Attracting experienced advisors is key for any startup founder looking to build a successful business. Compensating advisors with equity rather than just cash can help align incentives and get guidance from those invested in your startup’s growth.
One popular approach is granting advisors “advisory shares” – a form of equity compensation. But what exactly are advisory shares and how do they work? This comprehensive guide will explain everything startup founders need to know.
We’ll define advisory shares, how they differ from standard equity offerings, types of advisory shares, vesting schedules, how much equity to grant, and when advisory shares are advantageous for startups. Read on for clarity on optimally utilizing advisory shares.
Key Takeaways
- Advisory shares like options and RSUs are equity compensation granted to startup advisors.
- They provide upside tied to company growth while limiting certain shareholder rights.
- Typical vesting schedules are 3-4 years with a one year cliff.
- The optimal advisory share grant amount depends on the advisor value and equity context.
- Well-crafted advisor share agreements keep equity incentives aligned long-term.
What Are Advisory Shares?
Advisory shares are a form of equity compensation granted by startups to advisors in return for their expertise and guidance.
Advisors receive advisory shares rather than standard common stock. These shares can be structured as stock options or stock units.
Advisory shares give advisors equity exposure without full shareholder rights. The shares incentivize advisors to add value to help the startup succeed.
Startups may offer advisors equity compensation in the form of:
- Stock Options – The right to buy shares at a set price in the future.
- Restricted Stock Units – Promise to deliver shares if conditions are met.
- Actual Shares – Full common stock shares with more shareholder rights.
Advisory shares are a key tool for startups to engage advisors by providing “skin in the game”.
| Consideration | For Startups | For Advisors |
|---|---|---|
| Dilution | Assess fair market value of the company | Consider vesting period and liquidity |
| Tax implications | Consult with a tax professional | Understand tax consequences |
| Advisory agreements | Define terms and conditions of advisory shares | Factor in liquidity restrictions |
How Do Advisory Shares Work?
Advisory shares work by granting advisors equity exposure tied to future company growth, while limiting certain shareholder rights.
Some key aspects of how advisory shares function:
Vesting – Advisory shares vest over time to incentivize advisors to remain engaged. Standard vesting is 3-4 years with a 1 year cliff.
Tax implications – Advisors pay ordinary income tax when advisory shares are exercised or settle, versus more favorable capital gains tax treatment on standard shares.
No voting rights – Advisory shares typically do not come with voting rights on company matters. This limits advisors’ control.
Capped upside – Payout on advisory shares may be capped at a certain multiple of the strike price, limiting upside compared to standard shares.
Dilution protection – Advisory share agreements sometimes include dilution protection provisions in case of major financing rounds.
Understanding these key differences helps founders optimize the use of advisory shares.
The Role of Advisors in a Startup: Why Offer Advisory Shares?
Experienced advisors provide startups with invaluable expertise and mentorship in areas like business strategy, branding, operations, and technical development. Advisors are usually not involved in day-to-day activities but offer high-level strategic advice.
Compensating advisors solely in cash can be expensive for early stage startups. Equity in the form of advisory shares better aligns advisor incentives with the long-term growth and success of the company.
Advisory shares also allow startups to attract big name advisors who might otherwise require large cash payments. The potential for an equity payout down the road is an appealing draw for advisors passionate about the startup’s mission.
Equity Compensation: Comparing Advisory Shares and Regular Shares
Regular shares, also called common stock, represent true ownership in a company and come with rights like voting and dividends not typically granted to advisory shares.
Advisors granted actual shares become part shareholders with the associated rights. But issuance of regular shares to advisors is uncommon.
More often, startups use advisory shares in the form of stock options or RSUs. These provide upside exposure without ownership.
This avoids prematurely diluting founders’ and investors’ shares while still incentivizing advisors via potential equity gains in the future.
Types of Advisory Shares
There are a few main types of equity compensation that can be structured as advisory shares:
Stock Options
Advisors receive options to buy shares at a set “strike” price in the future. Stock options must be exercised after vesting to receive the shares.
Restricted Stock Units (RSUs)
RSUs promise advisors a certain number of shares in the future if vesting conditions are met. No upfront payment is required.
Actual Shares
Rarer for advisors, actual common stock shares may be granted with more shareholder rights than standard advisory shares.
The most common types granted are stock options and RSUs. Each have different tax/cash flow implications that must be considered.
Key Benefits of Issuing Advisory Shares
Offering advisors advisory shares rather than cash or standard equity has some important benefits:
- Incentivizes long-term commitment – Vesting provisions keep advisors engaged over time.
- Rewards future growth – Equity payouts are tied to company value creation.
- Preserves cash – Equity compensation conserves cash compared to large salaries or cash fees.
- Attracts top talent – The prospect of meaningful equity payouts draws high-profile advisors.
- Aligns incentives – Equity exposure focuses advisors on helping the startup succeed.
For these reasons, advisory shares have become a popular instrument for compensating advisors at startups of all stages.
How Much Equity Should You Provide as Advisory Shares?
Determining the right amount of advisory share equity to grant depends on several factors:
- Advisor value add – More influential advisors merit higher share compensation.
- Industry standards – Competitive equity levels must be matched to attract advisors.
- Existing equity split – The current founder/investor/employee equity percentages guide amounts.
- Vesting schedule – Shorter or no cliffs warrant somewhat reduced share allotments.
- Company stage – Earlier stage startups may need to offer more equity for advisor retention.
- Cash constraints – Companies with limited cash increase equity-based advisor compensation.
A typical advisory share grant range is 0.25% to 2% equity, but the optimal amount depends on the specific scenario.
Key Considerations When Structuring Advisory Shares
Crafting advisor share agreements requires balancing several elements:
- Vesting schedule – The standard is a 1 year cliff then monthly or quarterly vesting over 3-4 years. Accelerated vesting may be negotiated.
- Share type – Stock options or RSUs are most common. Actual shares increase advisors’ voting rights.
- Number of shares – Grant enough shares to incentivize advisors, but not so much it’s excessively dilutive to other equity holders.
- Termination clause – Define what happens to unvested shares if the advisor relationship ends. Full or partial acceleration may occur.
- Company repurchase rights – Include terms allowing the company to repurchase advisor shares at fair market value upon termination if desired.
Properly structured agreements keep advisors incentivized while protecting the startup.
Legal and Tax Implications of Advisory Shares
Using equity compensation triggers important legal and tax implications that startups must navigate:
- Equity grant documentation must clearly define advisor share terms and conditions.
- Tax counsel helps optimize advisory share structure for desired tax treatment upon issuance, vesting, and exercise.
- Income taxes apply when advisory shares are exercised. Capital gains taxes await later upon sale.
- Rule 701 imposes limits and filings on private company equity compensation.
- AMT tax may apply if exercise is structured improperly.
Proper legal documentation and tax planning prevents costly missteps when awarding advisory shares.
Advisory Shares in Practice: Real-World Examples & Case Studies
Some illustrative examples of advisory shares in startups:
- Social media platform company Snap awarded advisor Sony Pictures RSUs worth about $110 million at the IPO that helped Sony guide Snap’s growth.
- Leading venture capital firm Andreessen Horowitz commonly takes advisory shares in startups it invests in to provide guidance. Their shares netted over $680 million in the Facebook IPO.
- Global private equity firm Silver Lake received RSUs as an advisor to Tesla which vested in 2020 and amounted to a stake worth over $2 billion.
- Yahoo co-founder Jerry Yang advised hot startup Cooliris and was granted restricted shares and options representing 2% equity for his advice and connections.
These examples demonstrate how advisory shares enable startups to align with powerful advisors.
FAQs
What are the main types of advisory shares?
The most common types of advisory shares are stock options and restricted stock units (RSUs). Stock options give advisors the right to buy company shares at a set price in the future. RSUs represent a promise by the company to grant shares if vesting conditions are met.
How much equity do advisors typically get with advisory shares?
A typical advisory share grant is between 0.25% to 2% equity. The amount depends on the advisor’s level of involvement, industry standards, company stage, and existing cap table splits.
Do advisors get voting rights with advisory shares?
No, advisory shares usually do not come with voting rights. This helps limit advisors’ control and influence on company matters compared to founders and investors.
How are advisory shares taxed?
Advisors pay ordinary income tax rates when advisory shares vest or are exercised. This differs from capital gains treatment for standard shares upon sale. Proper planning is key.
Why use advisory shares versus standard shares?
Advisory shares incentivize advisors via upside while restricting certain shareholder rights. This preserves founder control and limits dilution from granting advisors full common stock.
Conclusion
Issuing advisory shares allows startups to compensate advisors using forms of equity such as stock options and restricted stock rather than large salaries. This helps align advisors’ incentives with the long-term growth of the startup, while allowing founders to maintain control through limited shareholder rights.
However, granting equity to advisors can also create potential conflicts of interest, dilution, and complex legal and tax implications that startup founders must consider.
Proper advisory share agreements with defined stock option terms, vesting schedules, and avoidance of non-qualified stock options can help balance the risks and benefits of bringing advisors into the capital structure through equity incentives. Moreover, the use of advisory shares—sometimes in conjunction with other forms like restricted stock or employee stock options—demonstrates a startup’s commitment to aligning the interests of its team with long-term success
