Building a company from scratch is a thrilling yet challenging journey, especially in the early stages. As a startup founder, you will eventually face problems that you can't solve alone. You need guidance from the right advisors who can draw on their industry experience for informed suggestions. But how are you going to compensate these advisors when funds are not exactly abundant, especially if you are a pre-seed or Series A startup? The answer lies in 'Advisory Shares'.
Advisory shares are a form of stock options you can offer consultants in exchange for their guidance. This not only compensates them for their time and expertise but also gives them a stake in the company's success. It is like giving them 'skin in the game,' aligning their interests with yours and creating a powerful incentive for their dedication.
However, issuing advisory shares requires careful consideration. Ownership dilution, overcompensation, and potential conflicts of interest are all complex issues that need to be addressed. This blog covers these concerns, exploring the meaning, types, workings, benefits, and challenges of advisory shares. Keep reading!
Advisory shares, also known as advisor shares, are a unique form of equity compensation. They are not given in exchange for cash but rather for the valuable time, expertise, and strategic insights that startup advisors bring to the table. These equity shares allow young companies to leverage the experience and networks of seasoned professionals without a significant cash outlay.
One key characteristic of advisory shares is that they do not confer voting rights or a share in the company's profits. Rather, they provide the holder with the right to offer advice and guidance to the startup's management team. This makes advisory shares a popular choice for compensating good advisors, consultants, and other experts who provide valuable insights and guidance to a startup.
Unlike other types of equity, such as common shares or preferred shares, advisory shares come with a vesting schedule. This means that company advisors do not receive all their shares upfront. Instead, they earn their shares gradually over several years. This arrangement encourages them to stay committed and continue sharing their guidance over the long term.
Equity, in simple terms, means an ownership stake in a company. It signifies a right to a portion of the company's assets and profits. As a startup founder, you might offer equity to investors, founders, or employees in exchange for their investment or contribution to the company.
Advisory shares, on the other hand, are a specific type of equity compensation that you can offer to individual advisors. These shares are not given in exchange for cash or investment but rather for the valuable time, expertise, and strategic insights that advisors bring to your startup.
Regular shares, also known as common shares or equity, represent ownership in a company. When you own regular shares, you own a part of the company and have a claim on the company's profits and assets. Regular shares also offer voting rights, which allows the holders to have a say in company decisions.
Advisory shares are a type of stock option that you can offer to advisors in exchange for their expertise and guidance. Unlike regular shares, advisory shares do not come with voting rights or a share in the company's profits.
When it comes to compensating business advisors with equity, you have two main options: Non-Qualified Stock Options (NSOs) and Restricted Stock Awards (RSAs). The distinction between these two lies primarily in their legal structure. RSAs represent shares that are purchased upfront, while NSOs provide the right to buy shares at a later date.
Non-Qualified Stock Options (NSOs) are another type of stock option that startups can offer to advisors. Unlike Restricted Stock Awards (RSA), NSOs do not qualify for the same tax-advantaged treatment as some other types of equity, such as Incentive Stock Options (ISOs).
NSOs can be granted to individuals who are not employees of the company, such as consultants, advisors, and independent board members. When advisors are granted NSOs, they gain the right to purchase a given number of company shares at a fixed price. This price is often referred to as the strike price or exercise price.
The potential benefit of NSOs comes into play if the value of the shares increases over time. If this happens, the advisors can also profit from the difference, or the spread, between the buying price and the selling price of the shares.
However, it is important to note that NSOs come with tax implications. The advisors may be liable for taxes at two key points: first, when they exercise the options and purchase the shares, and second, when they sell the shares.
RSAs are commonly issued in a startup's early stages, often before the first round of financing. At this stage, the startup may not have raised a significant amount of money, and the company's Fair Market Value (FMV) is typically quite low.
A Restricted Stock Award represents a grant of common stock shares to the advisor. The advisor can pay for these shares either with cash or through the services they provide to your company. Once the RSA is granted and any purchase requirements are met, the advisor becomes the owner of the stock.
If the RSA comes with vesting requirements, you retain the right to repurchase any unvested shares if the advisor ceases their association with your startup. A considerable number of advisors prefer receiving RSAs rather than stock options, as RSAs can be structured to require a lower cash outlay.
These shares are generally granted to professionals who can offer useful advice and guidance to your startup. These individuals, referred to as advisors, can be industry experts, seasoned entrepreneurs, or professionals with significant experience in your startup's field.
The decision to grant advisory shares is often based on the advisor's expertise and role within your startup. Factors such as the duration of the advisor's engagement and the expected contributions can also influence this decision.
In terms of equity, advisors can expect to receive between 0.25% and 1% of the startup's total equity, depending on their contributions and the business's growth. In some cases, up to 5% of the startup's total equity could be allocated to advisors.
It is important to note that these figures are not fixed and can vary across startups. As a founder, you have the flexibility to determine the equity allocation based on what you (and other founders and investors) believe is fair and justifiable.
Here are some important insights into the entire working process of advisory shares:
One key mechanism that makes advisory shares a strategic tool for startups is vesting. It is the process through which advisors earn their shares over time. This ensures that advisors remain committed to providing their expertise and advice over a longer period.
The most common vesting schedule for advisory shares is typically two years with no cliff. This means that advisory shares vest or become earned in monthly increments over 24 months. However, if advisors stop providing their services as described in the advisory share agreements, you do not owe them the entire vesting schedule.
This vesting schedule incentivizes advisors to stay engaged with your startup. It aligns their interests with your startup's success, creating a partnership geared toward mutual growth and success.
While the two-year vesting schedule is common, it can vary based on the specific needs and agreements of the startup and the advisor. Some startups may opt for a longer vesting period, while others may include cliff vesting, which is a period the advisor must serve before any shares vest.
Here are two of the other vesting schedules that you can include in your advisory agreement:
The issuance of advisory shares has tax implications for both the startup (issuer) and the advisor (receiver).
When your startup issues advisory shares, you are compensating advisors for their services. This compensation is often considered a business expense and can be deducted from your company's taxable income.
However, the tax implications can vary depending on the type of advisory shares issued. For instance, with RSUs, you can deduct the FMV of the shares at the time of vesting. This can reduce your startup's taxable income and potentially lower the tax liability.
For advisors, taxes may be incurred at two key points: when the shares are received and when the shares are sold. The tax implications may vary depending on the type of advisory shares. For instance, with Restricted Stock Units (RSUs), taxes apply when the shares are delivered at the time of vesting.
Advisors are required to pay ordinary income tax on the market value of the shares when they are delivered to them (usually as soon as they vest), even if they do not sell them at that time. This includes federal, state, and local taxes.
In the context of advisory shares, your startup acts as the issuer and the advisor as the receiver.
Issuing advisory shares can offer several benefits to your startup, but it also comes with its own set of challenges. Understanding these aspects will enable you to get a comprehensive understanding of advisory shares.
Navigating the complexities of advisory shares can pose significant challenges, especially when it comes to legal and tax implications. In addition, issues related to other types of equity can get complicated pretty quickly. But don't worry, as Qapita is here to address all your equity and cap table problems.
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