In the world of startups and early-stage companies, the term “advisory shares” plays a significant role in compensating individuals who provide strategic insights and valuable guidance to help a company grow. But what exactly are advisory shares? How do they differ from other forms of equity compensation, and what should both startup founders and advisors know before agreeing to such arrangements? In this article, we will explore the concept of advisory shares, their benefits, potential challenges, and important considerations.
What Are Advisory Shares?
Advisory shares are a form of equity compensation awarded to individuals who offer strategic and operational advice to a company. These individuals, known as company advisors, are not full-time employees but are often influential business advisors or experienced professionals with strong industry connections. They are typically brought in during a company’s early stages to help shape its direction and accelerate company growth.
Advisory shares are designed to reward these advisors for their contributions without paying them upfront cash compensation. Instead, advisors receive a share of the company’s equity, aligning their interests with the company’s long-term success.
Why Are Advisory Shares Important?
In early-stage or startup companies, resources are often scarce. Founders may not have the capital to pay advisors significant cash fees, but they still need access to strategic guidance from experienced advisors. Advisory shares offer a way to attract and compensate advisors without immediately depleting the company’s finances.
By offering advisory shares, companies can tap into the advisor’s expertise in exchange for a small portion of company stock. This allows advisors to benefit from the company’s future success, while the company gains access to valuable insights and industry connections that can help drive growth.
Types of Advisory Shares
There are various forms of equity compensation that companies can offer to their advisors. These typically come in the form of stock options, restricted stock, or restricted stock units (RSUs). Let’s explore the most common types:
1. Restricted Stock
Restricted stock is actual equity in the company, but it comes with certain restrictions on when it can be sold or transferred. Advisors must adhere to these restrictions, often tied to a vesting schedule, before they can fully claim ownership of the shares.
2. Restricted Stock Units (RSUs)
Restricted Stock Units or RSUs are a form of equity that doesn’t grant actual shares until the vesting period is complete. The vesting schedule is often determined by the advisory agreement and may be based on time or specific performance metrics.
3. Stock Options
Another common form of equity compensation is stock options. Advisors are given the option to buy shares of the company at a predetermined price, known as the fair market value, at a future date. Non-qualified stock options (NSOs) are often awarded to advisors, as they offer more flexibility than incentive stock options, which are typically reserved for employees.
Advisory Share Agreements
Before awarding advisory shares, companies and advisors typically enter into an advisory share agreement. This agreement outlines the terms of the relationship, including the advisor’s duties, vesting schedules, and the number of shares awarded. Some key elements of the advisory share agreement include:
1. Advisor’s Role
The agreement should clearly define the advisor’s role, including the specific responsibilities, expected contributions, and the time commitment required. Advisors may be expected to attend monthly meetings, provide strategic insights, and offer other valuable services to the company.
2. Vesting Schedule
The vesting schedule dictates when the advisor will gain full ownership of the shares. For example, a common schedule might be four years with a one-year cliff, meaning that after the first year, the advisor gains 25% of the shares, and the remaining shares vest gradually over the next three years.
3. Equity Dilution
One potential concern for both founders and existing shareholders is the equity dilution that results from issuing advisory shares. While advisors play a key role in the company’s growth, issuing new shares to them can reduce the ownership percentages of current stakeholders. The advisory share agreement should address how many shares will be issued and what impact this will have on the company’s total equity.
Benefits of Advisory Shares
Offering advisory shares comes with a host of benefits for both the company and the advisor.
1. Attract Experienced Advisors
Startups often struggle to compete with established companies for top talent, particularly when it comes to attracting experienced advisors with valuable industry knowledge. Offering advisory shares allows startups to bring in company advisors who are incentivized by the potential upside of the company’s long-term success.
2. Align Advisor Interests with Company Success
Because advisory shares give advisors a stake in the company, their financial rewards are directly tied to the company’s development. This helps ensure that the advisor’s guidance is aligned with the company’s goals and encourages them to contribute fully to the company’s future success.
3. Provide Financial Rewards Without Cash
Cash-strapped startups may not have the funds to pay for high-quality advisors. Advisory shares allow companies to offer financial rewards in the form of equity, which can be more attractive than immediate cash compensation in high-growth environments.
Tax Implications of Advisory Shares
One critical consideration for both companies and advisors is the tax implications of advisory shares. The IRS treats most forms of equity compensation as taxable income, and advisors may be required to pay ordinary income tax on the fair market value of the shares they receive.
For example, if an advisor is granted restricted stock or stock options, they may need to pay taxes based on the fair market value of the shares once they vest or when the stock options are exercised. Advisors should consult with a tax professional to fully understand their tax implications and plan accordingly.
Challenges of Advisory Shares
While there are many benefits to offering advisory shares, there are also challenges that both parties need to be aware of:
1. Conflicts of Interest
Advisors may be involved with multiple companies or have other competing interests. It’s important that both parties address any potential conflicts of interest in the advisory agreement to ensure that the advisor’s guidance is unbiased and aligned with the company’s goals.
2. Equity Dilution
As mentioned earlier, issuing new shares to advisors can dilute the ownership percentages of existing shareholders. This is particularly concerning for company founders who want to maintain control of the company. However, these concerns can be mitigated by carefully determining how much equity to award and clearly outlining the terms in the advisory share agreement.
3. Complexity of Stock Options
For advisors, stock options can be complex and difficult to manage. They need to understand the vesting schedule, the fair market value, and the potential tax consequences. Both parties should ensure that the terms of stock options are clearly explained and understood before any agreements are signed.
How Much Equity Should You Offer Advisors?
Determining how much equity to offer an advisor can be a delicate balancing act. Offering too little may fail to attract the right talent, while offering too much can lead to significant equity dilution.
Factors to Consider:
- Advisor’s Experience and Role: More experienced advisors or those offering critical strategic insights may merit a larger share of equity.
- Company Stage: Early-stage companies may need to offer more equity to attract advisors, while companies in the growth stage can offer less, as the company’s growth potential is already evident.
- Time Commitment: Advisors who are expected to contribute significant time and effort, such as attending monthly meetings and providing hands-on assistance, may deserve a larger share than those offering strategic guidance on an ad-hoc basis.
Conclusion
Advisory shares are an effective way for startups to attract top advisors without needing immediate cash. By offering equity, companies can tap into valuable expertise to drive long-term success. However, both parties must carefully consider the terms, tax implications, and potential conflicts of interest when negotiating these arrangements. If you encounter difficulties managing tax issues related to advisory shares, consider seeking the services of Vyde—Your Own Accounting Department—all rolled into one.
FAQs About Advisory Shares
1. What Are Advisory Shares?
Advisory shares are equity compensation awarded to individuals who provide valuable advice and guidance to a company. These shares give the advisor a stake in the company’s success in exchange for their strategic insights and industry connections.
2. How Do Advisory Shares Work?
Advisors are given equity in the company, often in the form of restricted stock, restricted stock units, or stock options. These shares typically come with a vesting schedule that dictates when the advisor can claim full ownership.
3. Are Advisory Shares Taxable?
Yes, advisory shares are generally considered taxable. Advisors may be required to pay taxes on the fair market value of the shares once they vest or are exercised.
4. What Is the Difference Between Stock Options and Restricted Stock?
Stock options give advisors the right to purchase shares at a future date at a set price, while restricted stock grants actual ownership but with restrictions on when the shares can be sold or transferred.
5. How Much Equity Should You Give to Advisors?
The amount of equity awarded to advisors depends on factors like the advisor’s experience, role, and the stage of the company. Typically, early-stage companies offer more equity to attract top talent.
