Ask an Investor: What’s the difference between a board of directors and an advisory board?

board of advisors

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Last week on Ask An Investor, we spoke about how a startup board of directors gets constructed and filled. This week, we will address the differences between a board of directors and an advisory board.

As with an effective board of directors, a strong advisory board is a key source of leverage and knowledge for an early stage company. If you are not filling all the seats on your board of directors or don’t have a set of advisors you can call on, you are at a serious disadvantage relative to your competitors.

The major structural difference between directors and advisors is that directors are legally bound to represent the shareholders of a company in a fiduciary manner and are liable for their actions. This is a very serious commitment in the eyes of the law, and founders should not take this relationship or commitment lightly. The role of the board is legally defined by the bylaws of the corporation, and these bylaws articulate what the board is involved in, how often they will meet, and how directors are appointed and replaced.

I’ve seen CEOS have good success getting advisors to become actual investors in a company. This happens as a natural extension of a growing relationship between a CEO and advisor over time.

On the other hand, advisory boards are more informal in nature. There are no legal boundaries on the function or role of an advisory board or individual advisors. Furthermore, there are no liabilities associated with taking the advice of an advisor, and there is no spelling out of how often an advisory board should meet or how advisors will be added or removed over time. In fact, you may not have formal advisory board meetings at all. You may decide that the best way to leverage an advisory board is direct, on-demand conversations with your advisors individually, or with a smaller subset of your advisory board ongoing.

The formal board of directors of a company is formed based on the bylaws of a corporation. Conversely, the CEO and management team have flexibility in the formation of an advisory board and can add and replace members with much autonomy over time.

When thinking about forming your set of advisors, identify the most strategic challenges and opportunities your company will face for the next 12 to 24 months. If you are tech-heavy company that is deep in R&D mode, you will want advisors with technical backgrounds in your sector that have been successful at getting products like yours to milestones and, eventually, to market. If you are a post-MVP company that is turning attention to cranking up your sales engine and customer onboarding, you will want advisors who have been there and done that in terms of taking an early-stage company from initial customers to a larger set of customers within a market similar to yours. If you’ve nailed a good sales rhythm in North America and are now looking to markets like Asia or the Middle East, you want advisors who know those markets intimately and know how to do business as a North American company operating in these markets.

Let’s break down who each board “works” for. This is a very important distinction. A board of directors works on behalf of the interests of a corporation and its shareholders, and will put those interests above that of the CEO, founders, or employees. Directors are looking out for the interests of all shareholders and this can sometimes be at conflict with the personal interests of a set of founders or a CEO. Boards of directors can be great sources of advice and connections for a management team, but when the rubber hits the road and a conflict arises, remember they have to act with the interests of ALL shareholders in mind, not just the management team.

An advisory board, conversely, works on behalf of the CEO and her management team. This is natural, because advisors are typically selected (and replaced) by the management team themselves. Their function is to provide advice on specific issues to said management team, but not to make actual decisions for a corporation like directors do. This relationship typically allows for information to flow much more freely and openly between advisors and managers, certainly in comparison to a board director and CEO relationship. Remember, advisors are not legally bound by the advice they give. Subsequently, you will find your discussions with your advisors are more frank and open than those with your formal directors.

It’s important to note that you may want to bring a certain individual onto your board of directors, but that individual may be legally prohibited from doing so. It’s not uncommon for senior executives from both large corporations and startups to not be able to assume formal director positions in companies other than their own. If this is the case, and you really want to get this person engaged and adding value to your company, think about bringing them on as an advisor. Usually, the rules around these individuals becoming informal advisors to your company are much less stringent.

In an early-stage company, you will typically not be paying cash compensation to advisors or directors. In fact, you should run, not walk, away from anyone who asks for precious cash from your company in exchange for a director or advisor position. These people just don’t get the game we are playing here. A game of longball. A game of being involved with a world-changing company for the intrinsic satisfaction of making a difference and having some equity upside as sole compensation.

board of advisors

In terms of compensation for out-of-pocket travel expenses for attending meetings, the company should pick up the tab for these on behalf of directors and advisors. In fact, in the case of directors, this is typically spelled out in legal terms. You should also extend this courtesy to your advisors if you do decide to hold formal meetings. Of course, you want directors and advisors to understand that expenses are to be within reason. Typically, you should just extend the expense rules you have for your management team’s reimbursement of travel expenses to your board’s travel policy. Good directors and advisors will understand that this sets a good example and precedence for the organization, as a whole.

Equity compensation is the primary lever you have to keep both your directors and advisors engaged and incentivized over time. Typically, equity compensation will come out of the ESOP of the company, so be sure to anticipate how much you will need for both your board of directors and various advisors. In terms of what is market, directors typically receive in the range of 0.25 percent to 1 percent of a company for serving on a board.

It’s important to note that you are typically only issuing equity to independent directors, and not directors that are appointed based on the fact that they are investors, founders, or the CEO of a company. These individuals are incentivized by their existing equity position in your company. Advisors will typically receive on the lower end of this range, and, sometimes be below 0.25 percent.

Make any cash or additional equity payouts based heavily on actual performance.

Just as you would with your general company ESOP, outline a vesting schedule for both directors and advisors. This protects the equity in your company, in case that you need to terminate your relationship with an independent director or an advisor. You may just adopt the vesting schedule you currently have in your ESOP (typically four-year vesting with a one-year “cliff”).

However, the most important thing to keep in mind is to match the vesting schedule to the anticipated term that each individual director or advisor will be engaged with your company, in their respective capacities. Typically, there is four-year vesting for directors. For advisors, you may feel the need to bring in different individuals to help you with different issues over time more often, and, subsequently, a shorter vesting schedule, around two years, might be more appropriate.

Generally, you should aim to incentivize all of your advisors at a similar level. Lay out a compensation policy with the help of your lead VC or a mentor, giving a certain band of equity that you are willing to give each advisor or director, and stick to this over time.

That being said, bringing on advisors, especially, is a case-by-case situation. You may feel the need to go above and beyond this band for certain individuals. Furthermore, there may be a situation where an advisor might be able to add specific operational value to your company, be that in a technical hands-on or sales-related matter. In these cases, you are better off formalizing a side consulting agreement with this advisor.

Again, you should minimize the need for any cash outlay for this advisor to perform the duties you want them to. Make any cash or additional equity payouts based heavily on actual performance. Performance could be defined as a commission paid for each customer introduced and closed by the advisor, or a small additional equity grant for the procurement of a named OEM partner.

A final point on compensation and incentive mechanisms. I have consistently seen the CEOs I have worked with have good success getting advisors to become actual investors in a company. This typically happens as a natural extension of a growing relationship between a CEO and an advisor over time. An advisor becomes so enthralled and excited about the prospects of a company over time, that they want to own more of the company. This is a typically a good thing and gets your advisor to become even more incentivized. Advisors are usually successful and accomplished people that have the means to invest cash in early-stage companies. Take advantage of this, if you have the right opportunity.

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Roger Chabra

Roger Chabra

Roger Chabra is a General Partner at Rho Canada Ventures, an early stage Venture Capital investment firm, based in Montreal. You can follow Roger on Twitter at @rchabra.