Insights and Opinions

 

Wednesday, December 17, 2008

Properly Compensating Entrepreneurial Advisors

from John Greathouse





Advice is judged by results, not by intentions.”

Marcus Tullius Cicero, Roman Lawyer and Statesman, 106 BC43 BC

With slight modification, Cicero’s astute quote aptly applies to the entrepreneurial world: Startup advice 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.

Advisor Agreements

A lean agreement is better than a fat judgment.”

Proverb

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 Expectations, 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 concluded.

Equitable Equity

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.

Advisor Profiling

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.

Motives

All actions are judged by the motive prompting them.”

Muhammad, Prophet of Islam

Motives matter, especially when assessing a potential advisor relationship. As noted in Frugal Is As Frugal Does, 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 part-time.

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.

Passion

There is a boundary to men's passions when they act from feelings; but none when they are under the influence of imagination.

Edmund Burke, British Statesman and Philosopher, 1729-1797

Spark the imagination of your advisors. As noted in PR Passion, passion 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.

John Greathouse has held a number of senior executive positions with successful startups during the past fifteen years. At Computer Motion (RBOT), he was the CFO and VP of Business Development. At Citrix Online (CTXS - formerly Expertcity), Greathouse served as CFO and SVP of Strategic Development. At CallWave (CALL), he served as the SVP of Sales & Bus Dev. In his capacities at Computer Motion and Citrix; Greathouse spearheaded transactions which generated more than $350 million of shareholder value, including Computer Motion's initial public offering and the sale of Expertcity to Citrix for over $230M. Greathouse is a Partner at Rincon Venture Partners (www.rinconvp.com).

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