Understand advisory capital

“Advisory capital is an investment of experience, expertise, social capital and public authority in a company in exchange for some form of equity in the company.”

Advisory Capital, a new twist on venture capital investing, is the direct result of a changing landscape among venture capitalists and entrepreneurs. This landscape has seen a stream of startups able to forgo the cheap, traditional venture rounds and still achieve tremendous market success. Examples of such successes include many Web 2.0 companies such as Flickr, JotSpot, and Weblogs. Even traditional venture capital firms have recognized this shift in funding needs. Guy Kawasaki has a fascinating post on how he built Truemors for $12,107.09. Charles River Ventures recently launched its Quick Start program, offering promising entrepreneurs up to $250,000 in convertible debentures.

Says George Lipper of the National Association of Seed and Venture Funds:

“That [issue] is the mismatch between the needs of worthy start-up entrepreneurs for relatively small amounts of venture capital and institutional venture capitalists who cannot find the time to justify handling small investments. As such, we are seeing a steady erosion of the proportion of venture capital (and therefore VCs’ time) pouring into the seed and startup stages to around 2% of available capital…while expansion and later-stage investments account for over 80%.”

For startups, advisory capital can be the best of both worlds: the ability to eliminate cash investments (resulting in significantly less dilution for founders) while spending minimal equity sufficient to take advantage of the “advisory” portion of a VC or Compensate Angel Relationship . I believe that advisory capital can also be viewed as a “bridging investment” that helps early stage companies build their valuations ahead of an angel or Series A investment round once initial market traction is gained.

However, the role of advisory capital advisors has been questioned by some. A key problem with such a model is the lack of what Union Square Ventures calls “capital at risk.” The argument is that the risk of investing “forms the basis of all the other roles the VC plays – advisory, oversight, liaison, etc. Without it, you won’t get anywhere near what you get with a VC.” Stowe Boyd, the inventor of the advisory capital letter, but fights the UPS position,

“If some of my existing advisory capital clients get acquired, go public, or start paying me dividends, I may start investing hard cold money in addition to the hard cold advice I’m dishing out.”

Coming back to my position that advisory capital is best used as a ‘bridge’, working with the right AC person or firm should lead to connections and desire for angel investors. Unless a company is simply developing a lightweight application, the need for outside capital will likely always be there. Ultimately, venture capitalists should seek to build relationships with these AC firms, which can act as filters and help screen investments and implement early-stage best practices; the basis for long-term success.

Ultimately, the advisory capital role is a catalyst to the next stage, a best-cost opportunity for founders and a risk-mitigating technique for prospective investors – win-win, win-win for all.