This article is written by Parth Ranade, a student at the Indian Law Society’s Law College who is pursuing a Diploma in Advanced Contract Drafting, Negotiation and Dispute Resolution from LawSikho.
Table of Contents
Introduction
Start-ups are the very embodiment of dreams and ambitions. They are founded with the purpose of achieving great things. Most start-ups, however, are floated by fledgling entrepreneurs. While they may possess amazing ideas, they can often make use of someone who possesses crucial specialized knowledge of their field, marketing acumen, or even just someone well connected. This role is fulfilled by persons known as “advisors”. The agreement entered into between a start-up and an advisor to memorialize the terms of their relationship is known as an “advisor’s agreement”.
Meaning
Advisors
An advisor assists start-ups in facing and overcoming the pitfalls in their way. Their aid may be in the form of strategy, fundraising, introductions, etc. To compensate them for their services, they are offered equity in the start-up.
The presence of an advisor aids the start-up in achieving its goals, as well as avoid common pitfalls. They help navigate the start-up through difficult decisions, introduce it to important persons, and may even bring in new talent.
Different from consultants
Start-ups employ consultants to apply their expertise to a specific task. Once the task is successfully performed, the agreement with the consultant comes to an end.
In contrast, the advisor’s role is to use his experience, know-how and connections to generate long-term value for the start-up. Moreover, consultants are generally remunerated with cash, whereas advisors may be compensated by cash, equity or a mix of both.
Types of Advisors
One might consider two distinct kinds of advisors:
- Advisors who are well-connected in the tech circles and the venture capitalist circles: they can acquaint you to the venture capitalists, bloggers and help with the start-up side of your business;
- People who are experts in your domain: those will help you in your business, with the marketing, sales, introduce to your customers and partners.
What is an Advisory Agreement?
It is a formal agreement which lays down the tenets governing the relationship between the advisor and a start-up. It lays out the terms and conditions for which services are to be performed, and the compensation in consideration thereof. An advisor could be considered as a type of independent contractor who is considered to be more specific and technical in their services.
While approaching a potential advisor, it is important to discuss the following essentials:
- What you can and cannot expect from one another?
- The scope of the advisory?
- The remuneration or other consideration for the services/advice?
- The methods and frequency of the communication between the parties?
- What would happen if the relationship fell apart?
The agreement should be composed such that it keeps everyone focused on reaching defined goals and prevents risks that payments could be missed or inaccurate advice could be given. This article shall now discuss how to tackle the essential clauses found in a typical advisor’s agreement.
Parties
The parties to the agreement shall be:
- The advisor; and
- The start-up/company.
The Promoter of the start-up may also be made a party to the agreement. The reason for doing so shall be explored under a further heading.
Services
An advisor is engaged by a start-up to provide advisory services. The parties should make sure that the scope of the services, and the manner of which they are fulfilled, are well detailed in the Agreement.
Some of the ways in which advisors can contribute to the growth of a start-up are:
- By providing advice about the matters which have been mutually agreed upon by the parties.
- By making a financial contribution to the capital of the company by investing in its shares.
- By making introductions to venture capitalists, potential employees, other start-ups etc.
- Having a reputed person as an advisor to your business can also lend significant social proof- this can be extremely useful for the start-up in achieving a favourable impression with important third parties
It is also imperative to discuss the frequency of communication and participation of the advisor. Some advisors may be able to participate in most of the start-up’s decisions, while others may be able to dedicate only one day of the month to it.
Compensation
While drafting an advisor’s agreement, deciding on the amount and method of compensation is extremely important. An underpaid advisor would cause a wasteful drain of a start-up’s oft-scarce coffers, while an underpaid advisor does not have much incentive to contribute to the growth of the start-up.
An advisor is generally compensated for his contributions in the two ways:
- Fixed cash compensation; and
- Stock options: a right to purchase equity in the start-up at a pre-determined price.
A start-up which does not want to spread its ownership thin may choose to compensate its advisors in the form of a fixed sum.
However, most start-ups do not have the luxury of possessing stable cash flows. Opting to compensate via stock options might be a better choice in such circumstances. This method has the added advantage of incentivizing the advisor to care about the long-term growth of the company, since in this case their compensation would increase exponentially.
It is also possible to contemplate a compensation scheme which incorporates both the afore-mentioned methods. Thus, parties can customize this clause to suit their needs the best.
What percent of equity is given to advisors?
Generally speaking, individual advisors may get anywhere from 0.25% to 1% of the company’s equity. The exact figure may depend on how much the advisor contributes to the company’s growth. It may be proportionate to the frequency of communication by the advisor, and the stage of growth of the company.
Ensuring compliance with regulations
Sweat equity shares are such equity shares as are issued by a company to its directors or employees at a discount or for consideration, other than cash, for providing their know-how or making available rights in the nature of intellectual property rights or value additions, by whatever name called.
Normally, the Companies (Share Capital and Debentures) Rules, 2014 governs and regulates the issuance of shares to directors and employees as compensation for intangible benefits such as technical skills and expert advice.
As per the provisions of the Companies Act, 2013 and the Companies (Share Capital and Debentures) Rules, 2014, sweat equity can only be given to employees, directors or promoters. They are issued at a discounted price.
In most cases, an advisor would not have the relationship of either “director” or an “employee” towards the start-up. As sweat equity can only be issued as per the said Rules, it is recommended for the start-up to issue the shares to the advisor at face value (or slightly more than it) to escape the aforementioned regulations.
The process of issuance of shares are price-regulated. If the advisor is not paying face value of shares to company and is instead providing services, then you are measuring the value of the service to the value of the share. The same is regulated.
However, the transfer of shares between two persons is not regulated. Thus, the promoter can be made party to the advisor’s agreement, and thus transfer his own shares to avoid the aforementioned hassles.
How is issuing stock to an advisor carried out?
For a private limited company, the Board of Directors can issue shares to any person (unless this power is restricted by the articles of association of the company).
Thus, the steps a start-up has to take for issuing shares to an advisor are:
- Pass a special board resolution in a general meeting for the purpose of issuing shares to the advisor.
- Make delivery of the share certificate to the advisor.
- Make an entry in the company’s register of members which denotes the advisor as the owner of the shares issued to him.
Timeline of vesting of shares
Instead of issuing all the shares to the advisor at once, it is recommended to construct the compensation clause such that the shares vest with the advisor over a predetermined time period. For example, a 1.2% shareholding can vest over a period of 18 months, with 0.4% shares being issued every six months.
One can also make the vesting of shares reliant on attainment of predetermined milestones by the start-up owing to the assistance of the advisor. This incentivizes advisors to keep adding value to the start-up and maintain the quality of the services provided by them.
Dilution of shares of advisor
As the start-up raises additional capital by way of shares, the equity of the advisor is likely to get diluted (along with other shareholders). Thus, when the vesting is to take place over a period of time, it is essential to determine the date from which the percentage of equity is to be calculated. If the agreement calculates anew the number of shares every time shares are issued to the advisor, he shall gain additional shares with subsequent issues (the reason being- the capital of the company increases).
Term and Termination of the Agreement
Meaning of term
It means the duration for which the agreement will function. The date from which the agreement comes into operation is known as the “commencement date”. Similarly, the date from which the agreement ceases operation is known as the “date of expiry”.
An advisory agreement generally ranges from two to three years. Parties may also elect for a shorter term, and keep the option to renew the agreement subject to the assent of both the parties.
Meaning of termination
A start-up should be prompt to terminate an advisor who is not adding any value to it. It is common business practice to include a notice period within the agreement.
In case of premature termination of the agreement, a stipulation should be included which forfeits the right of the advisor to the shares yet to be vested.
Expenses
The advisor may incur expenses while discharging his obligations under the agreement (e.g., for travelling).
The parties may negotiate a stipulation to the order that the start-up shall reimburse such expenses incurred by the advisor in discharge of his duties under the agreement. Such reimbursement may cover the whole or part of the expenses incurred.
Confidentiality, Non-disclosure and Non-Compete
An advisor is likely to be intimately familiar with the inner workings of the start-up, as well as its intellectual property. It is essential that the start-up protect such sensitive information from falling into the hands of its competitors.
To ensure the same, it is recommended for start-ups to include the following clauses into the agreement:
- Non-compete clause: a one-way agreement that’s designed to prevent a business from unfair competition from a former employee or contractor; and
- Non-disclosure clause: a mutual agreement that’s designed to protect private and confidential information from being disclosed to competitors and the public-at-large.
The start-up must define what constitutes ‘confidential information’ for the purpose of the agreement. It can be intellectual property, marketing strategies, written documents, electronic records etc. The agreement should clearly state that the advisor has access to such confidential information only to enable him to discharge his functions as per the agreement, and may not use it for any other purposes.
In addition to the above, it further needs to be stipulated that the advisor has no rights to any of the intellectual property of the company. The advisor is bound to protect the secrets of the company to the best of his abilities. When the agreement between the parties comes to an end, the advisor is to return all records inscribed with these secrets back to the start-up.
Dispute Resolution
Disputes are unavoidable in any commercial venture, and proactive steps should be taken to resolve the same in the advisor’s agreement. It is recommended that the parties opt for a multi-tiered dispute resolution clause. An example of one would be that in case of a dispute:
- Parties shall first attempt to resolve the same amongst themselves through discussion.
- In case of failure of the above method, parties shall resort to mediation to resolve the dispute.
- In case of failure of both the above methods, the parties shall mandatorily resort to arbitration.
Conclusion
A start-up can greatly benefit by engaging an advisor to help guide its growth. The tenets of this advisory relationship are governed by an advisory agreement. However, handing over equity is no small thing, and therefore it is important to select an advisor that adds value to the start-up. Hopefully, this article has achieved its goal of shedding some light on the process of drafting such an agreement.
Students of Lawsikho courses regularly produce writing assignments and work on practical exercises as a part of their coursework and develop themselves in real-life practical skill.
LawSikho has created a telegram group for exchanging legal knowledge, referrals and various opportunities. You can click on this link and join:
