Navigating the world of startups can be challenging, especially when it comes to compensating your Board of Advisors. You want to reward them for their expertise and time, but cash might be tight. Advisory shares could be the solution you need.
They offer a way to compensate your board without draining your resources, while also aligning their interests with the success of your startup. Read on to understand how advisory shares work and how they can benefit your startup.
What Are Advisory Shares?
Advisory shares are a type of equity compensation provided to advisors in exchange for their expertise and contributions to a startup. They’re a powerful tool to secure guidance without upfront cash, effectively aligning advisors’ interests with the success of your business. Unlike salaried employees, advisors receive a small portion of company shares.
The equity share ensures advisors have a vested interest in the company’s growth, which can amplify their motivation to provide valuable insight and open up network opportunities. These shares are usually subject to vesting conditions, often over a period of 4 years, to ensure sustained contributions.
Note that legal documentation, such as an Advisor Agreement, is necessary to outline the terms of the relationship. It helps in defining roles, responsibilities, and the vesting schedule of advisory shares.
Who Issues The Advisory Shares
The responsibility of issuing advisory shares falls upon the company itself. These shares are a type of equity given to company advisors in exchange for their expert guidance.
Typically, a startup’s Board of Directors, following their established equity plan, will authorize the issuance of advisor shares. It’s important to note, the terms are carefully outlined in an advisory agreement.
This document sets the scope of the advisor’s role, their compensation (in advisory shares), exercise price, and vesting schedule, among other key details.
Forms Of Advisory Shares
Advisory Shares come in two forms: stock options (NSOs) and restricted stock.
- Stock options (NSOs) here, the advisory shares are granted in the form of stock options, rather than actual company shares. However, similar to a conventional option, an NSO grants the advisor the privilege (but not the obligation) to buy a specified quantity of the startup’s common shares at a predetermined exercise price. This exercise price is usually set at the startup’s fair market value or 409A valuation at the time of the advisor’s engagement.
- On the other hand, restricted stock is equity granted outright but subjected to certain conditions, often time-based vesting. They are actual shares of the company, and the advisor may receive dividends or voting rights, even before the shares fully vest. However, this depends on the exact terms of the agreement between the company and the advisor.
In both forms, advisory shares represent a non-cash method for startups to compensate advisors and consultants. These share types align advisors’ interests with the company’s success, providing a powerful incentive for their contribution to the company’s growth.
How Much Equity Should You Give To Advisors?
Determining the amount of equity to give to the advisory board is a strategic decision that depends on various factors. These include the advisor’s role, expertise, the stage of the company, and the expected duration of their advisory role.
An advisor may get more shares if they join when the startup is young and cash-poor. As the startup grows, acquires more capital, and has a clearer idea of its value, it might offer fewer shares to new advisors.
Typically, startups allocate a small portion of their equity for advisory shares. A common practice is to set aside an “advisor pool” that ranges from 1% to 5% of the company’s total equity. This pool is then divided among the advisors based on their contributions.
For individual advisors, the equity granted can vary significantly. A general guideline suggests that a typical advisor who contributes less than two days per month and is compensated only in equity might receive around 0.25% – 1% of the company’s equity. However, this can fluctuate based on the advisor’s impact and the company’s needs.
It’s important to note that equity given to advisors usually comes with a vesting schedule. This means that advisors earn their shares over time, which helps ensure they remain committed to providing value to the company.
With that all aside, let’s see the tax treatment of different stock options that a startup provides to its advisors, so you can get a better idea of which one is better when it comes to taxes.
Pros And Cons Of Advisory Shares
Advisory shares offer several advantages and disadvantages for both the company issuing them and the advisors receiving them.
Pros Of Advisory Shares:
- Attract Expertise: Startups often lack the funds to hire experienced advisors. They can attract industry experts who can provide valuable insights and guidance by offering advisory shares.
- Incentivize Long-term Success: Since advisors only profit when the company does well, they are motivated to provide the best advice and support possible to ensure the company’s success.
- Preserve Cash: Startups often operate with limited cash flow. By compensating advisors with equity, they can preserve their cash for other critical business operations.
Cons Of Advisory Shares:
- Equity Dilution: Issuing advisory shares dilutes the equity of existing shareholders. This could make the company less attractive to future investors.
- Loss of Control: Advisors receiving shares may have voting rights (depends on the terms in agreement), which could influence company decisions. This could potentially lead to conflicts if the advisors and founders have differing views on the company’s direction.
- Potential Tax Implications: Depending on the jurisdiction, advisors may be liable for taxes when they exercise their options or when the shares vest. This could potentially reduce the net benefit of the advisory shares.
- Risk of Underperformance: If the advisor does not provide the expected value or if the company does not perform well, the equity given to the advisor could be seen as a loss.
- Confidentiality Issues: Advisors may have access to sensitive company information. If not properly managed, this could potentially lead to information leaks.
It’s important to note that the specific pros and cons can vary based on the company’s situation and the terms of the advisory shares agreement. Therefore, companies should carefully consider these factors and consult with legal and financial advisors before deciding to issue advisory shares.
Understanding The Difference Between Regular Shares And Advisory Shares
| Advisory Shares | Regular Shares | |
| Issued To | Typically issued to advisors or consultants in exchange for their expertise and guidance. | Issued to general investors, employees, and founders |
| Purpose | To compensate advisors for their advisory services when cash compensation is not feasible. | To raise capital for the company, reward employees, or establish an ownership structure. |
| Voting Rights | Usually do not come with voting rights. | Often come with voting rights, allowing shareholders to influence company decisions. |
| Dividends | Typically do not receive dividends. | May receive dividends, depending on the company’s dividend policy. |
| Risk | Holders are not typically exposed to financial risk if the company fails. | Holders may lose their investment if the company fails. |
| Liquidity | Not easily tradable or liquid due to advisory shares vesting schedule and restrictions. | More liquid, especially if the company is publicly traded. |
| Tax Implications | May have tax implications when the options are exercised or shares vest. | Tax implications occur when shares are sold at a profit. |
Please note that the specifics can vary based on the terms of the share issuance and the jurisdiction in which the startup operates.
How Advisory Shares Compensate Your Advisors
Now that we know about how a company can take advantage of advisory shares, let’s see how these shares can help compensate company advisors.
Potential For Financial Gain
One of the main benefits of advisory shares for advisors is the potential for financial gain. If the company does well and increases in value, the value of the advisory shares also increases. This means that advisors can potentially earn a significant return on their shares, especially if they are involved with the company from an early stage.
Better Relationship With Company
Advisory shares align the interests of the advisors with the success of the company. Since advisors only benefit when the company does well, they are motivated to provide the best advice and support possible. This alignment of interests can lead to a more productive and beneficial relationship between the advisor and the company.
Flexibility And Control
Advisory shares also provide advisors with a degree of flexibility and control. Advisors are typically granted options to buy shares, which means they can choose when to exercise these options. This allows advisors to manage their equity stake in the company in a way that aligns with their personal financial goals and circumstances.
Recognition And Reward
Finally, advisory shares serve as a form of recognition and reward for the valuable contributions that advisors make to a company. They acknowledge the time, effort, and expertise that advisors bring to the table, and provide a tangible way for the company to express its appreciation.
Advisory shares can provide a range of benefits for advisors. They offer the potential for financial gain, align interests, provide flexibility and control, and serve as a form of recognition and reward.
However, advisors should also be aware of the potential risks and tax implications associated with advisory shares, and may wish to seek professional advice before accepting them.
Best Practices For Utilizing Advisory Shares
Advisory shares are a powerful tool in the startup toolkit. But despite their importance, managing advisory shares requires a nuanced approach.
Identify The Right Advisors
The first step in utilizing advisory shares effectively is to identify the right advisors. Look for individuals who bring unique skills, experience, or networks that your startup lacks. The ideal advisors are those who can fill gaps in your team’s knowledge or abilities and provide strategic guidance to help your startup grow.
Set Clear Expectations
Before issuing advisory shares, it’s crucial to set clear expectations with your advisors. Define their roles, responsibilities, and the time commitment you expect from them. This clarity helps prevent misunderstandings and ensures that both parties are on the same page regarding the advisor’s contribution to the startup.
Use A Vesting Schedule
Advisory shares are typically subject to a vesting schedule, which means that advisors earn their shares over time. A common practice is to have a one-year cliff, where the advisor must stay with the company for at least a year to earn any shares, followed by monthly or quarterly vesting over the next one to three years. This approach incentivizes advisors to stay engaged and contribute to the startup over the long term.
Consider The Tax Implications
Advisory shares can have tax implications for both the advisor and the startup. It’s important to consult with a tax professional to understand these implications and structure the advisory shares in a tax-efficient manner. For example, advisors may be liable for taxes when they exercise their options or when the shares vest.
Maintain Confidentiality And Avoid Conflicts Of Interest
Advisors often have access to sensitive company information. It’s important to have confidentiality advisory share agreements in place to protect your startup’s proprietary information. Additionally, ensure that advisors are not in a position where they could have a conflict of interest, which could harm your startup.
Regularly Review And Adjust The Advisory Relationship
The needs of a startup can change rapidly. Regularly review your advisory relationships to ensure they are still beneficial. If an advisor is no longer adding value, it may be time to part ways and bring in new advisors who can better support your current needs.
Be Mindful Of Equity Dilution
Issuing advisory shares dilutes the equity of existing shareholders. Be mindful of this dilution and ensure that the value the advisors bring to your startup justifies their equity compensation. Too much dilution can make your startup less attractive to future investors.
Document Everything
Finally, make sure to document everything related to the issuance of advisory shares. This includes the advisory agreement, vesting schedule, and any other related documents. Proper documentation helps avoid disputes down the line and is crucial for maintaining good corporate governance.
Frequently Asked Questions
Q1. Do Advisory Shares Expire?
Advisory shares can expire depending on the arrangement. If issued under a fixed-term option, the shares expire after a set time. Alternatively, with a time-based option, shares vest incrementally over time, potentially expiring if the advisor doesn’t fulfill the service duration requirements. So, yes, advisory shares can expire depending on the terms of issuance.
Q2. What Are The Types Of Startup Advisors?
Startups can have different types of advisors. Industry experts have loads of experience in your business area. They know the ins and outs and can give you great advice on what works and what doesn’t. Technical advisors are pros in stuff like coding or product development.
They can help you make your product or service really awesome. Business growth advisors are good at strategies for getting more customers and making your business bigger. They can help your startup expand and succeed.
Wrapping Up
In conclusion, advisory shares are a valuable tool for startups. They attract expert advisors, preserve cash, and align interests toward the company’s success. However, they require careful management to avoid potential pitfalls like equity dilution and tax implications. With the right approach, advisory shares can significantly contribute to a startup’s growth and success.
