Advisory Capital? Not When VCs Do It Better

Stowe Boyd argued this week that increasingly tech entrepreneurs do not need the traditional VC value-add (cash) and therefore the entrepreneur needs a new source for the other values a VC provides – advice, contacts, etc. Stowe proposed a fresh thought that stimulated a lot of debate: advisory capital. Fred Wilson responded saying that “capitalism works for a reason” and without cash on the line it won’t be possible to “completely replace the role of the VC”.

I have issue with both Stowe and Fred’s arguement – not for what they debate, but for what they fail to discuss.

Stowe argues that VCs can’t/won’t support start-ups with incubator-like services. Fred claims that VCs are vital for reasons other than nontraditional VC value-adds. (Fred, you don’t explicitly discuss your thoughts on a VC adding non-traditional VC value to a firm, which is the underlying idea of Stowe’s arguement. Where’s your mind on that?).

Why can’t an innovative VC firm compete, and gain a competitive advantage by realizing this trend in tech start-ups and adjust their service offering to fill the gap?

An advisor is capable of adding value, in a select area of focus. Why can’t a VC build this value-add into their team? Many start-ups assemble multiple advisory boards – technology focused, strategy focused, etc. – and a well built VC firm, capable of filling many of the necessary needs, would add additional value due to the fact that the entrepreneur would only have to seek out one “advisor” to fill many needs.

It seems to me that a VC firm could add additional value, at a lower transaction cost (search/negotiate/…) than a traditional advisor could. (+ provide value that an advisor could not supply: having support structures to handle tedious office tasks, provide off-shoring support, etc.)

The question that will undoubtably be asked by my fine readers is: why would a VC bother to provide services like these?

Well, that’s a good question. And here’s a good answer.

The answer: because it will add a competitive advantage – allowing the VC to acquire equity, in increasingly more attractive start-ups, at increasingly cheaper rates.

David Hsu, from The Wharton School, published a paper in the Journal of Finance, in August 2004, titled “What Do Entrepreneurs Pay for Venture Capital Affiliation?”. It’s an academic article – here’s the summary:

“In the minds of entrepreneurs working to grow their fledgling technology companies, the intangibles brought to the table by their investors – experience and contacts – often are worth more than money itself… David found that offers from more reputable venture capitalists are three times more likely to be accepted by entrepreneurial companies and that, on average, these favored investors acquire start-up equity in the companies at a 10-14% discount.”

“Reputation” is defined as the intangibles brought to the table by the investor, and are mainly limited, with respect to the study, to experience and contacts. Fair enough. But wouldn’t a VC strengthen their “reputation”, in the eyes of an entrepreneur, by providing advisor-like/incubator-like services at a level beyond what a traditional advisor could provide? Wouldn’t a VC strengthen their “reputation” by providing services in addition to “nontraditional VC value-adds”?

And wouldn’t the stronger reputation become a competitive advantage – allowing the VC to increase the likelyhood of being accepted by the entrepreneurial firm and lowering the cost of equity? I think so.

[Bonus # 1: Many thanks to Daniel for the help with this post - the comment on Fred's post and the friendly email reminding me about the discussion. Again, reaffirming my thoughts.]

[Bonus # 2: Cem came close to touching on my issue in his post and humourously must have posted before reading Fred's response]

[Bonus # 3: I'm off to Santa Barbara tomorrow for a nice break from this crazy business trip. I wrote this post while listening to Ryan Adams' Cold Roses album and warming up for tomorrow by drinking some chardonnay from the Santa Barbara region - if my arguement gets confusing at the end, it's due to the quality of the wine]

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  • Eric Olson

    Another great piece of writing Fraser. Well done. I had commented on Fred’s article in agreement that money (“skin in the game”) is important to the VC/entrepreneur relationship. However, I should have thought things through a bit more and I would like to think that if I had I would have come up with your argument. VCs could easily add some of these “advisory” services into their current offering mostly untilizing staff they already have. I think as the VC space becomes more competitive for deal flow you will see some of these advisory services enter into funding offerings. Another intersting thing that advisory services could do is bring a tier 2 VC to the top tier. There are some good tier 2 VCs that just don’t have the reputation or track record of people like DFJ simply because they are too new. If these firms began to add advisory services to their offering they may be able to break out of the tier 2 level sooner and compete with the big guys for deals potentially shaking up the landscape in a way that not only benefits the tier 2 VCs but also benefits entrepreneurs. I think there are some very hands on VCs out there now already adding in advisroy services without calling them by that name. When I think of these individuals and how they are able to get such great investments things start to make a lot of sense.

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  • http://www.ventureweek.com/blog Eric Olson

    Another great piece of writing Fraser. Well done. I had commented on Fred’s article in agreement that money (“skin in the game”) is important to the VC/entrepreneur relationship. However, I should have thought things through a bit more and I would like to think that if I had I would have come up with your argument. VCs could easily add some of these “advisory” services into their current offering mostly untilizing staff they already have. I think as the VC space becomes more competitive for deal flow you will see some of these advisory services enter into funding offerings.

    Another intersting thing that advisory services could do is bring a tier 2 VC to the top tier. There are some good tier 2 VCs that just don’t have the reputation or track record of people like DFJ simply because they are too new. If these firms began to add advisory services to their offering they may be able to break out of the tier 2 level sooner and compete with the big guys for deals potentially shaking up the landscape in a way that not only benefits the tier 2 VCs but also benefits entrepreneurs.

    I think there are some very hands on VCs out there now already adding in advisroy services without calling them by that name. When I think of these individuals and how they are able to get such great investments things start to make a lot of sense.

  • Fraser

    Hi Eric, As always you provide a very thoughtful response. I love how you phrase this thought: “Another intersting thing that advisory services could do is bring a tier 2 VC to the top tier… If these firms began to add advisory services to their offering they may be able to break out of the tier 2 level sooner and compete with the big guys for deals potentially shaking up the landscape in a way that not only benefits the tier 2 VCs but also benefits entrepreneurs”. That’s a very clean summary of one of the points I’ve been trying to make lately — that the ENTIRE venture capital industry is not due for a “shake-up” (I dislike the thinking that is behind a blanket statement like this); rather, in the short-term there is an opportunity for an innovative VC firm to experience “growth” at a faster pace than another firm by offering a suite of nontraditional VC services. I think you’re also right in saying that there are a number of VC firms out there providing such services without calling them by this name (Maybe they don’t want to draw attention to their competitive advantage? Maybe they’re too busy being awesome. Who knows.) I think sometimes my point gets lost in the longwindedness of my arguements. I’ll try to work on that. (I did not succeed with that in this comment ;) )

  • Fraser

    For those interested, http://www.ventureweek.com/blog/2006/02/27/adviso…rel=”nofollow”>Eric adds to his comment in a post on his blog.

  • http://www.disruptivethoughts.com Fraser

    Hi Eric,

    As always you provide a very thoughtful response.

    I love how you phrase this thought: “Another intersting thing that advisory services could do is bring a tier 2 VC to the top tier… If these firms began to add advisory services to their offering they may be able to break out of the tier 2 level sooner and compete with the big guys for deals potentially shaking up the landscape in a way that not only benefits the tier 2 VCs but also benefits entrepreneurs”.

    That’s a very clean summary of one of the points I’ve been trying to make lately — that the ENTIRE venture capital industry is not due for a “shake-up” (I dislike the thinking that is behind a blanket statement like this); rather, in the short-term there is an opportunity for an innovative VC firm to experience “growth” at a faster pace than another firm by offering a suite of nontraditional VC services.

    I think you’re also right in saying that there are a number of VC firms out there providing such services without calling them by this name (Maybe they don’t want to draw attention to their competitive advantage? Maybe they’re too busy being awesome. Who knows.)

    I think sometimes my point gets lost in the longwindedness of my arguements. I’ll try to work on that. (I did not succeed with that in this comment ;) )

  • http://www.disruptivethoughts.com Fraser
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