Giving Them a Piece of the Action - Equity Compensation for Advisors
by Matt, on 18 Feb 2020
As a successful entrepreneur, you understand the importance of conserving cash. If the money runs out, it’s game over. And, especially during the early days when you’re bootstrapping the business using personal savings and capital invested by friends and family, there’s barely enough to pay everyone a salary.
Yet it’s during precisely the same time period that you and your fledgling business can benefit most from the wisdom and professional services of others. Their expertise and experience could be critical to avoiding mistakes and making your business a success.
In this edition of SPT, we explore the challenge of securing that expert advice without having to pay in cash, and the pitfalls that can arise if you start handing out equity for advisors instead.
Why THE DESIRE TO HAND OUT STOCK?
You’re on the entrepreneurial rollercoaster. Time is flying by, you have a million-and-one things on your to-do list, and your emotional state oscillates between exhilaration and abject panic.
Luckily, you’re not going through this alone. Thanks to your professional network and some fortuitous meetings at the co-working space that’s become your second home, you’ve picked up several advisors with deep, relevant experience.
With their help, your chances of success seem to have skyrocketed. In fact, your biggest risk now is that they disappear before you finish raising Series “A” next year…
And, what’s to stop them from disappearing? They must have plenty of exciting opportunities to pursue. Opportunities that come with a consulting fee to make it worth their while – a consulting fee you couldn’t even dream of paying with only a few months’ runway in your bank account.
So, how the heck are you going to keep them interested and involved? They’ll only give so much advice for free.
This is where many entrepreneurs reach for their stock certificates and begin handing out equity to crucial advisors and mentors.
And, why not? It costs nothing, it sounds cool, and it ensures the advisors’ interests are aligned with those of the company, right?
Yes and no. Compensating advisors with equity does preserve cash, extending your runway and making it available for other uses. But there are some potential pitfalls to consider.
What could possibly go wrong?
Here are just a few reasons why handing out equity like Halloween candy could become more of a trick than a treat:
- What happens if the advisor leaves relatively quickly?
Once equity has been issued, it can be hard to get back. You can end up with a list of passive minority shareholders who no longer have any real interest in the company’s fortunes.
- What happens if you remain cash-strapped for a long time?
It can take months – even years – for some companies to prove their business model works, gain customer traction, raise investment, and begin generating cash. How many advisors are you going to compensate with equity during that time? How much overall equity are you willing to give up?
- What if advisors don’t see value in your equity?
Without a financial event in sight that will significantly increase the value of your company, your stock isn’t worth very much. Savvy advisors will discount its value for technical and commercial risks, as well as a lack of liquidity (there’s no way for them to sell the stock). This means they will demand a larger piece of your company in lieu of cash compensation.
- What happens if you reach the end of the vesting period?
You might smartly tie your advisors’ equity compensation to a vesting schedule so that they must be present to win (going some way toward resolving pitfall #1). However, they’re unlikely to accept vesting over more than three years and time flies when you’re having fun (or growing a company). If you reach the end of their vesting period, you might need to issue even more stock to keep them engaged.
- How does this all look by the time you’re ready to raise some money?
A cluttered capitalization table with numerous small or no-longer-involved shareholders can be a deal-breaker for investors. They don’t want the hassle of tracking down minority or passive shareholders for signatures, or having to create and send them paperwork, such as tax forms. The cleaner you can keep the cap table, the better.
Things to consider before writING the certificates
Think long and hard about which of your advisors you really need to compensate.
Although it’s tough to let go of a helpful advisor, it’s even tougher finding out that you’ve given away a significant piece of your company for naught or that investors don’t want to touch you because of a messy cap table.
Are there other, less-expensive sources from which to obtain similar advice?
It can sometimes be hard to gauge the true value of online information, but it’s worth investing some time to find trustworthy sources. Where do your advisors go for the latest insights? Many reputable websites offer libraries of relevant resources, including video content and podcast episodes.
You can also access helpful resources through local startup hubs, accelerators, incubators, co-working spaces, and organizations such as the Small Business Administration, which works with local partners in many cities to mentor and train early-stage business owners.
What sort of stock should you issue, and how much?
Most companies prefer to use stock options for compensation and incentives rather than actual shares. Unlike regular shares, stock options don’t confer any voting rights, dividend payments, or ownership in the company until and unless the options are exercised.
Your board of directors will typically authorize the issuance of a limited number of stock options – known as the ‘option pool’ – so that they can calculate their fully-diluted ownership position once all the options have been issued and exercised.
Typically, the total equity set aside for the management team and other recipients will be in the range of 10-20% of the company’s total issued share capital.
It’s worth being judicious with option grants because, as we mentioned, you don’t know how many advisors or employees you’re going to want to compensate during the life of the option pool.
There is no hard-and-fast rule for how much equity an individual advisor ought to receive. However, somewhere between one-quarter and one percent of the company’s share capital seems to be a typical range for an early-stage business, depending on the recipient’s professional and advisory experience.
Who is really incentivized by stock options?
You might think everyone would appreciate owning a stake in your high-potential venture, but that’s not actually the case.
Stock options are worth nothing until the business grows significantly and reaches a liquidity event – such as being acquired – when, in most cases, the options will automatically be triggered and cashed out.
If a potential recipient is independently wealthy (i.e. they don’t need cash right away) and comfortable with high-risk, high-return investing (i.e. they understand the world of startups), then they might well appreciate stock options as a way to create upside potential for themselves beyond what they could make in normal cash fees.
However, a recipient who could really use the cash and has a correspondingly short time horizon when it comes to financial returns is likely to take a dim view of your worthless, illiquid, trust-me-an-exit-is coming stock options.
Most business advisors lie somewhere in between, so have an open conversation with each one before deciding to offer them stock options. They might be willing to work for a reduced or deferred fee, rather than foregoing the cash completely.
Should you raise cash rather than handing out equity?
At a certain point, you have to be honest about what your company can and cannot afford, and what it really needs to afford to have a chance at being successful.
There’s much written – and many a bar-room story told – about entrepreneurs who have scraped by on precariously limited resources before finally making it to the promised land. Unfortunately, for every nail-biting success story, there are ninety-nine unwritten tales about the companies that failed.
If you need to engage specific talent or experience to be successful – whether as a part-time advisor or a full-time employee – then paying for that talent should be part of your baseline budget. Compensating them with equity can be deceiving. It’s much better to accept that you need more money to run your business properly, and then go find a way to raise it.
- Think twice before promising shares in your company in return for advice or expert assistance. What seems like valuable work for free could turn out to be costly in the long run.
- Preserve your equity for key hires and truly indispensable advisors who you believe will stick with the company until it achieves significant growth in value.
- Look for alternative ways to tap into necessary skills and expertise, both online and via organizations that support early-stage businesses.
- And finally, don’t wait too long to raise working capital if that’s what your business really needs to reach its full potential. Pretending that you can survive on too little cash – while papering over the funding gaps with stock options – is a fool’s errand.