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Advisory shares represent a form of stock option awarded to individuals advising a company, distinct from its employees. These shares are often provided to startup company advisors in place of cash compensation. Typically, advisors receive the option to purchase shares rather than receiving the actual shares outright. This approach helps maintain confidentiality and mitigates potential conflicts of interest. However, it’s worth noting that advisory shares can also incur expenses for a burgeoning company. For guidance on advisory shares and other financial matters tailored to your specific requirements and objectives, consulting a financial advisor is advisable.
Advisory Shares Explained
Advisory shares, also referred to as advisor shares, typically constitute a form of financial compensation in the shape of stock options. Those who receive advisory shares are typically seasoned business professionals, often with prior experience as company founders or high-ranking executives. They offer their expertise and industry connections in exchange for an equity stake in a fledgling company.
These advisors are distinct from accountants and attorneys, who typically charge fees for their services. Advisors eligible for advisory shares are not usually tasked with providing technical guidance on matters like taxes or contracts. Instead, their role primarily involves contributing strategic insights and providing access to extensive networks of contacts.
How Advisory Shares Differ from Regular Shares
Regular shares, often known as common stock, are standard units of stock traded on public markets such as the New York Stock Exchange or NASDAQ. These shares are accessible to all retail investors.
In contrast, advisory shares are non-qualified stock options granted to experts as compensation for their advice or expertise. They are distinct from incentive stock options typically provided to employees as part of their compensation packages.
Two Types of Advisory Shares
Advisory shares can be categorized into two main types: stock options and restricted stock units (RSUs).
Restricted Stock Units (RSUs)
Restricted Stock Units (RSUs) represent a form of common stock that a company commits to deliver to an employee in the future, subject to specific vesting and performance criteria. These RSUs are not granted until the established restrictions have lapsed or the prescribed conditions have been met. An employer may pledge to provide an employee with stock based on certain conditions, such as achieving specific work objectives or maintaining a certain tenure with the company.
Taxation on RSUs takes effect when the shares are distributed, typically at the time of vesting. At this point, you are required to pay ordinary income tax on the market value of the shares when they are delivered, even if you choose not to sell them immediately. This tax obligation encompasses federal, state, and local taxes. Some companies allow employees to sell a portion of the vested shares to cover the tax liability.
Subsequently, employees have the option to retain the remaining shares for future sale or to sell them promptly. Opting to sell the shares will entail paying capital gains taxes on any appreciation or increase in value between the selling price and the fair market value at the time of vesting.
Stock Options
Stock options represent a form of compensation extended to a range of individuals, including employees, contractors, consultants, and investors, through contractual agreements. These options grant the recipient the privilege to purchase a specified number of company shares at a predetermined price, commonly referred to as the grant price.
It’s important to note that this offer is not indefinite. There is a predefined window of opportunity during which you can exercise your options before they expire. Additionally, some employers may stipulate that options must be exercised within a specific timeframe after departing from the company.
The quantity of options granted by a company can vary, contingent on the company’s policies and practices. It may also be influenced by the employee’s seniority and specialized skills. In many cases, the approval of investors and other stakeholders is necessary before an employee can be awarded stock options.
How Advisory Shares Work
Advisors typically receive options to purchase shares instead of being directly given the shares themselves. This approach helps circumvent potential tax liabilities, especially when the advisory shares hold significant value.
Advisory shares serve as incentives for advisors to become invested in a company’s sustained growth and prosperity over the long term. In contrast, company executives and managers may receive actual shares rather than options. Stock options typically have a vesting period, often spanning one to two years. This vesting period enables the company to defer the transfer of ownership to advisors while ensuring their continued commitment to the company’s long-term achievements.
Who Issues Advisory Shares?
Many companies that issue advisory shares are startups, often in the early stages of development, where the company may exist primarily as a concept. Alternatively, issuers of advisory shares might be in the later seed capital stage or an active and expanding enterprise. The allocation of equity to advisors can vary significantly, influenced by factors such as an advisor’s expertise, role, and the anticipated duration of their collaboration with the company.
Companies may allocate up to 5% of their total equity to advisors. In some cases, young companies establish advisory boards and distribute equity to incentivize board members. Individual advisors may receive anywhere from 0.25% to 1% of the company’s equity, contingent on their level of contribution to the company’s growth.
For instance, an advisor providing insights at monthly meetings might receive 0.25%, while an advisor who introduces a prospect that becomes a substantial customer could receive 1%, given their more tangible impact on the company’s success.
As a company matures, the percentage of equity that advisors can expect to receive tends to decrease. For instance, a company in its conceptual stage might allocate 0.25% of equity to an advisor attending monthly meetings, whereas a company past the startup phase and in the growth stage might reduce this allocation to 0.15% for the same advisor.
Advisory Shares: Pros and Cons
Many startups utilize advisory shares as a means to attract experienced advisors during critical phases of their development. However, there are potential drawbacks to consider. Advisory shares serve the purpose of safeguarding a company’s confidentiality, as advisors often gain insight into closely guarded product development and marketing strategies. To address this, companies may request advisors to sign confidentiality and non-disclosure agreements.
Additionally, advisors often engage with multiple companies simultaneously, which may limit a company’s ability to prohibit them from collaborating with competitors. It’s advisable for companies to ascertain in advance if advisors have existing commitments that could influence their impartiality.
Furthermore, young companies must exercise caution to avoid overcompensating advisors with advisory shares. Founders might be inclined to allocate fractional percentages of equity in a fledgling company with limited assets. As the company expands, these fractional stakes can become more significant. This is one reason why the equity granted to individual advisors tends to decrease as the company matures.
Experts recommend that companies contemplating the use of advisory shares take a measured approach before offering equity in exchange for advice. Even seasoned business leaders may not necessarily be effective advisors, making research a crucial step before committing to equity arrangements. Some advisory share agreements include a three-month trial period during which the arrangement can be terminated without any equity transfer to the advisor.
How do I manage my advisors and their shares?
Imagine you’re the visionary behind the next big thing in the insect world, and you’ve assembled a stellar team of advisors. Now, you’re faced with the task of efficiently managing their advisory shares and ensuring the proper documentation.
Here are some valuable resources to explore:
- FAST Agreement by Founder Institute: The Founder Institute’s FAST (Founder Advisor Standard Template) agreement is a widely used resource by founders and advisors worldwide. It offers a structured framework for advisory arrangements.
- Cabal: Cabal is a versatile app designed to help founders streamline introductions, track contributions, and connect with top talent. What sets it apart is its ability to simplify equity programming to incentivize advisors effectively. It also features a leaderboard that highlights the most supportive advisors and investors.
- Fairmint: Fairmint empowers founders to grant equity to their community members in exchange for their investments, whether in time, money, or contributions. This approach extends beyond advisors, benefiting contractors, influencers, and others by rewarding them with tokenized equity.
If you’re aware of any other tools or resources for managing advisors effectively, please feel free to email us at steph@openvc.app, and we’ll be sure to update our list accordingly.
Business Tips
If you have inquiries regarding the allocation of advisory shares or any other aspects of your burgeoning company, enlisting the expertise of a financial advisor can aid in formulating a comprehensive financial strategy for your business. The process of finding a suitable financial advisor need not be challenging.
SmartAsset offers a complimentary tool that matches you with up to three carefully vetted financial advisors in your area. You can also arrange a free introductory call with these advisor matches to determine the one who aligns best with your needs and preferences. If you’re prepared to locate an advisor capable of helping you achieve your financial objectives, you can initiate the process now.
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