Properly Compensating Entrepreneurial Advisors
With slight modification, Cicero’s
astute quote aptly applies to the entrepreneurial world:
should be judged by results, not by intentions.”
One way to accomplish this
goal is to compensate your advisors with equity and clearly specify the
tasks that they must perform in order to earn their remuneration. If
their advice proves sage and the company’s value increases, then they
will be duly rewarded. If the company fails, their advice is free,
as it should be.
The key covenants to consider when crafting your advisory agreements include:
- Equity Only – ensures the Advisor’s and Company’s interests are aligned
- Specificity – clearly state the tasks to be performed and the minimum time requirement
- Restricted Stock – ideal form of equity, with no detrimental impact on your venture
- Cashless Loan – allows the advisor to have beneficial ownership of stock, with no cash outlay
- Vesting – reduces your risk of parting with equity and not receiving requisite value
- Out Clause – motivates both parties to keep each other happy and allows either party to quickly terminate an ill-fated relationship
- Short Term – reflects the relatively brief duration of most advisor relationships
Each of these issues is discussed
in greater depth in the following section.
Your Advisor agreements with
should be brief, as advisory relationships are not based upon, nor
are they bound by, contractual terms. However, a verbal understanding
is not adequate. Honest peoples’ memories change over time. Thus,
in order to avoid a misunderstanding with a valued advisor, codify
your relationship in a simple, straightforward agreement, which incorporates
the following characteristics.
- Specificity – Include an Exhibit to your advisor agreements that articulates the precise tasks the advisor will accomplish, the minimum hours per week or per month to be worked and the minimum frequency and manner of communications (e.g., weekly calls, monthly meetings, etc.). Your advisors should track their time and report it to you monthly. If they balk at this request, you may be working with someone who has the wrong motives, as discussed later in this entry.
The greater the specificity
of quantified goals, the less likely a conflict will arise with your
advisor. As noted in Great
you can avoid misunderstandings by ensuring that both parties share
the same expectations at the outset of their relationship. Documenting
such shared intentions guarantees an unequivocal meeting of the minds.
- Restricted Stock – Equity should be granted as restricted stock. This form of equity is similar to an option, but the IRS recognizes “beneficial ownership” at the grant date, which allows the advisor to enjoy preferential tax treatment. This approach also has advantages for your company, because you do not have to track and recognize an ongoing expense, as is the case with non-qualified options.
- Cashless Loan – Your company should loan the advisor an amount equal to the purchase price of the restricted stock. No money changes hands in this transaction, but it allows your advisor to purchase the restricted stock without a cash outlay. If your venture fails, the loan will be irrelevant. If your venture is successful, the advisor will repay the loan when he or she liquidates their shares.
- Vesting – The advisor’s restricted stock should vest over the term of the advisory agreement. For instance, if you establish a six-month term, the advisor would vest one-sixth of the total grant monthly. This approach minimizes the company’s dilution, in the event that the advisor either becomes unwilling or unable to deliver value to the company, as vesting can be terminated.
- Out Clause – Include a no-cause, non-recourse termination covenant that allows either party to cancel the agreement, for any reason, upon 30-days written notice. This protects you, as you can effectively end the advisor’s vesting, in the event you do not feel the company is deriving adequate value from the relationship.
- Short Term – The duration of your advisor agreements should be relatively short-term, with one year as the maximum. If the relationship continues to be fruitful after the initial term, you can always extend it and grant the advisor additional options via a simple addendum. However, such subsequent grants will likely be smaller, as all grants tend to decrease over time, as the company’s risk profile decreases. Such smaller grants translate into less dilution for you, your fellow employees and your investors.
Although tracking the amount
of time your advisors apply to your venture helps make certain you
obtain an adequate amount of your advisors’ mindshare, keep in mind
that advisors can often add tremendous value by exerting relatively
little effort. For instance, a timely endorsement or a warm introduction
might lead to a meaningful, long-term relationship. Just because such
actions are relatively easy, you should not discount or otherwise
under-appreciate the value of such help. If you focus on the value delivered
and not the effort expended, you will be able to avoid the “buyer’s
remorse” that sometimes occurs after an advisor’s involvement is
Assuming you incorporate all
of the above contractual terms into your advisor agreements, the most
significant remaining issue is the size of each advisor’s equity
grant. As with any stock issuance, the number of shares is irrelevant.
The important issue is the percentage of the total capitalization represented
by the grant. Total capitalization comprises the following elements:
- Founders Stock– in the form of Common Stock
- Other Common Stock – issued to unsophisticated investors and early employees
- Qualified Options – granted to employees
- Restricted Stock & Non-qualified Options – granted to advisors and other third-parties
- Preferred Stock – purchased by sophisticated investors
- Warrants – usually granted in association with debt financing
For instance, a grant of 10,000
restricted shares represents 1% if the total capitalization equals 1,000,000
shares. However, the same size grant translates into only equals 0.1%
if the total capitalization equals 10,000,000 shares. As such, all stock
grants should be evaluated in terms of the percent of total capitalization
and not with regard to the “whole” number of shares granted.
Even at the early stages of
an venture’s life, advisors should be granted a relatively modest
percentage of the company’s total equity, in the range of 0.25% -1.5%.
Although these percentages may seem small, a grant within this range
represents a significant allocation of equity, roughly equivalent to
a Vice President’s initial grant.
The exact size of each advisor
grant will depend on the company’s relative maturation and the degree
of the advisor’s involvement. Be stingy with your equity. You must
conserve your equity to ensure you can adequately reward current and
future employees who will put their heart and soul into your venture’s
success, without overly diluting your investors.
There are a number of characteristics which distinguish potential high-impact
advisors. Individuals with the proper motivation, passion and relevant
experiences can generate tangible, incremental value to your venture.
Muhammad, Prophet of Islam
Motives matter, especially
when assessing a potential advisor relationship. As noted in Frugal Is As
you cannot afford to purchase advice. Even if you have adequate
cash, such interactions are likely to be of marginal and relatively
short-term value. Once you pay for such advice, the pay-to-play advisor
has no further incentive to help your venture succeed.
Advisors with motives conducive
to startups generally have achieved enough past financial success that
cash compensation, which is taxed at the advisor’s personal tax rate,
is not motivational. Rather, advisors with the proper intentions prefer
equity grants, which have significant upside potential and are taxed
at much more advantageous, long-term capital gain rates. Any potential
advisor who demands cash compensation, has the wrong motives and should
be eliminated from further consideration. If they want cash, they should
get a job. It may even be appropriate to consider them for an employee
position, but you should not pay them to think about your venture
Potential advisors should
not expect to get rich helping your venture. Certainly, you want them
to be well-compensated, as the more money they make, the more successful
your venture. However, seasoned advisors realize that the real
work is done by the operational team and thus the lion’s share of
the rewards should be accrued by them and the investors, not the advisors.
One way to help align the advisor’s
motives with your company’s interests, in addition to rewarding them
with equity, is to allow them to invest in your venture. Allowing
advisors to purchase equity strengthens their attachment to your company
and may result in you gaining more of their mindshare. If you are not
in the process of raising money, the advisor’s investment could be
in the form of a bridge note, which will eventually be converted into
equity upon the completion of the next funding round. If you are
raising institutional funds, carve out a portion for your key advisor(s).
If you have no near-term fundraising plans, consider selling particularly
valued advisors a small portion of your Founder’s stock.
Spark the imagination of your
advisors. As noted in PR
is an emotion that cannot be outsourced, as it is vital to a startup’s
success. It is also an essential component of your advisor relationships.
Your advisor must be passionate about your venture.
One way to evaluate your advisor’s
passion level is the degree to which they are accessible and responsive.
Your advisors must want to
help you. You cannot afford to spend time and energy repeatedly attempting
to convince a potential advisor that your venture is worthy of their
involvement. Hoping you can drag an unwilling advisor to your aid in
a time of need is not a viable strategy.
John Lusk and Kyle Harrison,
authors of The Mouse Driver Chronicles learned this lesson
the hard way. After multiple attempts to communicate with Ken Hakuta,
whose most notable accomplishment was the commercialization of the “Whacky
Wall Walker,” they finally scheduled a meeting to discuss his fit
as a potential advisor.
After flying across the country
and meeting with Ken, Kyle was disappointed. Despite Ken’s feedback
that the Mouse Driver was “a good product but not a great one,”
he still expressed an interest in joining Mouse Driver’s Board. It
was also apparent from this meeting that their respective styles were
out of sync. According to Kyle, Ken “told a lot of stories and laughed
a lot for no apparent reason.” It was also clear that Ken’s retail
connections were “a little dated” and thus the relevancy of his
insights was questionable.
Even so, John and Kyle decided
to continue their discussions with Ken. After pulling together a variety
of materials and forwarding them to Mr. Hakuta, they received no reply.
Repeated emails, voicemails and even calls to Mr. Hakuta’s friends,
asking them to contact Mr. Hakuta on their behalf, failed.
John and Kyle eventually realized
that Ken’s motivations were not aligned with those of their startup.
Rather than being driven by a passion for the Mouse Driver product,
Mr. Hakuta was apparently motivated by the potential financial return
he believed he might derive by attaching his name, but not his energy,
to John and Kyle’s venture.
Advisors who intend to simply
attach their name to your venture seldom generate significant value.
If an advisor is not willing to passionately and knowledgeably endorse
your venture, his or her involvement will be of little value. To be
effective, an advisor must be willing to risk sullying their personal
brand by closely associating it with your venture.
Heavy Lifters Will Not Apply
The Latin translation of “advisor”
is “no heavy lifting.” OK, not really, but it would be fitting.
An advisor’s role is to provide guidance, make introductions and help
you troubleshoot specific challenges, but they should not be expected
to get dirt under their fingernails.
If they wanted to work hard,
they would join an venture as an operating executive. As such, do
not stress your advisor relationships by making unreasonable demands
or establishing unrealistic expectations. Your advisor might agree
to perform certain unrealistic tasks because of their desire to help,
but later realize they cannot deliver on their well-intentioned commitments.
One way to ensure that you
never leave your company exposed to the whims of a well-meaning but
overburdened advisor is to establish a relationship codified in specific
terms and compensated via equity that is earned over time. If you are
able to establish such relationships, you will never have to worry about
paying too much for your advisor’s advice.