In this article, Anubhav Kumar Pandey explains the common problem in hiring an advisor in exchange for equity or money. 

Understanding equity

Let us understand equity by reviewing our environmental classes lessons which we all learnt at school. Steps required to grow a plant!

• First, you sow the seed.
• Second, you keep watering it on a daily basis.
• Third, you wait for some time with patience.
• Fourth, with due respect to time, you will get the fruits of the efforts you made.

The same concept applies to equity too. It is an ownership in the business. If you own 200 shares of company X which has a total of 1000 share in public domain. You are 20% owner of company X.

Equity advisory

To an alternative to borrowing money, a company can raise capital by selling equity. As an equity advisory, a person or a firm gives independent financial advice to companies issuing equity via the market. Advisors, who are mostly veterans in their field advise start-up companies and in return takes a certain share of the equity of the company. The work of an advisor involves, advising, bringing funds, providing solutions to the problems the company is facing. This is equity advisory.

What does equity advisor do

Good equity advisors have great network, reputation, and skills required to boost the growth of any company. Having an advisor in exchange for equity or money has its own pros and cons. Bringing funds, hiring a person, solving issues are few of the jobs which an advisor does.

How much equity to give and what kind of equity is it

Incentives are a crucial part of doing any business. It is a tricky part when it comes to dividing the equity between the founders, team members, directors, investors and advisors. Diving equity poses a challenge to the founder. Typically a start-up allocates 1/10%  – ½% of equity for the advisors vested (explained below) for 3 or 4 years. Keeping the grant small is the key. 

Pic courtesy https://www.linkedin.com/pulse/how-divide-equity-among-startup-founders-investors-advisors-kazanas

There are various models too which are helpful in dividing the equity in a company. One such model is Slicing pie model.

Different kinds of equity available are as follows.

Sweat equity

These equities are issued to exceptional employees or directors or officers for performing considerably well and adding to the Intellectual Property Rights of the company in any form. Sweat equity is governed by section 54 of the Companies Act 2013. Sweat Equity is a grant of shares at discount or without monetary considerations. A company can only issue sweat equity if it fulfils the following conditions.

• The issue is authorised by a special resolution passed by the company.
• The resolution specifies the number of shares, the current market price, consideration if any, and the class or classes of directors or employees to whom such equity shares are to be issued;
• Not less than one year has, at the date of such issue, elapsed since the date on which the company had commenced business; and
• Where the equity shares of the company are listed on a recognised stock exchange, the sweat equity shares are issued in accordance with the regulations made by the Securities and Exchange Board in this behalf and if they are not so listed, the sweat equity shares are issued in accordance with such rules as may be prescribed.

Employee stock ownership plan (ESOP)

ESOP is a grant of an option to purchase shares at a predetermined price given to employees. It is in the form of incentive and can be issued only to employees and officers. It is a form of remuneration given to employees. ESOPs can be in the form of Stock Option Plans, Phantom Equity Plans and Stock Purchase. Different companies have their different eligibility criteria for ESOP schemes but there is statutory condition which needs to be followed.

• An employee who is a promoter or belongs to the promoter group shall not be eligible to participate in the ESOP.
• A director who either himself or through his relative or through anybody corporate, directly or indirectly, holds more than 10% of the outstanding equity shares of the company shall not be eligible for ESOP.

Should equity be vested or should it be given on a DRIP basis

There are two things.

• First, vesting the equity which means, at the very beginning each founder gets his or her full package of stocks at once but, the company has the right to purchase a percentage of the founder’s equity in case he or she walks away. It is an observed practice for companies in India to vest equity for a time period of 3 years (36 months). The longer you stay, the larger percentage of your equity will be vested until you become fully vested in the 36th month.
• Second, DRIP or dividend reinvestment plan. This is a long term prospect. A dividend reinvestment plan (DRIP) is a method through which existing shareholders can reinvest their dividends to purchase additional shares of the company.
• Out of these two, vesting is considered as your best friend. Let us understand this by narrating a simple story. A and B start a company and divide equity among them on a 50-50 basis. After working for a complete year, B decides to walk out and do work on his own. Now, in this situation A will be obliged to give 50% of the company’s stake to B. But if the equity would have been vested, the situation would have been completely different.

How to structure the performance standard of an advisor

In the practical arena, it is very hard to find advisors who can continue to maintain their performance same for the whole time span of 3 or 4 years, whichever is in the advisory agreement. Therefore, it is advised by most veterans that, the advisory agreement should have the following structure, One year of NSO shares, monthly vesting, no cliff. (Cliffs basically allow you to “trial” a hire or partnership without an immediate equity commitment.)

Hiring an advisor in exchange of money

The technicalities are the same just in place of equity, the advisor will be facilitated with money either on a monthly term or in whichever manner their agreement facilitates it. Most advisors do not look for money as equity is what makes them rich. Equity gives you the power to own a part of the company. All the big billionaires in the world derive their wealth from the equities which they have in big companies.

Cash flow Vs equity. Cash might help you to receive a permanent flow for a short duration of the agreement, but equity helps to own partnership stake in a particular company.

Let us now move to common problems in hiring an advisor in exchange for equity or money

#1 What if advisor starts a competing company or advises competitors

• When founders and co-founders of a company look for an advisor, trust is an important factor which they look for. The company bestow trust upon the advisor and at the same time expects the same in return. But there are situations where your advisor might start a competing company or starts advising competitors. What to do in such situations?
• Solution to this problem is an advisor’s agreement. Time is one of the most important things which your advisor is giving to you and it is indeed valuable to your advisor too. Having a legal backup ready is valuable for both the advisors and the company founder too. It assures the advisor of the equity or whatever incentive is to be given to him. A proper legal framework must contain clauses which specifically mention that your advisor will not be involved with the same kind of business and they will not advise your competitors or share your business ideas with them.

#2 What if the advisor starts to leak your confidential papers and ideas

The solution to this problem is related to the first problem. There can be situations where your advisor might break some confidential obligations imposed upon him. The solution to this is to have a strong Confidentiality clause in your advisor’s agreement.

These are the following ways to have a strong confidential information clause in your advisor’s agreement.

Having a strong No conflicting obligations

It is recommended to have a strong ‘No conflicting obligations’ in the advisor’s agreement.

Having a strong proprietary information clause.

The clause may read as follows.

• During the term of this Agreement, Advisor may receive and otherwise be exposed to information regarding the patents, trade secrets, technology and business of the Company.  Advisor therefore agrees that all Proprietary Information, whether presently existing or developed in the future, whether or not patentable or registrable under copyright law, shall be the sole property of the Company and its assigns, and that the Company and its assigns shall be the sole owner of intellectual property and other rights in connection with such Proprietary Information.
• “Proprietary Information” includes, without limitation, any information created, discovered, developed, or otherwise known to the Company, all inventions, works of authorship, trade secrets, business plans, confidential knowledge, data or any other proprietary information of the Company and any information assigned or otherwise conveyed to the Company by another entity.
• To have a look at sample advisor’s agreement, click the following link.
• Further, having strong non-disclosure clause, no improper use clause is recommended.

#3 Deciding expenses and compensation

• It is for the company’s administrator to decide how to compensate the advisor. Should they be compensated with equity or money? In general advisor’s agreement contract contains a compensation clause which goes as follows.
• In consideration of the foregoing Services, the Company will grant Advisor, subject to approval of the Company’s Board of Directors (the “Board”), an option to purchase XXXX shares of the Company’s Common Stock at the fair market value of such stock as determined by the Board on the date of the grant.  The foregoing stock option shall provide that the shares subject to such options vest in equal monthly instalments over a period of four (4) years, provided that Advisor is still performing Services for the Company.

#4 What representations to take from the advisor

Fundraising – Capital is the biggest requirement for any business to grow. The founder and members of any company depend on their advisor when it comes to fundraising. One of the most important duties of any advisor advising a company is to advise them on places from where funds can be raised. Every company have different expectations from their advisors depending on the field of work of the company.

Here are few general representations to take from the advisor.

• Advising- As the name suggests, it is the responsibility of the advisor to advise the company on all matters. Even at times, advisors are expected to sort the matters relating to equity between the founder and co-founder.
• Product development– An advisor is expected to give ideas regarding the development of products, how to improve the quality of existing products or services.
• Recruiting– Advisors are involved in hiring members for company too.

#5 After taking equity advisors do not add much to value

Not all advisors are created equally. All those who are looking for an advisor need them as they add value to their business. Advisor tends to lose interest when the company’s performance is not on par with the expectations. When availability, desire and priorities of an advisor change, it is an indication that your advisor won’t add much to value to the company.

How to tackle such situations? What to do when, after taking equity advisors do not add much to value to the company?

First, try to talk it out. Try to resolve the difference between a company and the advisor as the relation between an entrepreneur and his advisor depends upon trust. If things do not work out, the only solution left is, terminating the advisor’s agreement.

Under what circumstances can the advisor’s agreement be terminated and what are its consequences

An advisor’s agreement may get terminated on the account of any reasonable reason such as,

• When the advisor starts a competing company or give advice to a competitor
• When the advisor breaks the confidentiality clause.
• When the advisor is not adding much to value to the company.

A time limit to terminate the agreement between company and advisor exists, which generally is of 3 years. This time period is subject to certain conditions such as,

• With the mutual consent of both advisor and company, the agreement can be extended for a period of 1 year (preferably).
• Both, the advisor as well as the company is free to terminate the agreement at will subject to a notice of 30 days prior to termination.

Consequences of termination of an advisor’s agreement

• Each party shall be released from all obligations and liabilities to the other.
• But such relief shall not release the advisor from the duty of keeping the intellectual properties of the company a secret.
• The advisor shall promptly deliver to the company all documents and other materials of any nature in advisor’s possession pertaining to the services, together with all documents and other items containing or pertaining to any Proprietary Information.
• Share in equity will depend upon the nature of the contract between company and advisor. If the nature of equity is vested consequences will be as explained above in the section of vested equity.

When and how the advisor will leave the company

The advisor will take an exit when the advisor’s agreement will come to a conclusion. As specified in the agreement, the advisor will take an exit with his allotted equity or money at the fulfilment of the time period mentioned in the agreement. If there is a mutual consensus between the advisor and the company, the agreement might get extended for a further duration of time. The advisor may also take an exit when he does not conform to the agreement clauses of the agreement.

This was all about the common problems in hiring an advisor in exchange for equity or money. Do comment and share with your friends and family.