Welcome to a BetaKit weekly series designed to help startups and entrepreneurs. Each week, investors tackle the tough questions facing founders today. Have a question you would like answered? Tweet them with the #askaninvestor hashtag, or email them here.
Perceptive readers of Ask An Investor will know that we’ve previously discussed advisors on a number of different occasions, including establishing that as VCs, we generally don’t care about your advisory board as well as a more in-depth view of the difference between boards and advisory boards.
In both articles, we point out that there is real value in surrounding yourself with great advisors (just don’t oversell this to investors!). After all, good advisors will help you navigate bumps in the roads that they’ve faced before. However, building a win-win relationship with an advisor isn’t always straightforward. After all, people, as a rule, do precisely what they are incentivized to do. Warped incentives, in turn, produce suboptimal results.
There are a number of approaches to aligning interests, but by far the most useful is equity. However, there are a number of different and valid approaches to assigning and aligning advisor equity interest in your company.
Approach 1: Only accept advisors from your pool of investors
Approach 1b: Insist that potential advisors invest in the company to become an advisor
The advantage of this approach is you don’t need to negotiate a performance plan: they win if you win. They lose if you lose. All things being equal, having advisors who are also investors is highly desirable. I’m not just saying this, we live this very advice: advisors of Impression Ventures are also investors.
Another advantage of this approach is you keep your employee stock option pool (ESOP) entirely focused on employees. Venture capitalists like that (or rather, we don’t like diluted ESOPs, more on this below).
However, this approach has a significant downside: the Venn diagram of experienced talent and accredited investor is small. Without mincing words, the intersection of those two pools is mostly male and white. This approach, therefore, has an inherent downside if you are looking to bring a diversity of thinking and approach to your company from your advisors, which I highly encourage. It can be partially or entirely be overcome with hard work on your part to ensure diversity in your investor pool.
Approach 2: Grant your advisors equity
Generally, on a per advisor basis, this will be between 10 bps to a max 50 bps for very early companies. Grants are almost always made from the ESOP. Very rarely, companies will grant common shares to advisors. I strongly discourage this practice. Stick with options.
The advantage of this approach is that you can broaden your potential advisor pool as much as possible. The downside of this approach is it comes with two significant risks. The first is that if you don’t establish the right incentives, you may create a misalignment of interests: if you win, they win. If you lose they don’t lose anything. The end result is typically an underperforming advisor. Setting performance expectations and establishing outcomes based equity grants is critical.
Always be sure to bring advisors who share your values and ethics. If you don’t know what they are, do your homework!
The second issue is granting out of the ESOP. One or two advisor grants out of the ESOP isn’t an issue. However, as the number of advisors grow, the equity available for employees in the ESOP will increasingly diminish. If you are too free with advisor grants, at some point you will end up with a broken cap table, as it will be out of alignment with accepted equity allocation norms. As you’ll recall, a broken cap table is a great excuse for a VC to walk away from your company.
It would be a shame if your desire to surround yourself with great people kills your opportunity to raise capital. Be careful!
Approach 3: Don’t require or give any equity stake to advisors
Sometimes a friend is happy and willing to help out, no compensation required. It happens, and it’s great!
In this arrangement, neither party is taking any real risk except perhaps reputation. There should be no surprise that a rewarding outcome for either party is not at all guaranteed. The reputational risk comes in when one party to the relationships doesn’t check the background, reputation, and legitimacy of the other party. Example: Secretary Kissinger on Theranos’ board. That didn’t work out well for him.
While likely the most common advisor arrangement, I discourage this approach. The time and energy involved in marshalling uncompensated advisors isn’t worth it. As a busy founder, it’s not a good use of your time.
With all approaches, always be sure to bring advisors who share your values and ethics. If you don’t know what they are, do your homework! It won’t help you bring in customers or investors if someone with a checkered past is listed as a trusted advisor!
Advising is both a valuable resource for startups and a rewarding experience for senior talent. Getting the incentives dialled in just right is an excellent starting point for a great mutually beneficial relationship.
Christian has a great overview of the choices at your disposal, but my rule of thumb is a bit simpler.
What are your advisors getting out of the experience? If your advisor brings excellent industry insights and credibility during sales cycles, but has been looking to boost their own profile and gain credibility as an innovator, they’re likely willing to advise for free.
If you’re paying them for their service, granting them options as well is overkill (this is most common with CEO coaches). If they’re a respected industry titan that has five other CEOs approaching them to join as an advisor, give them some equity. It’s much more important to negotiate expectations for your advisors’ time and network than it is to argue for 0.1 percent to 0.5 percent of a company (this is the right range though, don’t go higher unless Sheryl Sandberg herself is in the running).
Got a question for the investors? Email them here.
Photo via Burst