What Are Advisory Shares? A Guide for Startups
No startup, least of all one in its early stages of growth, has all the answers. Certain challenges are better solved with help from outside advisors who can draw on years of experience in the trenches. That’s all well and good, but how is a young startup company supposed to compensate these advisors for their invaluable tutelage? When cash is short (as it often is in the early going), startups may instead issue advisory shares.
Advisory shares, also known as advisor shares, are a type of equity compensation that startups can give to advisors in exchange for their, well, advice. This often ends up being a good deal for both the company and the advisor. The former gets the knowledge it needs to supercharge growth, while the latter gets a stake in the company they’re helping to build.
Advisory shares come in a few different flavors, but they’re typically issued as common stock options. There’s a whole host of other stuff you should know about this equity type before breaking out your rolodex of startup advisors, from how vesting schedules work to how advisory shares affect dilution. We’ll cover all of it in this guide.
- What are advisory shares?
- What’s the difference between advisory shares and regular shares?
- What are the different types of advisory shares?
- What is the vesting schedule for advisory shares?
- Who issues advisory shares?
- What is an advisory board?
- What is the downside of issuing advisory shares?
- Manage your complex cap table with Pulley
What are advisory shares?
Advisory shares, also known as advisor shares, are not any one specific thing. This blanket term covers any type of equity compensation a startup may issue to individual advisors or advisory groups instead of (or alongside) cash.
While advisors can help at any stage of a company’s growth, many startups that seek out advisors are still in the pre-seed or seed stage. This means they probably don’t have a ton of cash lying around. What they may have to offer instead is equity, i.e. a share of ownership in the company.
Why would an advisor accept equity in a company that hasn’t proven itself yet? One word: potential. Many early-stage company advisors are entrepreneurs and successful business people who may actually value equity more than cash—especially if they’re confident in their own abilities to advise a company into its next stage of growth.
As we noted above, advisory shares typically refer to shares of common stock options. But this isn’t always the case. Other types of advisory shares may include restricted stock awards (RSAs) and restricted stock units (RSUs). The specific type of equity award should be spelled out in the advisory agreement, which also includes information about vesting schedules and any other terms and conditions of the relationship.
What’s the difference between advisory shares and regular shares?
Advisory shares differ in some key ways from other types of equity a company may issue. The main difference is a pretty obvious one: advisory shares are only granted to advisors.
Another key difference is that advisory shares issued as common stock options are always non-qualified stock options (NSOs). NSOs don’t have the same restrictions as incentive stock options (ISOs), which can only be granted to employees. To read more about the distinction between the two, check out our guide on NSOs vs. ISOs.
Advisory shares also differ from regular, non-advisory shares in some key ways that have to do with vesting schedules and taxation. We’ll get into that, but first let’s break down the different types of advisory shares you may encounter.
What are the different types of advisory shares?
Remember, “advisory shares” is kind of a made-up term that may refer to different types of equity. Let’s break down three equity types that may be considered advisory shares depending on the circumstances.
Most of the time, advisory shares refer to common stock options. Stock options are essentially contracts that allow the holder to purchase shares of stock at a fixed strike price. These contracts are called “options” because the holder may purchase a share of stock at the specific price associated with the option contract, but they certainly don’t have to.
When advisory shares are issued as stock options, these stock options aren’t taxed the same way as certain employee stock options would be. This is because advisory shares are NSOs. NSOs are taxed at the ordinary federal income tax rate when they’re exercised, while ISOs (including many employee stock options) are only taxed when the holder sells the stock. This additional taxation event for NSOs applies to the difference between the exercise price and the fair market value of the common shares at the time of exercise.
A bit less commonly, advisory shares may be issued as either restricted stock awards (RSAs) or restricted stock units (RSUs). Both of these equity types differ in substantial ways from stock options, as well as from each other.
A restricted stock award is a grant of company stock that is restricted in certain ways. If the advisor accepts the award, they may be required to pay a purchase price for it, after which they’ll technically own the stock from the grant date. (Their rights to that ownership may be stripped from them if they fail to meet certain restrictions or vesting conditions.) Some advisors might like RSAs because they offer the chance to own company stock outright, and may come with shareholder voting rights.
A restricted stock unit is another type of equity that grants the holder actual shares of company stock. Unlike with RSAs, RSUs aren’t immediately issued to the advisor. Instead, they convert into common stock after the vesting conditions are met.
Why would an advisor prefer RSAs or RSUs to stock options? Well, an advisor may not have the cash flow or interest required to exercise their options at the company’s current fair market value. Instead of having to spend cash to purchase shares of common stock, the advisor may opt to just receive actual shares of stock.
What is the vesting schedule for advisory shares?
Startups depend on vesting to ensure that anyone who’s granted equity demonstrates a sustained commitment before receiving full ownership of said equity. You may be familiar with common vesting schedules for employees, but vesting works a bit differently when it comes to advisory shares.
The main difference is that advisory share agreements typically involve an abbreviated vesting schedule. (A one- or two-year schedule with no cliff is fairly common.) This makes sense when you think about an advisor’s contributions relative to a typical employee’s. While an employee theoretically continues to deliver more and more value as the years stack up, an advisor may deliver the majority of their insights within the first year or two of the engagement.
Different advisors may be required for different stages of a company, too, so it’s not totally uncommon for one batch of pre-seed advisors to make way to another batch of advisors at a later fundraising stage. Given the nature of these relationships, a shorter vesting schedule generally makes good sense.
Who issues advisory shares?
The companies that issue advisory shares tend to be startups. Some of these startups seek to lock down advisory services as early as the idea stage, with the hopes that bringing in an advisor early on will lead to stronger networking and fewer mistakes at a critical stage of growth. The idea is that an advisor’s input will lead to business practices and strategies that ultimately increase a startup’s valuation and increase its odds of long-term success.
With that said, there’s no rule saying that late-stage startups or other companies can’t bring in advisors and issue advisory shares.
What is an advisory board?
In some cases, a startup may engage in relationships with quite a few advisors. In order to align these advisors—who may come from different backgrounds and areas of expertise—along a singular vision, the startup may form an advisory board.
An advisory board, then, is a collection of advisors that generally meets at a regular cadence to build relationships and contribute complementary insights. An advisory board may also help a company stay organized when it comes to issuing equity; it’s not uncommon for a startup to divide a certain percentage of the company’s total equity among individual board members.
What is the downside of issuing advisory shares?
There may be some very real downsides to issuing advisory shares.
For one, any time a company issues new equity, existing shareholders may be diluted. Some level of dilution is usually inevitable as a company continues to grow and issue new stock, but it’s important to stay on top of this so you don’t give away too much of your company and make your existing shareholders all grumbly. Fortunately, Pulley’s pro-forma tools can help you double-check the dilution math across multiple equity issuances.
It’s also important to have clear agreements with your advisors regarding issues such as confidentiality and conflicts of interest.
In the course of an advisory relationship, an advisor may come to know some confidential information involving everything from strategy to customer data. In order to limit your risk exposure and/or prevent that advisor from turning around and sharing these insights with competitors, your advisory agreements should include specific terms and conditions regarding confidentiality.
And then there’s the related issue of conflicts of interest. What’s to stop an unscrupulous advisor from working with a competitor, or even starting their own competing company based on your hard-thought ideas? These aren’t necessarily likely scenarios, but you should work with a legal advisor to construct an advisory agreement that doesn’t leave you exposed.
Manage your complex cap table with Pulley
By the time you’re juggling advisory shares with other types of equity, you may have caught on to an underappreciated fact: equity can get complicated pretty quickly. Pulley is here to take the stress out of managing your cap table and help you avoid mistakes that could cost you big in the long run.
Schedule a demo with us today to learn more.