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February 23, 2006

Disrupting the Venture Capital Industry – Advisor Capitalists

Everyone knows that many businesses can be started with much less capital than used to be required – especially Internet services businesses.  Hosting is cheap; hardware is cheap; blog hosting is free (in some cases); much software is free yadyadayada..  Less money needed for startups means that more businesses can get by without VC money.  In fact, VC money typically isn’t available if you need less than a million dollars.  But, Stowe Boyd asks in an excellent post, what happens if you still need all the other stuff that VCs bring like advice and connections even if you don’t need their money?

Stowe’s answer is that you need Advisory Capital – everything that VCs do minus the money.  He calls it “capital” because he means you to treat it that way.  “Like venture capital, advisory capital is about the investment of a critical resource into a startup. It's not money, however, but the experience, expertise, social capital, and public authority that advisory capitalists invest,” he says.

You would pay your Advisor Capitalist (AC) in equity the way that VCs are paid for their investment although presumably in less equity.  The AC would promise not to take other advisory gigs or presumably consulting contracts which would be in conflict with his or relationship with your company.  It’s a long term arrangement in which the AC earns sweat equity.

Stowe recognizes that many firms have “advisory boards” which are supposed to fulfill at least some of these functions.  But he dismisses them saying: “Advisory boards in principle are a way to involve well-known authorities or business celebrities into the mix of the business, but in practice they have become a PR exercise with flabby results, in general. The minimal levels of involvement -- an occasional call, an annual dinner -- do not lead to great results, because there is not a deep enough investment being made.”

I think I agree with that; I never formed an advisory board for any of my companies although that may have been my mistake.  When I have been asked to be on an advisory board, I’ve usually found that the asking company was more interested in my name than my advice.  Hurt my feelings so I’ve never done it. On the other hand, Bernard Moon has had some success with advisory boards and blogs some good advice on setting them up here.

Venture capitalist Fred Wilson doesn’t think that advisor capitalists are the answer.  In response to Stowe, Fred blogs: “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.”

Fred suggests that, if you don’t need enough money to qualify for venture capitalist, you seek an angel instead.  I agree with that IF YOU NEED money and recently posted myself on angel investors.  Moreover, I have raised money from Fred in the past AND gotten good advice so do agree that, when the VC relationship works, it works.

But what if you don’t need money but still need advice and connections?  I don’t think you ought to sell more equity earlier than you have to just to get the advice and connections you want.  I do think that the venture industry, just like so many others, can be horizontally delaminated or micro-chunked like much content is or ought to be.  No packaging of one service with another is sacrosanct.

I must admit I like Stowe’s suggestion as much in my present role as consultant (when I’m not writing murder mysteries) as in my ex-CEO role.  My consulting is too expensive for many interesting start-ups to pay me cash.  Equity is a currency they have.  A best-effort does imply a long-term relationship in which the consultant does not flit from one competitor to another like a cross-pollinating bee.  I think if I have forgone fees and put in time, I WILL begin to think of my sweat equity as if it were actual cash I put in despite Fred’s concern.  After all, most of the entrepreneur’s investment is also likely to have been in sweat if she hasn’t yet raised any money.

I am sometimes asked to serve on the boards of private companies and have sometimes done that.  When I am the first outside board member other than VCs, I am often serving in a quasi-consulting role.  For that I like to get paid in either cash or restricted stock or a combination of the two.  The VC are often unhappy with that idea and think I should get options; that is usually the way it’s done.  But I think stock makes me think more like the entrepreneur.  You want your advisors to be motivated like you (the entrepreneur).  In tough times you want them to think about preserving as much value as possible.  Someone who is compensated only in options is motivated to take enormous downside risk in return for some possibility of an upside since options have only upside value.

The reason I bring this up is that I think ACs ought to be compensated, at least in part, with restricted stock rather than options.  This is similar to the compensation that a VC gets although I’m not sure this stock needs a liquidation preference like angel or VC stock gets.

One question I don’t know the answer to is how the AC relationship gets started if the potential AC doesn’t know the entrepreneur.  Just like a VC, a consultant can’t spend much time evaluating prospects which aren’t likely to pan out.  Similarly, how does the entrepreneur know which AC really can help.  At least money is money when you’re looking for a VC.  Will there be AC firms whose reputation you can trust?  There probably will be AC firms but I can see myself telling entrepreneurs that nothing matters except the skill and personality of the specific AC he will be working with.

Maybe, when there aren’t personal relationships, the AC relationship starts with paid consulting.  Tough on cash flow, though.  Even with kinks like this to be worked out, I think Stowe Boyd is on to something – if you don’t need the money a VC or angel would bring or if you are a consultant looking to live a little more on the edge.

I wrote an earlier post on disrupting the VC business here.

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