Advisors bring invaluable expertise to startups, but most startups do not have the resources for cash compensation.
So, they prefer to give out advisory shares instead. But what are advisory shares, and why are they the best solution to this problem?
We share the full details below.
What Is an Advisor to a Company?
An advisor is a person who helps plan and execute business strategies that can improve financial management and bring in operational efficiency.
They may be involved with tasks like strategic planning and risk analysis or else advise business executives on key projects and marketing strategies. Some companies also refer to them as business consultants.
In most cases, these are senior executives or former founders who have strong credentials and are respected for their insights and connections in the industry.
Note that we are not talking about accountants or lawyers who provide technical services to the business.
Rather, these people offer experience, business insights, strategic guidance, and access to their network of connections to the company.
Advisory shares are a stock option offered only to company advisors (not employees). They are most prominently used by startups that may not have the cash flows to offer a salary or other perks but need the advisor’s expertise and contacts.
As the firm grows, the value of the advisory shares could also grow with it.
Hence, these shares are a good way to attract experienced advisors who understand and believe in the firm’s core business proposition.
They issue such shares to incentivize senior business leaders to guide the company while keeping their plans hidden.
No, advisory shares are not the same as equity. They are a type of stock option; they don’t confer any ownership in the company to the advisor.
Companies issue advisory shares to their consultants in lieu of their strategic guidance, access to their contacts, or help with the firm’s business planning.
Having advisory shares gives them some bit of “skin in the game.” If the company does well, its stock will grow, and the advisor can gain from the company’s growth when they eventually receive shares.
What Are Advisor Options?
Advisor options are a form of stock options given to business advisors which confer the right to buy regular shares at a pre-agreed price when the company issues shares.
Firms usually offer options instead of actual shares to advisors.
This is because once the company valuation grows significantly, issuing the advisor shares may have large tax consequences for the firm.
Regular shares are stocks that give the holder a small part in the company’s ownership. They can be bought or sold on the stock markets after the company has issued them.
Advisory shares are stock options. They only offer the right to buy the firm’s shares at a pre-agreed price at a later date. Additionally, they are given only to company advisors.
These shares do not include the right to trade the company stocks or to get dividends from the firm. There is no voting power given to their holder either.
Giving advisory shares instead of stocks avoids conflicts of interest.
The same advisor might be working for several firms at a time; hence, directly having the company’s equity could be problematic for them.
Young companies often issue advisory shares to get the knowledge, experience, strategic insights, and connections that advisors can bring to the table.
They are an excellent way for such firms to attract business leaders without paying huge sums in cash compensation.
However, these shares are not a good idea for every startup type. At times, young firms may end up paying more advisory shares than necessary.
No, advisory shares cannot be bought on the market. They are just an option to purchase company stocks later, at a preset price.
They also do not confer any sort of ownership of the company to the advisor.
No, as mentioned previously, they are not actual shares that can be bought or sold on a stock market.
Advisory shares are merely an option given to the consultant. They can exercise this option to get shares of the company later on.
As such, they do not have any immediate value and are not tradable anywhere.
Yes, advisory shares are taxable. They are taxed twice, once when they are converted to shares and the second when they are sold.
When the advisor exercises the option, they need to pay ordinary income tax on any gain of the underlying stock over the original price on which it was granted.
While selling, normal capital gains taxes are applicable.
If the shares were held for more than a year after converting them, it would be long-term capital gains tax. Otherwise, it would be short-term.
How Much Equity Should I Give an Advisory Board?
Individual advisors can be given anywhere between 0.25% and 1% of the company’s total equity, depending on the advisor’s value.
Various factors come into play when companies evaluate what percentage to offer an advisor. Some of these may include the following:
- Ability to bring in new clients
- Influence in the industry
- Length of time the advisor is willing to work with the firm
- How early the advisor comes on board
For example, someone who brings in regular clients might be offered a higher percentage. This is because they are involved directly with the company’s success.
But an advisor who only provides inputs on strategic discussions and attends monthly meetings may receive a lower percentage.
Another factor is that early-stage startups offer higher percentages to advisors, whereas mature startups will probably give lesser.
Another thing to consider is the format in which advisory shares are given. There are usually two types:
- Non-qualified stock options (NSOs)
- Restricted stock agreements (RSAs)
RSAs are stocks offered upfront but restricted for sales up to a certain period (known as the advisory shares vesting schedule).
NSOs are stock options that can be converted to stocks later on.
Due to their direct nature, RSAs are offered in a lower percentage (between 0.2% to 1% of company equity).
Equity is an ownership stake in the company, whereas a share is a tradable financial instrument whose value measures the proportion of ownership the investor has in a firm.
The biggest difference is in the tradability – equity is not easily tradable, whereas shares can be bought and sold over stock markets in a matter of minutes.
Secondly, equity is available in any form in which a firm is running, whether it is a proprietorship, partnership, or publicly listed enterprise.
Shares are only available for corporate systems.
An equity stake might also include ownership capital. Stocks can either be equity share capital or preference share capital.
Another key difference is the risk – equity is riskier because it represents a long-term illiquid interest in the company.
Equity holders are directly involved with the business and are therefore exposed to all its uncertainties.
Shareholders only have their own subscribed capital at risk.
They don’t have any direct involvement in the firm and will not be liable if the company fails or defaults on its obligations at some point.
Lastly, equity holders do not get dividends, but shareholders do.
Usually, startup companies might offer advisory shares in their ideation stage.
Another point where they might need to bring in advisors is during the seed capital stage or growth stage.
Depending on when the advisor comes on board, the percentage advisory share that they get offered might vary.
During the early stages, a higher percentage of shares is offered, but as the firm matures, the percentage keeps going down.
Unlike employee stock options, advisory shares are typically offered without cliffs.
They typically vest in monthly increments over a two-year horizon and stop if the advisor decides to discontinue their work.
Advisory shares are a way for startups to get the expertise and connections of senior professionals without giving them equity in the company or cash compensation.
They are usually not in the form of an actual share in the company. Rather, they are options to get shares at a pre-decided price later on.
Depending on various factors, individual advisors might get somewhere between 0.25% to 1% of advisory shares.
These factors include the length of their involvement, how significant their work is, and how valuable their connections and inputs are to the firm.
Startup businesses benefit greatly from the flexibility they offer to help fuel growth without parting with precious cash flows.