Most startup founders are "big picture" types – creative, visionary, innovative thinkers with a unique and marketable skill-set. Yet, many do not have the 'business chops' to grow their ideas into revenue-generating operations. Whether they lack experience with certain business functions or simply the bandwidth to handle them all on their own, choosing to "go-it-alone" can carry a greater risk of failure. For most new ventures, especially those in the idea- and pre-seed stages, the key to success is having access to a deep bench of trusted advisors.
What is an advisor?
Founders often talk about their experiences receiving help from sponsors, mentors, advisors, and even their co-founders. Although the nomenclature may vary, advisory relationships essentially fall into 3 categories:
- A single advisor is someone who provides support, either informally (without an agreement) or formally, where the relationship is papered and compensation is given.
- An advisory board is a more structured and consistent means of receiving help from advisors; these relationships are typically papered and compensated with either cash or equity.
- A governing board is a group of advisors acting in an official capacity with authority to act on behalf of the business. These relationships are usually appointed, papered and compensated in equity, and are required to follow the provisions of a corporations or limited liability company act issued by the state of incorporation.
Choosing advisors
It is never too early to seek out individuals who can provide expertise in support of a new venture. Depending upon your specific needs – business development, fundraising, sales/operational skills, industry knowledge – the right person can add value from day one. The key is choosing advisors thoughtfully to ensure that you are getting value for your business. If approached hastily, you may end up with an unwieldy situation and not enough time to extract the knowledge and skill sets you need most from them.
Several industry frameworks offer guidance to founders who are working to determine the appropriate scope of an advisory relationship for their venture. A common rule of thumb is 3-5 hours of advisory service per month in exchange for a percentage of equity (anywhere from 0.1% – 0.5% ) that vests over an agreed upon length of service (2 years, monthly vesting is standard).
Granting equity to advisors
It is a well-known fact that equity incentivizes performance and creates long term incentives to support your business. Therefore, giving your advisors some 'skin in the game' can be an effective motivator. That said, equity grants should not be unrestricted, but rather, tied to specific milestones pursuant to the terms of an advisor agreement. It is in your best interest, as founder, to define such milestones as clearly as possible. For example, there is a significant difference between 'making introductions' and 'signing up' new customers. An experienced startup attorney who understands the needs of early-stage ventures can help paper this relationship at a reasonable cost.
Also, before you can grant equity to your advisors, you will need to have basic formation documents in place. For example, your Article of Incorporation (corporation) or Certificate of Formation (LLC) will need to be created and filed. You will also need to decide if you want to grant your advisors either options or outright stock. In the case of the former, adopting an option plan may take more time and involve additional costs to set it up, including possibly a formal valuation for purposes of setting an exercise price (see below). The benefit to your advisors is that they do not have to pay you any cash up front, and they will not be subject to tax.
If stock is granted outright, advisors typically pay for it to avoid being subject to income taxes on the value of the stock. Unlike options, issuing stock is easier for a founder, as it is usually just one piece of paper and does not require a formal plan. Finally, with respect to having formal, third-party valuations done, it is important to note that they are not a prerequisite to issuing options or stock to advisors so long as you follow the safe harbor guidelines under Section 409A. For more information on pricing common stock under Section 409A, please see our blog post by OGC Partner Kristin Kreuder.
Setting up the future
Perhaps the greatest benefit to choosing advisors early and building those relationships is that they eventually become candidates for your governing Board of Directors. As your company grows and processes evolve, you will be tasked with increasing the size of your Board and filling it with the appropriate people. Having existing advisor relationships will significantly decrease the risk of filling your Board with unknown people who may, or may not, believe in your ability to run the company. It is all about relationship building and finding the right people well in advance; otherwise you may find yourself in a position where the Board's interests do not necessarily align to yours.
There are always a million priorities when running a business, but finding and bringing on advisors should be at the top of your list. Not only do advisors help with getting started and making key early connections that can bring you success, they also impact your long term strategy by becoming trusted Board members.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.