial system.
Financiers competing on anything less than WACC operate in a less than fully developed, efficient market, and the best way forward for nascent managers is to avoid getting sucked into the "we offer value add" trap (set by top tiers) and concentrate on manufacturing financing packages offered at competitive risk adjusted cost of capital.
Not that historical term sheet data should be public information, but anything less quantitattive is not a sustainable measure for developing any financing market, least of all venture capital.
So......as a founder, I care about: a) how much me and my shareholders pay for vc money b) how my personal net worth is diversified and c) how much value add I get from someone on 12 other boards.
Posted by Daniel Nerezov , February 24, 2006 10:17 AM
I don't think the AC model is strong enough, and there's a more important risk in this issue than is not being addressed.
The more important risk is that the deal flow going into a VC office will be segmented. The best deals with experienced entrepreneurs will start to be missing because the amount of capital needed has lowered while the availability of personal funds has risen. Worst of all 1; VC businesses will be stuck trying to identify an event that didn't happen, which is really hard to do. Worst of all 2; this could have a highly leveraged effect in taking out the top deal in a portfolio could make the returns drop a whopping amount. Control is an issue too and in the AC model it's not really mitigated.
If capital isn't the issue in getting involved with best deals, perhaps a more proactive model would suit VC money better. Perhaps the VC's should look at being more proactive and instead of saying, 'I'd like a deal in X space', create that deal, hire managers, let them office in your space, and hire more Associates to watch the company. Sounds like iDealabs to me.
A third non-exclusive option would be just for the VC's to hire the AC's to create the time required to manage a larger portfolio of businesses.
Posted by Lloyd Fassett , February 24, 2006 02:02 PM
this is a nice post but reading it I felt you did not engage with the original Boyd argument that the VC model is somehow inherently unable to accommodate a VC that also provides 'value added' advice across a range of financial/legal/marketing issues.
Rather, you make the case that the VC remains vital for other reasons.
Do you think that the VC can, in fact, alter its operations so as to provide either inhouse or outsourced 'incubator-style' value added?
Posted by Daniel , February 24, 2006 04:11 PM
There are individuals that add significantly to the value of a business. Some of the individuals invent the business, founders. Some work for the business full time, employees. Some add money, venture capitalists. Some people catalyze the relationships that make a business, but these people are typically not rewarded. For example, introducing a new entrepreneur to a VC; introducing a new business to a media company at a level that gets a deal done; recasting a pitch to suit an audience.
The VC typically assumes that he/she will provide the catalyst functions that separate a good business from a great business. But my experience shows me that there is another class of individual that steps in and makes some businesses, and that class of individual is not frequently rewarded. In fact, the "skin in the game" has little to do with it.
Posted by stephen ackroyd , March 21, 2006 10:15 PM
Venture Capital needed for a Top Projekt in Berlin. Everything is ready but the Venture Capital.
Posted by Michael Stockbauer , July 3, 2006 10:47 AM
Agreed...and there is another solution -- I have found many (though certainly not all) VC and Private Equity guys ready willing and able to make Angel investments. You get the best of both worlds -- cash, top-tier advice, introductions and a smooth path to the next set of needed capital.
Posted by Alan Warms , February 23, 2006 02:25 PM