Offer stock options based on engagement, responsibilities & company stage
As a mentor or advisor to many early-stage startups, I’m often asked, “How much am I supposed to pay you?”
I’m glad you asked since most startups assume I’m happy to spend all my time helping them for free. And the truth is, for occasional advice and guidance, I don’t expect compensation beyond the satisfaction of seeing a startup moving in the right direction. So please stroke my ego every once in a while and make me feel like a hero. Let me know you’re using my advice, so I feel like my time is well-spent. I know I’m right (even when I’m not), but it’s heartening to see my advice making a difference.
However, at some point, the occasional phone call becomes a weekly zoom, and general guidance turns into a substantial commitment reaching out to potential customers, rewriting pitch decks or rethinking the company’s strategy.
While I’m honored you consider me a trusted advisor and want me to be a core member of the team, it’s starting to feel like work. And let’s be honest — your goal is to make a billion dollars, and you’re asking my help to do it.
Prior to Series A funding, the company has little cash and very few employees, and the founders have to make critical strategic decisions that will make or break the company. A few insights from people who’ve been there and done that can help you navigate the market or understand how to bring in investors can be invaluable to getting off the ground and avoiding preventable mistakes.
I don’t think anyone disputes that key advisors should be compensated. The only questions are how much and how to structure it?
Conventional wisdom, reinforced by anecdotal evidence from my own experience, together with online sources and an informal survey on my alumni mailing list (in other words, based on a collection of random opinions), conclude that advisor compensation is typically in the range of 0.25% to 1% of equity.
Within that range, the exact amount varies by company stage, the amount of engagement expected, and the value of the contribution.
The Founder’s Institute has a nice template for advisor services that they call the FAST agreement (Founder Advisor Standard Template) that can be downloaded at https://fi.co/fast. Unless your lawyers have their own template, I recommend using this FAST agreement as simple and effective. (Cooley Go also offers a more generic advisor agreement at https://www.cooleygo.com/documents/form-advisor-agreement/)
The FAST agreement includes a simple 3 x 3 matrix of equity grants based on stage (idea, startup, growth) and engagement level (standard, strategic, expert). It defines engagement levels by expected time commitment per month and types of services to be provided.
Note that the FAST is an agreement for services, similar to a consulting contract. It sets the conditions, commitments, and compensation to be received. However, it does not provide the actual compensation. The advisor agreement needs to be combined with an options agreement that provides the actual options grant.
While I recommend the FAST agreement, the listed equity compensation seems low. Therefore, I would double the values listed in the template.
For example, the FAST recommends an equity grant of 0.6% for an advisor with deep experience acting essentially as a quarter-time employee (expert level) in a seed-stage startup. This is far too low. 1.0% to 1.25% seems more appropriate for this high level of engagement by an experienced executive.
Another Method to Calculate Compensation
One trick I use to calculate a fair equity compensation is to translate everything into dollars. If you hired the advisor as a consultant for real money, how much would you expect to pay?
Let’s say the advisor would make $250K per year in a regular corporate job. You expect her to commit to 5 hours per week working with you. Let’s call that 1/10 of a full-time job or $25K per year. At a company valuation of $5M, that’s 0.5% equity.
If the role is expected to last 1 year, the compensation would be 0.5%. If 2 years, then 1.0%.
Vest the stock options over the same time period so that if she doesn’t provide the value you expect, you can end the relationship and cancel the unvested shares.
As discussed below, the advisor will be getting stock options that at the current valuation are worth exactly $0. So this technique isn’t the same as writing a check. Nevertheless, I find it gives a reasonable estimate for the amount of equity to pay with a good justification beyond just referring to this article or the FAST agreement.
This method also makes it easy to account for the expected time commitment and value to be provided (hourly rate x number of hours) as well as the company stage (current valuation).
Legal & Tax Complications
Advisors have to be granted stock options, not stock. Here’s why: if you give me stock, the IRS considers that to be the same as getting cash. Which means I have to pay income tax on it.
If your company is valued at $10 million and you give me 1% of the stock, from a tax perspective, it’s identical to writing me a check for $100,000. Thank you very much.
But between Federal income tax rate of 35% or so, and a California income tax rate of around 12%, I now have to write a check to the government for $47,000. Plus self-employment taxes of around $15,000.
Although I can deduct the stock as a loss if the company ultimately fails, I don’t want to pay $62,000 in tax now to be an advisor to your company. So please don’t give me stock.
Next critical detail: the exercise price of the stock options has to be the current valuation of the company. The exercise price is the amount I have to pay to purchase the stock from the company.
While I appreciate your generosity in offering me 10,000 options for a total of $1, that creates the same problem with the tax man as giving me stock. If the options have a value of $100,000 and they only cost me $1, then it’s the same as getting a check for $99,999.
If the options have a current value of $100,000, then the options exercise price has to be $100,000. For tax purposes, I’ve received no income.
However, if the company does well, those options will be worth millions in the future. When the company is acquired or goes public, I’ll pay the $100,000 to purchase the stock from the company and sell them immediately to reap the difference.
But this means it’s critical to issue the options as soon as the advisor joins the team to take advantage of the lowest valuation possible.
It can be tempting to wait to handle the options paperwork until a convenient time later and backdate it to when the advisor joined the team. However, this is something the SEC and IRS looks at closely, and people have actually gone to jail for backdating stock options. So get the stock options issued immediately.
Disclaimer: I’m not a lawyer. I’m not an accountant. I’m not a tax expert or valuation specialist. This is free advice from a random person online. You get what you pay for.