Advisory Capital: A New Basis For Strategic Involvement

There has been a great deal of discussion in the tech community about the changing needs of Web 2.0 tech startups. When the underyling economics of innovation have shifted so drastically -- cheaper high-powered servers, open source LAMP stack, accelerated development tools and techniques (AJAX, Ruby, Php, etc.) -- more and more companies can bootstrap from pocket change, and be up and running in less time than it takes to secure capital. As a result, going the VC route is increasingly seen as a brake on this class of tech innovation, not an accelerator, at least in the very earliest stages.

But the needs of today's start-ups for quality advice and guidance has not changed, but because the VCs have a harder time getting involved -- they aren't geared to make <$50,000 investments, generally -- small start-ups are left with a variety of options to fill the advisory gap since they don't have VCs advising them:

1. Go without advice from outsiders -- seems to happen a lot, but can lead to big goofs.
2. Go with advice from an extended network of informal advisors -- friends, family, and others well-known to budding entrepreneurs may have their interests at heart, but may not understand the market that their innovations will be playing in.
3. Look for knowledgeable angel investors -- those well-off individuals who are geared toward making smaller investments in early stage companies can often be knowledgeable about tech in general, but are not necessarily clued into what is happening in the innovators' space.
4. Seek the advice of leading authorities in the market that the product will be competing -- and often, this translates to the leading bloggers, consultants, and authorities writing about the market in question.

It is this last option that I have had the most experience with recently, since I have spent most of my time since 1999 blogging about new technologies, particularly those with a dominant social orientation, and in recent months I have spent most of my time as a consultant working with small start-ups.

But the basis of involvement in this shifting territory -- the area between the consulting authority, and the advice-hungry innovators and entrepreneurs -- has to be rejiggered to better account for the needs of both parties. Pure play consulting may not be workable any longer, because the potential value of the involvement of a specific consultant cannot be accurately determined at the start of an engagement. A consultant is unlikely to want to part with a strategic concept that could make a client into a $100M player, potentially, in exchange for a per diem and the possibility of some downstream consulting, maybe, if you're lucky. And the best results may not come from a few days of consulting, but a long-term strategic involvement, like venture capitalists typically make in their portfolio companies, the expense of which small companies have historically been unwilling to take on.

What I think is needed is a fusion of the best of both the venture capital and advisory board models. I call this Advisory Capital:

• 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.
  
• The leverage from advisory capital comes from consistent involvement over strategic scope of time: months and years of frequent interaction. Weekly calls, monthly meetings, quarterly planning sessions. A constant focus on bringing strategic goals into realization.
  
• 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 believe that someone who will be an effective advisory capitalist will view that role as their primary professional purpose. Just like the best venture capitalists are not doing something else on the side, those moving into this new frontier will not be part-timing it.
  
• In order for the AC model to work, other elements of the VC model have to fall into place. The AC has to avoid conflict of interest -- if she is affiliated with one company building a product to do X, she cannot do the same with a second company. But this also means that the return on involvement (ROI) for the AC has be be more like a VC than a consultant. For a strategic level of involvement there must be a non-trivial return on involvement.
  
• The historical levels of stock participation for the passive, PRish, list-of-names sort of advisory board membership are inadequate for the degree of involvement contemplated. ACs will have to prove their worth, but my feeling is they will prove to be something on the order of 10 times more effective that the Madame Tussaud wax dummies that most companies populate their advisory boards with. And a company will only need a handful of ACs, rather than a boatload of in-name-only advisory board members.
  
• Advisory board stock participation is often as much as 0.25% to 0.5% ownership in a startup, subject to normal vesting periods of 4 or 5 years. I believe we will see this boosted 5X, 10X, or more, to attract and retain powerful ACs.
  
• Unlike VCs, ACs are not amassing cash from passive investors, and managing it for them. ACs do not have a pool of cash to draw a salary from. (Or at least many of us don't.) As a result, they will seem like a consultant on some level, since they will charge for their time and expenses. However, at least in my case, I am discounting from my a la carte, short-term consulting rates when moving into an advisory capital situation: when the client is interested in a long-term, high involvement relationship, involving a serious stock share (1% ownership or more).
  

So, along with coming up with a term to put on the business cards that I have yet to order, I believe that the concept of advisory capital may clarify some of the issues swirling around about the potential conflicts that confront leading authorities -- especially prominent bloggers and others in the public eye -- relative to their making public comments about companies that they are affiliated with:

1. Simply by stating that I am an advisory capitalist -- and not a journalist, hobbyist, analyst, nor a consultant, per se -- I am making clear what I am up to. I am seeking to invest my time and energy into a portfolio of potentially successful startups in return for the appropriate ROI (return on involvement), plus a living wage. By analogy with venture capital, people will be able to bend their heads around advisory capital.
2. Those that announce that they are, in fact, advisory capitalists can subscribe to the (as yet unformulated) Advisory Capital Code Of Ethics. These will likely be heavy on disclosure, openness, and transparency.

This also suggests another thing for venture capital firms to do: rather than trying to focus on how to reorganize to invest smaller and smaller sums into more and more companies -- and thereby diluting their involvement -- they need to jump from investing cash to investing advice. This would allow them to vet dozens of very early stage companies, and cherry pick the most likely contenders for future success, even if they didn't need cash at all yet.

Alternatively, as some of my existing portfolio of advisory capital clients are acquired, go public, or start paying me dividends, I might start investing hard, cold cash on top of the hard, cold advice I am doling out. Or potentially, I could take on investment for my company, A Working Model, in effect making my advisory capital investment fungible. I could wind up backing into a situation where the primary asset of A Working Model is the stake it holds in its various advisory portfolio companies. So, the world of advisory and venture capital may start to overlap, and blur, becoming two halves of the sphere of involvement that drives high tech innovation.

tags: advisory+capital, venture+capital, return+on+involvement, a+working+model, advisory+capital+code+of+ethics

Comments

[Alexander Muse]

Sounds a lot like what we are trying to do here in Dallas. Love to chat sometime if you have a minute. Cheers, and good luck!

[Amy Bellinger]

How about "mentor capital?"

[Peter Caputa]

Amen, brother!

So, where do we sign up?

[John Seiffer]

The AC concept may be able to eliminate what has been a structural problem with the VC model: that the desires/needs of the VC are not aligned with those of the founders when it comes to cashing out. Paul Graham, and others have written extensively on this.
http://paulgraham.com/paulgraham/venturecapital.html

The cause is in large part due to areas unrelated to the founders or the start-up but rather to the business model of the VCs: their need to have a certain rate of return so they can continue to raise funds and the model where they expect the returns from one or two super star performers to in effect pay for the losses or mediocre results of the rest of their portfolio.

The AC concept should be able to avoid this problem and allow the time horizon and expectations of the advisor to be more in line with that of the founders.

[Sean Wise]

Stowe,

I think you are bang on. North of the Border, my team and I have being doing what you call Advisor Capital under the nom de plum of Mentor Capital. This has been extremely valuable to the entrepreneurs we assist and to us.

Can’t wait to discuss more with you next week at Deb’s event.

Sean

===========================================
Sean Evan Wise, BA, LLB, MBA
Wise Mentor Capital
257 Adelaide Street West, 6th Floor
Toronto, Ontario, M5H 1X9
(416) 995 9017
www.WiseMentorCapital.com
Wise Counsel for Smart Companies

Read my latest column on Entrepreneurship and Venture Capital online at: http://www.theGLOBEandMAIL.com/smallbusiness/

[MIke]

The challenge is defining roles and responsibilities upfront. What will the individual do and how much time will they commit? What if the deal goes sideways and the commitment drops off? What if the entrepreneur was oversold by the AC? Like any partnership, these things are tough. I'm actinf in such a role now, taking no money and with no fixed participation. If I add value, we'll work something out, if not we won't. I am running my own company and this is how I would structure the deal myself. Like all things in life, you get out what you put in...

[Darren Fast]

Steve,

Thanks for a great post. Although I am in the biotech industry, Advisory Capital is exactly what my company was set up to do. I just didn't have the name for it.

Thanks!

[Bob Sargent]

Good description and name of a deal we did about a year ago. We were asked to take an equity position in a startup with no capital invested due to expertise and contacts. Not tech; our expertise is insurance. I don't think Advisory Capital will replace the more traditional VC approach, but it has its place.

Bob

[Daniel Nerezov]

Not that I know what I am talking about, but "advisor capital" is a silly, flawed concept prone to unsustainability and failure.

It simply isn't empirically correct for financiers to compete on the basis of value added advice, services and support offered to investees.

First of all, the use of these soft, qualitative factors makes for an immature market and, secondly, producers are not in the business of telling directors how to make movies (to use a simile).

The best way for early stage financiers to compete in the future is to make term sheets public information and differentiate them selves on the basis WACC.

As long as cost of capital is obfuscated, the venture business will remain an anomaly in the global financial system, and as long as nascent financiers fall for the "we offer value add" trap, these said financiers will continue to fail. The top tiers can offer value add - not you, and you shouldn't compete with people where they are most comfortable.

The WACC is the way forward for nascent funds. Consideration of WACC forces nascent managers to repackage their investment offers as risk efficient financing packages and better alignment of risk/return, vc/founder profiles is the original problem facing the venture community (inclusive of entrepreneurs).

I don't care how much advice I get from someone juggling golf and being on 12 boards. I do care how much I pay for the capital, and how my personal wealth is diversified.

Least of all, should there be any consideration of the supposed dropping costs of doing startups. Whichever entrepreneur thinks they need less money in 2006 to commercialise innovation - must be smocking crack, and failing to manage their undercapitalisation risk.

[Daniel Nerezov]

Not that I know what I am talking about, but "advisor capital" is a silly, flawed concept prone to unsustainability and failure.

It simply isn't empirically correct for financiers to compete on the basis of value added advice, services and support offered to investees.

First of all, the use of these soft, qualitative factors makes for an immature market and, secondly, producers are not in the business of telling directors how to make movies (to use a simile).

The best way for early stage financiers to compete in the future is to make term sheets public information and differentiate them selves on the basis WACC.

As long as cost of capital is obfuscated, the venture business will remain an anomaly in the global financial system, and as long as nascent financiers fall for the "we offer value add" trap, these said financiers will continue to fail. The top tiers can offer value add - not you, and you shouldn't compete with people where they are most comfortable.

The WACC is the way forward for nascent funds. Consideration of WACC forces nascent managers to repackage their investment offers as risk efficient financing packages and better alignment of risk/return, vc/founder profiles is the original problem facing the venture community (inclusive of entrepreneurs).

I don't care how much advice I get from someone juggling golf and being on 12 boards. I do care how much I pay for the capital, and how my personal wealth is diversified.

Least of all, should there be any consideration of the supposed dropping costs of doing startups. Whichever entrepreneur thinks they need less money in 2006 to commercialise innovation - must be smocking crack, and failing to manage their undercapitalisation risk.