Advisors can offer valuable expertise when a company is at its formative stage. However, most startups won’t have the cash flow to compensate advisors appropriately, so presenting them with a certain percentage of the company as a reward in the long term emerges as the best solution.
The following guide will look at what are advisory shares, why it matters to companies, in particular start-ups, and what advisors themselves can expect as reimbursement.
Advisory shares definition
Advisory shares, also known as ‘advisor shares’, are a type of stock given to company advisors instead of employees. Start-up companies most often use them as an alternative compensation since they might not have extra funds to compensate these advisors adequately. It is an excellent way for a young company to offer advisors a non-cash stock option for their expertise without requiring them to give up capital.
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Which companies issue advisory shares?
For the most part, advisory shares are issued by start-up companies. The company may be in the idea stage at the time. Alternatively, in the later seed capital stage or even much later, when there might be an active, growing need to bring on experts.
The equity provided to advisors can vary notably. It depends on a particular advisors’ expertise and role within a company and how long they are expected to work together.
How much is offered to advisors?
Up to 5% of a company’s total equity can be allocated to advisors. Sometimes a young company may form an advisory board to distribute equity to incentivize board members. Individual advisors can expect anywhere from 0.25% to 1% of the company’s equity, depending on their contributions and the growth of the business.
For example, an advisor who provides counsel at monthly meetings might receive a more modest amount of 0.25%. On the other hand, a beefier slice of 1% might be presented to an advisor who introduces a prospective client that becomes a sizable customer.
The more mature the company, the smaller the equity percentages advisors can expect to collect. For instance, a company in the idea stage might give 0.25% of equity to an advisor who attends monthly meetings, compared to a company past its startup phase, giving a cut of 0.15% for the same work.
Difference between regular shares and advisory shares
The primary difference between regular and advisory shares is that regular shares are standard stock units that are sold on the open market, as opposed to advisory shares, which are stock options given to experts in exchange for their business insights.
Advisor shares fall under NSOs (non-qualified stock options), which differ from ISOs (incentive stock options) usually given to company employees.
ISOs and NSOs tax management
The tax benefit of ISOs compared to NSOs is that you may not have to pay ordinary income tax when you exercise them.
Incentive stock options are generally reserved for employees, offering them an opportunity to buy the stock at a reduced charge. Since employees with ISOs don’t need to pay taxes immediately upon exercising their options, they are generally considered more tax-advantaged than NSOs.
Taxes need to be paid only once you sell your shares. If the shares are kept for a certain holding period (keep ISOs for at least one year after exercising and two years after your options were granted), they will qualify as capital gains instead of ordinary income, and therefore are taxed at a much lower capital gains tax.
Non-qualified stock options may go to consultants, company partners, directors, or others, not on the company payroll. NSOs are different from ISOs in that, regardless of whether you hold your stock options or sell them, you must pay taxes on the spread (the difference between the grant and exercise price) at your ordinary-income tax rate. What is more, the income is also subject to payroll taxes, including Social Security and Medicare. However, NSOs taxes are withheld at the time of exercise.
Exercising a stock option means purchasing the company’s available stock at a price set by the option (grant price), no matter the stock’s worth when you exercise the option.
A vesting schedule is an incentive program instituted by the employer to give the employees the right to specific asset classes. It is used to incentivize employees to remain with the company for longer.
A vesting schedule lets employees gain full ownership of employer-provided assets only over time. It can also allocate profits, equity, and stock options to employees. Employees surrender their unvested portion of securities if they leave before being 100% vested.
Vesting schedule for advisory shares
Vesting does not work the same way for advisors as it does for regular employees. In addition, because young companies can go through a fast transformation, the advisors needed at the seed stage will likely differ from later stages of the company’s evolution.
Common advisory shares vesting schedules are often two years with no cliff. Therefore, advisory shares vest or are granted in monthly increments over two years. However, the company will not owe an advisor the entire vesting schedule if they stop providing advisory services per the advisory agreement.
Cliffs in vesting schedules
Cliffs are periods without stock vestments, commonly occurring in one year. This vesting schedule is usually a prerequisite of employee stock options and is not part of the advisory shares vesting schedule.
Shark Tank & advisory shares
Shark Tank is a famous American business reality television series that features aspiring entrepreneurs making business propositions to a panel of investors or “sharks” and persuading them to invest in their company.
In exchange for their investment, ‘the sharks’ generally require a stake in the business – a percentage of ownership plus a share of the profits. In return, the entrepreneur gets funding, but more importantly, they get access to the sharks, their expertise, network of contacts, and suppliers.
On top of a percentage of ownership in the business, investors are also often offered advisory shares. These can be a safe option for the sharks as they merely grant them the opportunity to buy equity instead of being offered the actual shares, which helps avoid any foreseeable conflict of interest.
Squatty Potty example valuation
For example, Squatty Potty asked for $350,000 from the sharks for a 5% stake in their company, meaning they believe their company is valued at $7 million in sales (5% of 7 million is 350,000). The sharks, in this case, agree with the valuation but are interested in a higher ownership percentage in the company. Lori Greiner’s counteroffer at 10% for $350,000 eventually seals the deal.
Settling on an amount to invest in the company and the percentage of stake in the business each is open to considering comes down to estimating revenue and applying a valuation to the company. But, of course, the sharks ultimately want to get their investment back and earn a profit.
See the video: Squatty Potty Makes The Sharks Say “Holy Crap!”
PROS of advisory shares
- Can provide crucial help in a business’s development, whether in the early seed stage or much later;
- They can help protect a company’s confidentiality. Advisors are often asked to sign confidentiality and non-disclosure agreements (NDAs) since they are likely to witness product development and marketing proposals that companies want to keep secret.
CONS of advisory shares
- However, essential to keep in mind that advisors may be working with several companies. Firms that issue advisory shares may not have the power to restrict advisors from working with rival companies. Therefore, it is essential to clarify in advance if advisors have pre-existing arrangements that could affect their ability to give impartial advice;
- Companies can frequently over-compensate advisors with stock options. Management might be comfortable with giving away fractional equity percentages in a start-up with few assets. Those cuts could get much more prominent with the company’s growth.
Advisory shares can be an excellent motivator for specialists to work for young companies. Moreover, it allows start-ups to benefit from professional expertise and insight without having to rely on limited corporate resources.
However, handing out equity is something management needs to do conscientiously. Cheap advice in the company’s idea stages can get quite pricey as a company grows. It’s easy to give away 1% of nothing but much harder to part with 1% of a multibillion-dollar market cap.
FAQs about advisory shares:
What are advisory shares?
Advisory shares are equity given to company advisors who provide expertise during the company’s different stages of development. They are normally given out as non-qualified stock options (NSO).
Who are the advisors in a company?
A company advisor is a strategist who works with your business to help with planning, finances, marketing, and development. An adviser’s role is that of a mentor or guide and differs categorically from the salaried employees.
Who gives out advisory shares?
Start-ups often give out advisory shares since they lack the appropriate capital to offer them a typical salary. Paying out advisory shares also helps to incentivize advisors to be invested in the company’s long-term success.
How much can advisors expect?
Up to 5% of a company’s total equity can be allocated to advisors. Individual advisors can expect anywhere from 0.25% to 1% of the company’s equity, depending on their contributions and the growth of the business.