Advisory shares are a type of stock option given to company advisors rather than employees. They may be issued to startup company advisors in lieu of cash compensation. Advisors to the company are usually granted options to buy shares rather than given the actual shares. Advisory shares can help ensure confidentiality while preventing conflicts of interest. However, they can also prove costly for a young company. A financial advisor can help you answer questions about advisory shares and other financial concepts for your needs and goals.
What Are Advisory Shares?
Advisory shares, also known as advisor shares, are typically financial rewards in the form of stock options. Recipients of advisory shares are usually businesspeople with previous experience as company founders or senior executives. They exchange their insight and contacts for equity in a young company.
These advisors are different from accountants and attorneys. Those professionals are likely to be paid a fee for their services. Advisors who might get advisory shares won’t likely be expected to give companies technical guidance on taxes or contracts. Rather, they will be expected to supply strategic insights and access to networks of contacts.
Advisory Shares vs. Equity
Advisory shares and equity both represent ownership interests in a company but serve different purposes and come with distinct rights. Advisory shares are typically granted to advisors or mentors in exchange for their strategic guidance, industry connections or expertise. These shares are often structured as stock options or restricted stock units (RSUs) and usually vest over time, similar to employee stock options. Unlike regular equity, advisory shares often have limited voting rights and do not always grant the same level of ownership control.
On the other hand, equity refers to actual ownership in a company, which founders, investors or employees can hold. Equity holders, especially common or preferred shareholders, generally have more substantial rights, including voting power and claims on profits through dividends or liquidation events. While advisory shares are a form of equity, they are typically used as a compensation tool for non-employee contributors rather than as a means of significant ownership or control in the company.
Types of Advisory Shares
Advisory shares can take different forms depending on how they are structured and issued. The most common types of advisory shares include stock options and restricted stock units. Here is what you need to know about each of those two types.
1. Restricted Stock Units (RSUs)
An RSU is a form of common stock that a company promises to deliver to an employee at a future date, depending on various vesting and performance conditions. RSUs are not received until these restrictions are over or conditions are met. An employer will promise to give an employee stock under certain conditions, such as meeting particular work goals or being at the company for a particular amount of time.
Taxes on RSUs apply when the shares are delivered – at the time of vesting. They require you to pay ordinary income tax on their market value when the shares are delivered to you (usually as soon as they vest), even if you do not sell them at that time. This includes federal, state and local taxes. Sometimes companies allow employees to sell a portion of the vested shares in order to cover the amount in taxes.
Following that, the employee can choose between holding the rest of the shares to sell later, or selling them right away. Selling the shares of course means paying any capital gains taxes on any appreciation, or increase in value between the selling price and the fair market value when the person vested.
2. Stock Options
This type of compensation, which is granted to employees, contractors, consultants and investors, is a contract. It gives the recipient the right to buy, or exercise, a set number of shares of the company stock at a preset price, also known as the grant price.
This offer doesn’t last forever, though. You have a set amount of time to exercise your options before they expire. Your employer might also require that you exercise your options within a period after leaving the company.
The number of options that a company will grant its employees varies, depending on the company. It will also depend on the seniority and special skills of the employee. Investors and other stakeholders have to sign off before any employee can receive stock options.
How Advisory Shares Work
Advisory shares function similarly to other equity instruments but come with distinct characteristics tailored to the advisory role. Here’s a closer look at their key features:
- Vesting schedules: Advisory shares are typically subject to a vesting schedule, which means that advisors earn their shares over some time. This aligns the advisor’s interests with the long-term success of the company. A common vesting period for advisory shares is between one to four years, often with a cliff period during which no shares vest until a specified duration has passed.
- Performance milestones: In some cases, advisory shares are tied to specific performance milestones. These milestones could include achieving certain business objectives, securing funding rounds, or reaching revenue targets. By linking shares to milestones, companies ensure that advisors remain motivated and focused on tangible outcomes that drive the business forward.
- Equity Dilution: Granting advisory shares inevitably results in equity dilution, meaning the percentage ownership of existing shareholders decreases. However, the trade-off is the potential value that advisors bring to the company through their expertise and networks. Companies must carefully balance the benefits of advisory shares against the impact of dilution on their overall equity structure.
Who Issues Advisory Shares?
Most companies that issue advisory shares are startups. The company may be little more than an idea at the time. The issuer also may be in the later seed capital stage or even later when it is an active, growing concern. Equity given to advisors can vary considerably. An advisor’s expertise and role can determine if they receive advisory shares. It could also depend on how long the advisor and company expect to work together.
Up to 5% of the company’s total equity could be given to advisors. Sometimes a young company will form an advisory board and allocate equity as an incentive for board members. 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.
For instance, an advisor who offers insight at monthly meetings might receive a smaller amount of 0.25%. An advisor who introduces a prospect that becomes a sizable customer could get 1% for this more concrete contribution.
The more mature the company is, the smaller the percentage of equity advisors can expect to receive. For instance, a company in the idea stage might give 0.25% of equity to an advisor who attends monthly meetings. A company that is a past startup and is in the growth stage could cut that to 0.15% for the same advisor.
Pros and Cons of Advisory Shares
Many startup businesses use advisory shares. They can attract experienced advisors during a crucial stage in a company’s development. However, they do have some potential drawbacks. Advisory shares can help protect a company’s confidentiality. Advisors are likely to see product development and marketing plans that businesses want to keep secret. For this reason, advisors may be asked to sign confidentiality and non-disclosure agreements.
Meanwhile, advisors may be working with several companies. Companies that issue advisory shares may not be able to restrict advisors from working with rival firms. They can find out in advance if advisors have pre-existing arrangements that could affect their ability to give impartial advice.
Young companies must also take care not to over-compensate advisors with advisory shares. Founders may find it easy to give away fractional percentages of equity in a young company with few assets. Those slices could get much larger as the company grows. This is one reason the equity given to individual advisors shrinks as the company ages.
Experts suggest companies considering using advisory shares take their time before offering equity in exchange for advice. Even experienced business leaders may not make good advisors. It is best to do some research before parting with equity. Some advisory share agreements call for a three-month trial period. During this time the deal can be terminated without any options being transferred to the advisor.
How to Create a Startup Advisor Agreement
Creating a startup advisor agreement is a crucial step for any new business seeking guidance from experienced professionals. This agreement outlines the terms and conditions under which an advisor will provide their expertise in exchange for advisory shares. It serves as a formal contract that protects both the startup and the advisor, ensuring clarity and mutual understanding. The agreement typically includes details such as the advisor’s role, the scope of their responsibilities, and the compensation structure, which often involves equity in the form of advisory shares.
The first step in drafting a startup advisor agreement is to clearly define the advisor’s role within the company. This involves specifying the areas where the advisor will contribute, such as strategic planning, marketing, or product development. It’s important to outline the expected time commitment and the nature of the advisor’s involvement, whether it’s attending regular meetings, providing feedback on business plans, or leveraging their network for business development.
Compensation is a key component of the startup advisor agreement, and it often involves granting advisory shares. These shares represent a portion of the company’s equity and serve as an incentive for the advisor to contribute to the startup’s success. The agreement should specify the number of shares or the percentage of equity being offered, as well as any vesting schedule.
Finally, the startup advisor agreement should outline the conditions under which the agreement can be terminated. This includes specifying the notice period required for termination and any circumstances that might lead to an immediate end to the agreement, such as a breach of contract or failure to meet agreed-upon responsibilities.
Bottom Line
Advisory shares can help young companies motivate savvy experts to help them on their growth path. They’re not appropriate for all companies or all advisors, but they can help founders tap valuable contacts and insight without letting go of scarce cash. Entrepreneurs who are willing to part with equity and exchange for advice should do some homework first. Cheap advice in the company’s planning stages can get quite expensive as a company grows. It’s easy to give away 1% of nothing, but much harder to part with 1% of a company with a multibillion-dollar market cap.
Business Planning Tips
- If you have questions about giving away advisory shares or other parts of your young company, a financial advisor could help you put a financial plan together for your business. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Don’t know how to buy a small business? Having trouble telling an S corp from an LLC? Looking for ways to make your business stand out? SmartAsset’s small business coverage can point the way to bigger things.
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