Several clients have reached out to our team at Intellectual Strategies recently to help them engage advisors for their startups. Here are some of the basics you’ll want to know as you start to put together a board of advisors for your early-stage business.
First of all, you need to understand the difference between “advisors” and “directors” for your company.
Directors of a company fill a formal role and have certain authority to make decisions for the company. If you’re taking money from investors, your investors might require that you put them on your board of directors so they have official positions to make official decisions for the business. This can include things like replacing the executives, approving annual budget and other large expenditures, and similarly important decisions.
If you’re just getting started and looking for some friendly advice, you’re looking for an advisor, instead of a director. Advisors don’t have the same authority as directors, which they can’t officially make decisions for the business. This also means they don’t have the same potential liability, or risk exposure, for making bad decisions.
Startups often find advisors to help them fill one of the following functions:
• Bring technical or business skills to fill a gap in the startup team
• Provide domain expertise to help with strategy, industry networking, and regulatory affairs
• Act as a mentor for the executive team
Startups should find advisors to fill specific roles within their business. This can be like hiring a key employee, except the advisor’s time dedicated to the company is usually much more limited, both in the amount of time dedicated to working for the company and the duration of time the engagement will last with the advisor.
You might pay your advisors a little cash to cover nominal meeting costs. However, most advisors will be open to accepting “advisory shares” in the company. “Advisory shares” are simply a form of equity you grant to the advisor in exchange for their time and expertise.
So what type of advisory shares can you issue to an advisor?
There are typically two types of advisory shares you might grant to advisors:
• Restricted Stock Awards (RSAs)
• Stock Options
RSAs are actual stock you grant, but it is subject to vesting so it can be pulled back by the company if the vesting conditions aren’t met. A person who is granted RSAs acts like a typical shareholder of the company, with voting rights and such, as long as they hold the RSAs. Until the RSAs are vested, the company might repurchase the shares from the shareholder. But once the RSAs vest, they can’t be repurchased by the company under typical RSA conditions.
Stock Options are not actual stock, but rather a contractual right to buy stock at a future time at a predetermined price (called the “strike price” or the “exercise price”). A person who holds stock options does not have the right to participate as a shareholder in the company, until the options vest AND the person exercises the options by paying the strike price.
There are lots of tax consequences tied to granting RSAs and stock options because these are different forms of compensation from the company to the advisor. The amount and timing of tax liabilities can vary substantially on a lot of factors.
In general, RSAs have lower tax consequences early on when a company’s valuation and stock price is low. These are typically used for founders and sometimes used for advisors.
Stock options have different consequences because the timing of the stock ownership is different than RSAs. Plus, a person much purchase the stock by paying the strike price, so the amount of compensation is typically different than RSAs.
It’s important to note the tax liabilities for stock subject to vesting for any individual advisor or shareholder also depends on whether they elect a specific tax treatment with the IRS. This is typically done with an “83(b) election” that is filed with the IRS by the individual (or, perhaps, coordinated by the company on behalf of the individual).
Here are a few more things to consider when it comes to vesting equity compensation:
• You should award an amount of equity that is commensurate with the role of the advisor. Lots of advisory share grants are in the range of 0.10 – 1.0%, with most of them between 0.25 – 0.5% of the total company shares.
• Vesting can happen on different schedules. While employees typically vest over four years, advisors often vest over 1-3 years, with most of them vesting over 2 years. Consider the duration you expect to use each advisor, as well as any probationary trial period and/or milestones that might be relevant to vesting.
• Stock options typically are granted as either Incentive Stock Options (ISOs) or Non-qualified Stock Options (NSOs). ISOs have tax advantages, but they can only be issued to W2 employees. NSOs are common for grants of advisory shares when the advisor is considered a 1099 independent contractor.
Like most legal matters, the grant of advisory shares is heavy with corporate governance and paperwork.
RSAs and stock options must be granted under the company’s Incentive Stock Plan. Also, each type of grant can have several documents associated with it. For example, in order to grant stock options, you’ll need to prepare each of the following documents:
• A stock option grant form
• A stock option agreement
• A stock option exercise form
• A stock purchase agreement
• A stock repurchase agreement or provisional assignment
• An 83(b) election form
While it’s important to have the correct corporate documents in place (and all the necessary director/shareholder approvals), fortunately the actual grant of advisory shares can be relatively simple.
Some companies opt to grant advisory shares using a simple advisor letter. The letter outlines the basic terms of the agreement between the company and the advisor. At a minimum, the letter should explain the advisor’s expected role and involvement, term of the engagement, compensation, confidentiality, independent contractor status, and avoidance of conflicts of interest.
Ideally, the company will provide the advisor with a formal advisor agreement, in addition to the cover letter outlining the basic terms of the engagement. The advisor agreement is helpful to specify more detailed terms of the engagement. It is simply the legal contract version of the advisor letter.
Getting your startup set up for advisors can take some work, as you can see. If you’re not ready to create advisor roles and all the structure you should have in place for advisors, consider whether it’s simpler to find an uncompensated mentor or hire a consultant as an independent contractor you can pay in cash, instead of equity.
When you’re ready to bring on advisors, Book a Free Strategy Call so we can guide you through the best process.
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