Advisory shares are an advantageous equity arrangement between start-ups and business experts. Rather than give up capital, new companies entice advisors to offer guidance while incentivizing them to help it grow over time per a pre-determined vesting schedule.
In this article, we help start-ups and advisors understand the basics of advisory shares, issuance, and vesting schedules. We also share a few example scenarios to show you how they work in practice.
What are Advisory Shares?
Advisory shares are stock options that start-ups give to company advisors instead of cash compensation. They are different from full-time employee stock options and common stock from a vesting and taxation standpoint. Advisory shares offer advisors a non-cash stock option for their expertise without requiring the start-up to give up capital.
Who Gets Advisory Shares?
Advisors receive advisory shares from start-up companies.
The amount of equity will vary according to the situation considerably. In general, the advisory board receives around five (5) percent of a company’s total equity while individual advisors receive between 0.25 and one (1) percent. The advisor’s background and level of participation will also determine if the individual gets shares.
However, the total amount that an advisor receives depends upon how much they are expected to contribute. More mature start-ups can command lower percentages, whereas younger, riskier companies may need to increase.
Here is an article that defines advisor.
Who Issues Advisory Shares?
Start-up companies issue advisory shares to advisors.
They offer advisory shares to start-ups when they need specific business or subject-matter expertise. However, a start-up may still be in the pre-launch phase, making it challenging for ideal investors to provide capital funding. The advisory shares option can take a company from concept to launch more efficiently and effectively under an expert’s watchful and equity compensated eye.
Equity given to advisors can vary considerably. An advisor’s expertise and role can determine if they receive advisory shares. It could also depend on how long the advisor and company expect to work together.
Here is a web page that defines start-up companies.
Common Advisory Shares Vesting Schedule
Common advisory shares vesting schedules are typically two (2) years with no cliff. As such, an advisor’s advisory shares vest, or become earned, in monthly increments over 24 months. However, the start-up does not owe an advisor the entire vesting schedule if they stop providing advisory services as described in the advisory agreement.
What Are Cliffs in Vesting Schedules?
Cliffs are periods without stock vestments, typically occurring in one (1) year. This vesting schedule is usually a condition of employee stock options and not part of the advisory shares vesting schedule.
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Difference Between Regular Shares and Advisory Shares
The primary difference between regular shares and advisory shares is that regular shares are common stock units available for purchase on the public market. In contrast, advisory shares are stock options given to experts in exchange for their strategic business insights.
The latter fall under non-qualified stock options, or NSOs, which differ from employee incentive stock options, or ISOs.
ISOs vs. NSOs
ISOs are stock options for employees, while NSOs incentivize consultants, partners, advisors, directors, and others. The Internal Revenue Service (IRS) taxes NSOs as regular income when shareholders want to exercise the stock option. ISOs do not incur tax liability at the time of exercise.
Examples of Advisory Shares
No two start-ups and advisory share deals are alike. The situations that you face as an advisor or start-up will always bring about unanticipated events. However, a solid advisor agreement can help you mitigate challenges.
Below, we’ve outlined two common examples of advisory shares to help better illustrate how they work regardless of which role you play:
Example 1. Great Idea But Not Enough Capital
This example demonstrates the power of start-up advisory shares when paired with a strategic business expert. Let’s take a look:
- PKW, Inc. is a start-up that sells Bluetooth tags that integrate with smartwatches, phones, and other devices that helps forgetful people remember their phone, wallet, keys, briefcase, or any other items they tend to forget
- They offer a location-based tracking tag that sends an alert as soon as you hit your front door and can produce these tags in-house with raw materials coming from international suppliers at a great price
- The application interface is easy to use and optimized for accessibility, making it ideal for students, older adults, and those with memory impairments
- Sales have been below projections, and PKW has been receiving complaints that the front door function does not work intermittently, competitive advantage is waning, and a host of other issues
- PKW convinces Premiere Group, a technology marketing advisory group, to help them turn things around in exchange for 10% of the equity in advisory shares, with vesting occurring over three years
- Premiere quickly determines that PKW left several opportunities on the table by limiting their product to “commonly forgotten items” while falling short on the development of their location-based Bluetooth technology
- The advisor group guides them through the necessary changes, including rebranding, research and development, strategic marketing management, and more
- After three years, PKW has a successful company with an interesting origin story and fully vests the advisory group’s shares
This example highlights a great use of how advisory shares work and the exchange of value that can occur, even between seemingly risky investment opportunities. However, the success of a deal ultimately depends upon the product or services offered and the type of advisors that join the project.
Example 2. Advisor Departs Early
This example features a smart vehicle manufacturer and a solo advisor named Howard Dewey:
- Orion is a smart vehicle manufacturer headquartered in Coralville, Iowa
- Howard Dewey promotes himself as a savvy investor and knowledge incubator in the smart technology space with 30 years of executive automotive industry experience
- Orion and Mr. Dewey believe they can create value with his knowledge but agree the company does not have enough equity for traditional investment instruments
- They also agree to Mr. Dewey taking a 1% advisory rate with full vesting occurring at two years
- Seven months into the agreement, Mr. Dewey becomes ill and can no longer offer advisory services, for which he provides 30 days’ notice per the advisor agreement
- Orion agrees to release him from the agreement and waives the 30-day notification requirement based on Mr. Dewey’s exceptional performance and unanticipated situation
- They pay him the equivalent of 7 month’s advisory services or 7/24ths of the total amount
- Both parties walk away from the agreement amicably having met all contractual obligations and exchange “thank you” letters as a matter of formality
As you can see, advisory situations can lead to unique but unanticipated problems. The example above illustrates how health complications can cause significant disruptions. However, Orion and Dewey had an agreement to govern the situation.
They followed through on the terms and conditions, which is all that anyone can legally ask of a contractually-obligated party.
Get Legal Help with Advisory Shares
Advisory shares can entice business- or subject-matter-savvy experts to assist start-ups in their growth efforts. However, suitable advisors will anticipate a deal to include the formal agreements, including advisory agreements and advisory board agreements if they serve on the board of directors. Start receiving proposals from start-up lawyers near you today.
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