ADVISORY SHARES | WHAT ARE THEY AND HOW DO THEY DIFFER?

Although starting a company may sound like a great idea and is heavily romanticized by the media, 95% of start-ups fail, and 99.5% of start-ups never get funded. Being part of a start-up is like riding a rollercoaster: there are a lot of highs and a lot of lows. The journey to product-market fit is arduous, long, and continuous. Businesses succeed or fail based on the decisions that they make. Not being able to check their decisions is a common limitation that early-stage start-ups experience.

To combat this, a good option may be to hire an experienced advisor who can provide strategic advice. In many cases, advisors just want to see your company succeed. However, if you want their dedication, a start-up should pay their advisors. The problem is that it is necessary to have money to pay the advisor—money that small companies generally do not have.

This is where advisory shares come into play. They provide companies with the ability to provide their company advisors with deferred compensation in the form of stock options and shares. Thanks to this, companies can pool their resources to compensate advisors for driving product market fit and acquiring customers. The advisors can receive something valuable in return for their expertise.

Equity compensation is a common method to attract and retain company advisors.

The additional benefit of advisory shares is that they create a better and continuous alignment between the company's financial rewards and the advisor's. The more the company succeeds, the greater the internal satisfaction and the greater the payday for advisors.

In this article, we will discuss advisory shares, how they work, and the benefits they can bring to your company.

What are advisory shares?

Advisory shares are stock options delivered to advisors engaged by the company. They are usually given as compensation for services provided or to be provided, especially in the case of start-up companies. They can also be given to ensure the confidentiality of the business advisor. The advisory share grants are tied to a set of quantitative and qualitative measures outlined in advisory share agreements that advisors must achieve to earn the grants.

What share class are advisory shares?

A common misconception exists that there is a share class called Advisory Shares. There are no share classes called Advisory or Founder shares. The Articles of Incorporation define the share classes for a company. The Corporate Secretary or the person serving in that capacity defines each of the share classes and the rights and obligations that these classes carry. Most companies would set aside a pool of shares from one of their common equity classes that they would issue to Advisors.

How do advisory shares work as equity compensation?

Who can become an advisor is usually tied to a knowledge and experience gap that the company is trying to close by acquiring the expertise externally in the form of advice. Usually, the beneficiaries of this type of stock are entrepreneurs with a long and successful track record. They provide smaller companies with strategic insights and knowledge in exchange for some of the company’s shares. In addition, this type of entrepreneur usually provides the company with a network of contacts that can boost the company’s development. Good company advisors can often be the accelerant a company needs.

Engaging an Advisor to join the company’s Advisory Board should be accompanied by an Advisory Agreement that spells out the agreed-upon rights and expectations between an Advisor and a company. But this is a topic on its own that we will tackle in a separate post.

With advisory shares, advisors have an option for the company’s equity in the future, as agreed upon in the Advisory Agreement, which is then tied to the stock options grant.

In general, these types of stock options are usually delivered in different percentages, taking into account the participation requirements and value that each advisor drives. For example, an Advisory Board may be entitled to incentive stock options up to 2% of a company’s common stock. This is the pool of shares (issued or not) that the company has set aside to attract advisors. Each advisor is entitled to a portion of the pool in alignment with the Advisory Agreement. Like any stock option instrument, companies can establish different vesting rights based on the immediacy of the value delivered by the advisor.

The percentage of advisory shares that advisors receive also depends very much on the size of the company. An early-stage company carries a smaller valuation than an established mature company. As such, an advisor typically would receive a larger proportion of the company. The relative percentage is the wrong metric to focus on. What is more important to establish is the overall value of the company and how much equity the advice would or did drive the company's growth.

But are advisory shares always delivered under these conditions? While they usually are, it can also happen that a company has not yet been formally launched. In this case, advisory shares can be issued not only to get advisors to provide expertise in various fields but also for the experienced advisors themselves to help the company secure financing.

Although this may sound like a win-win, this comes with a potential risk. Advisors will own a portion of the company. Like any other investor, they will have a say, in proportion to their ownership, over the direction and decisions the company makes. Unlike other investors, they will have more knowledge of the company and more influence. Choosing the right advisor is of the utmost importance. Just like finding the right partner to share your life with takes time, take your time to search and attract the right advisors.

Do advisory shares get diluted?

Before answering this question, it is necessary to clarify that the relative ownership (% of shares) an individual or company holds in a company fluctuates over time. As the company grows and matures, more and more shares (or pools of shares) are issued to employees, advisors, investors, strategic partners and so forth, impacting the company's total equity.

So, more and more people and corporations own these shares. Thus, with every additional share issued, the relative ownership of a share in the company gets smaller, resulting in what is commonly referred to as dilution. What is important to underscore is that in an up round (when the current value of company stock is higher than the value at the time of receiving the stock grant), this is not an issue. While the overall ownership of the company is diluted, the overall enterprise value continues to rise, as does the value of the shares that advisors hold. The issue is when this is a down round. In this case, when more shares are issued with a lower valuation, the value per share goes down.

Next, we will introduce you to the main differences between advisory shares and other types of shares.

Advisory Shares vs. (Common) Equity Shares: The 21 Most Common Myth

There are several common myths and misconceptions about advisory shares. Here are some of the most prevalent ones:

• Advisory shares are the same as regular equity: This is not true. Advisory shares are typically a form of stock options or restricted stock units, not outright equity ownership.
• Advisors automatically get shares: Many people assume that all advisors receive shares, but this isn't always the case. The compensation structure depends on the Advisory Agreement between the company and the advisor.
• Advisory shares are always valuable: It depends. The value of advisory shares depends on the company's success. In many cases, especially if the company fails or doesn't exit, these shares may end up being worthless.
• Advisors have the same rights as regular shareholders: Generally, advisory shares come with fewer rights than regular shares. Advisors often don't have voting rights or access to company financials. (Note: This is highly dependent upon the share class used for the advisory shares.)
• Advisory shares are free from tax implications: This is a dangerous misconception. Depending on the type of advisory shares and when they're exercised, there can be significant tax consequences.
• All advisory agreements are the same: Terms can vary widely between different Advisory Agreements. One size does not fit all. It's crucial to understand the specific terms of each arrangement.
• Advisory shares vest immediately: Most advisory shares vest over time, often with a cliff period. Immediate vesting is rare.
• Advisors can sell their shares anytime: Usually, there are restrictions on when and how advisory shares can be sold or transferred.
• The percentage offered is standard across all companies. However, the amount of advisory shares offered can vary greatly depending on the company, the advisor's role, and the advisor's perceived value to the business.
• Advisory shares don't dilute: Like any form of equity compensation, advisory shares do contribute to the dilution of existing shareholders.
• Advisory shares are always liquid: Many people assume that once they receive advisory shares, they can easily convert them to cash. In reality, advisory shares in private companies are often highly illiquid, and there may be no market to sell them until the company goes public or is acquired.
• Advisors have insider information rights: Some believe that holding advisory shares automatically grants them access to insider information about the company. However, most advisory agreements don't include rights to detailed company information beyond what's necessary for the advisor's role.
• Advisory shares are immune to down rounds: There's a misconception that advisory shares are protected from devaluation in subsequent funding rounds. In fact, down rounds can significantly impact advisory shares, potentially causing them to lose much of their value.
• All advisory shares come with anti-dilution protection: While some equity agreements include anti-dilution provisions, it's not standard for advisory shares. Many advisors may see their ownership percentage decrease as the company issues more shares over time.
• Advisory shares can be used as collateral: Some advisors mistakenly believe they can use their unvested advisory shares as collateral for loans. However, most advisory share agreements prohibit this, and financial institutions typically won't accept unvested shares or options as collateral.
• Advisory shares are immediately vested: This is incorrect. When the vesting conditions are met, the stock option converts into a grant.
• Advisory shares are delivered to the company’s advisors, who do not necessarily own a part of the company. Equity charges, on the other hand, are usually in the hands of the people who own a part of the company. This is incorrect. Advisory shares are not a standalone share class. As such, they would carry the rights and obligations of that class.
• Advisory shares have the same voting rights as equity shares? This is incorrect. Once the stock options vest and convert into shares, those shares carry the same rights and obligations as all of the shares in that share class. What determines who can vote are the voting rights of the share class. Both common and preferred shares can have voting rights. The most famous example of common shares with special voting rights is when Facebook went public. Mark Zuckerberg’s shares were in a common share class that carried 10X the voting rights compared to the other common share classes. This was an intentional move to preserve his decision-making rights once the dilution from the public share issuance took place.
• The path to owning advisory shares is the same as that of equity shares. This is incorrect. While advisory shares are given to advisors in exchange for their strategic advice, common shares are available for purchase on the public market or secondary markets or, in some cases, as part of a subsequent financing round.
• Advisory shares only give you influence over the company’s decisions rather than the right to vote in different business decisions, for example, when there are intentions to merge that company with another. This is incorrect. Legally, advisory shares will have the rights bestowed upon them from the share class and in proportion to the share ownership. However, informally, advisors’ voices will have a higher level of importance than other investors as they are more actively involved and familiar with the business.
• Advisory shares are always a better deal than cash compensation.
• Many people assume that accepting advisory shares is always more financially beneficial than receiving cash compensation. However, this isn't necessarily true. The value of advisory shares is speculative and depends entirely on the company's future success. In many cases, especially for early-stage startups, the shares may never become valuable. Cash compensation, on the other hand, has immediate and guaranteed value.
• Additionally, advisory shares often come with various restrictions, tax implications, and potential future costs (like the cost to exercise options). In contrast, cash compensation is straightforward and immediately useful.
• The best form of compensation depends on various factors, including the advisor's financial situation, belief in the company's potential, risk tolerance, and the specific terms of the advisory agreement. It's important to carefully consider these factors rather than automatically assuming shares are superior to cash.

3 Major Benefits of Advisory Shares

1. Keeps cash in the company

Early-stage companies tend to have limited resources, while their need for strategic advice is arguably much higher. Preserving as much cash in the company as possible to extend the run room is of critical importance. At the same time, attracting the right advisors can have a catalytic impact on the company. 

Advisory shares allow companies to defer cash compensation to advisors instead of compensating them now. Paying later is almost always more expensive than paying now, but it has a myriad of other tangible benefits.

2. Advisory actions could encourage an advisor to work harder on your company's growth

By owning advisory shares in your company, an advisor will probably want your company to do well, as this will increase the value of his advisor shares in the future and make him more money. For that reason, many advisors, especially those who invest money in a small company, decide to give a network of contacts to the CEO or board of directors, which will allow them to boost the development of the company. Quite often, advisors become the first investors in the company as they are doing due diligence with the company day-to-day.

"If you want money, ask for advice. If you want advice, ask for money." Steve Jurvetson (Future Ventures)

3. Taps into an extended advisory board networks

Advisors are typically highly connected and regarded professionals with large networks of contacts. Just like you are doing due diligence on advisors, they are doing due diligence on the company. Attracting the right advisors borrows credibility from the individual advisors’ reputation. This is the reason why many early-stage companies are willing to disclose who sits on their advisory board even though, unlike the board of directors, advisors have no fiduciary or oversight responsibility to the other shareholders or stakeholder groups.

Advisory shares example in an advisory agreement

So, let’s introduce you to one of the most common situations involving advisory shares.

Let’s say Company A is new and it’s in the business of offering cloud services. The company has hit a plateau. The Founders are trying to raise capital to hire more talent. However, investors are shy as they can see that growth has slowed down or flattened.

The fair market value of the company shares is crucial in determining the value of the advisory shares granted. This value is used to calculate the worth of issuing advisory shares at the time of vesting and has significant tax implications.

So, the company decides to look for new alternatives. In a meeting between the founders, one of them suggests contacting an entrepreneur—but not just any entrepreneur: one with a lot of experience in the market who can offer the company strategic guidance.

Advisory shares are often categorized as non-qualified stock options (NSOs) due to the contractor/service provider relationship, which differs from employee stock options in terms of vesting schedules and taxation.

But the money problem comes up again. At this point, one of the other founders suggests offering advisory shares in lieu of cash, with a cliff vesting schedule of 50% after 1 year, 25% after year 2, and the remainder at the end of year 3.

The rest of the founders support this idea, so the decision is made to look for an entrepreneur who wants to fulfill the role of advisor.

Advisory shares and restricted stock units (RSUs) are taxed as ordinary income. This means that the advisor must pay regular income tax on the value of the equity received.

On the other hand, there is also company B, which, unlike company A, already has a large customer base and is very successful. One of the company’s founding entrepreneurs has more than 15 years of experience in the market and has previously worked with companies offering services similar to those of company A.

The founding entrepreneurs of company A decide to contact the entrepreneur of company B. They share their current situation with him and tell him that, in exchange for his experience and advice, they can offer him 0.5% of the company in terms of advisory shares, vesting over 3 years.

After analyzing the situation, the entrepreneur decides to accept the offer to advise the company for three years.

Advisors receiving advisory shares must pay ordinary income tax on the value of the shares at the time of vesting or delivery, even if the shares are not sold immediately.

A few days later, after signing an Advisory Agreement, the entrepreneur begins having monthly meetings with the Board of Directors to become fully immersed in the company’s situation.

Restricted stock awards (RSAs) are another form of equity compensation given to advisors, often in a company's early stages. RSAs have specific vesting requirements and tax implications.

The advisor begins to give some advice to company A on how they can start improving their product and service offering and even offers some contacts of other companies that start-up advisors might be interested in their services.

Restricted stock units (RSUs) are a form of common stock that a company promises to deliver to an employee or advisor at a future date, depending on various vesting and performance conditions.

As time passes, Company A begins to develop better-quality products and increase its customer base. This causes the value of the company's actual shares to rise, and some investors and advisors become interested in the company.

The tax implications of advisory shares are significant. They are taxed as ordinary income and may differ depending on the type of compensation and individual circumstances.

Company A then decides to raise new financing. This improves the company’s liquidity and provides it with a much-needed injection of capital to invest in R&D and drive customer acquisition.

There are different types of advisory shares, including stock options, restricted stock awards (RSAs), and restricted stock units (RSUs). Each type has specific characteristics and conditions that advisors may prefer.

Final thoughts

Starting a company is fraught with risks and opportunities. Companies are defined by the risks that they manage and avoid, as well as by the opportunities that they seize. Speed matters! Engaging an advisor who can help you accelerate while avoiding the risks that lie on the road to success could be the difference between becoming a market leader and being a distant follower.