Advisory Shares - Definition and how do they work?

Early-stage startups often require expert assistance. As a reward for their contributions, startups issue advisory shares. Read more about advisory shares here.

TABLE OF CONTENTS

  1. What are advisory shares?
  2. How do advisory shares work?
  3. How much equity do advisors get?

What are advisory shares? 

Advisory shares (aka advisor shares) are a type of stock option granted to a company’s advisors in return for them contributing to the growth of the company. They are given as compensation to outside board members who help a company grow and flourish as well as help investors and employees. 

Advisory shares can be used to incentivise a variety of roles, so long as they operate in the best interests of the company. Moreover, they offer a way to give compensation without the tax limitations and accounting complexities of stock options.

Although consultants and attorneys could also serve as advisors for a company, they are more likely to charge a fee for their service. While experienced individuals with previous experience as founders, senior executives, or industry experts are usually provided with advisory shares.

Companies in the startup phase are most likely to issue advisory shares. Since startups may not have the cash flow or revenues to cover the high salaries of their experts and advisors, they often issue advisor shares as an alternative to cash payments and keep them on board. 

The advisory share allocation in any one company is usually capped at 5%. The reason for this is to discourage companies from issuing too many of them.

How do advisory shares work?

Advisors are typically given options to purchase shares instead of being given actual shares. By doing so, the company can avoid a potential tax obligation if the company grants advisory shares worth a significant amount.

An advisory share is different from many other types of equity because it does not entitle the shareholder to voting power, the right to sell or trade shares, or to receive dividends. In most cases, an advisory share does not entitle the shareholder to any rights at all. This means that an advisory share does not carry any risk and should be seen as just another form of compensation by the company.

Moreover, the stock options for advisors usually have a vesting schedule. This allows the company to postpone transferring ownership to advisors while keeping them on board for long-term success.

Just like employees, advisors also have a vesting schedule. The vesting schedule is a set of rules that determines how the advisor’s equity will be distributed. The rule can vary from a fixed term, best-fit, to time-based policies.

There are two types of vesting schedules:

1) Fixed term - The fixed-term option gives the advisors shares that expire after a set period of time.

2) Time-based - In this case, the shares vest incrementally over time. For example, 10% will vest after one year's worth of service and an additional 10% will vest at two years' worth of service and so on. 

Often, agreements have a cliff of three months, allowing the parties to sort out if the relationship will provide mutual benefits.

As a final note, it's a good idea to do some research before offering advisory shares. One of the most common mistakes companies make is overcompensating advisors with stock options. Even though those fractions of equity are not particularly valuable at an early stage, they would be worth considerably more as the company grows. It would be ideal to make special arrangements, such as offering a three-month trial period. 

How much equity do advisors get?

Just like employees, advisors receive shares of common stock, which vest over time. Advisors usually receive one of the following options:

  • Restricted stock agreements (RSAs)

The following is a simple explanation of the differences between RSAs and NSOs:

Restricted stock agreements (RSAs) are shares that are purchased upfront but are restricted by a vesting schedule. While Non-qualified stock options (NSOs) are an option to purchase shares that are usually granted later on.

Individual advisors can expect to get anywhere from 0.25% to 1% of the company’s equity. But the exact percentage depends on how much the advisor contributes to the company's growth.

The equity granted to advisors may vary considerably depending on their experience, influence, and role. It also depends on how long the advisor and the company plan to work together. 

For example, an advisor who offers industry insights for a 2 year period would get 0.5% of the company’s shares while an advisor who is able to consistently bring in new clients would receive 1.5% for their direct involvement.

Additionally, early-stage and seed companies will be willing to give up a higher percentage of their equity to an advisor, whereas growth-stage and mature companies will only offer a smaller percentage.

Carta conducted an interesting study on startups that raised less than $2 million in 2019. They found that:

  • Advisor RSAs: Ranges from 0.2% to 1% of a startup
  • Advisor NSOs: Ranges from 0.1% to 0.5% of a startup

RSAs have a higher percentage since they are issued immediately after incorporation, well before a company's market value has increased. An advisor who joins a company earlier usually receives higher fully-diluted shares.