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Advisory shares is the term used to describe any form of equity compensation given to a startup’s advisors. Most often, advisory shares are stock options. While giving out advisory shares is a common practice in the startup world, there are several critical considerations founders should account for before handing out advisory shares.
In this article, we’ll dive into the world of advisory shares—covering why startups offer them, key considerations for founders, and a few helpful tips when structuring advisory shares agreements.
An “advisory share” is a term of art used in the VC space; there is not a uniform legal or securities law definition applicable to an advisory share. Advisory shares are often understood to refer to equity compensation for advisors. Instead of draining precious capital, a young startup company may instead offer an adviser equity in the form of advisory shares. However, not all advisory shares are created equal. These shares often come in two forms, and the form they take influences how advisory shares work.
An advisory share can take the form of a “Non-Qualified Stock Option,” or NSO. Here, the advisory shares are presented as stock options, not actual shares in the company. However, like a typical option, a NSO will provide the advisor with the right (but not obligation) to purchase a predetermined amount of the startup’s common shares at the option’s exercise price. The exercise price will typically be the startup’s fair market value or 409A valuation at the time the advisor is brought on. Also note that common shares are not the same as preferred shares, which are reserved for investors.
Advisory shares given as NSOs may have a few key differences with employee stock options (e.g., an Incentive Stock Option [ISO]). As compared to an employee stock option with a typical 4 year or longer vesting schedule, an NSO granted to an advisor may vest in 1-2 years, with either no cliff or a cliff that is only a few months long. This is because most of the value advisors can provide a startup usually happens upfront. Finally, the tax implications for NSOs will be different than ISOs and other types of employee stock options.
The second—though less common—form that advisory shares can take is restricted stock agreements (RSAs). As compared to an NSO, which is an option to purchase shares, a RSA represents a direct grant of shares in the company.
However, the RSAs are “restricted,” meaning the shares are subject to a vesting schedule and are non-transferable (though they typically become unrestricted in the case of a liquidity event). When the RSAs vest, the advisor will receive them at the startup’s fair market value. In practice, RSAs are typically granted in the early stages of the startup’s life when the fair market value of the startup is difficult to determine or negligible.
Startups grant advisory shares for many of the same reasons they offer employees stock options—incentive alignment and cash flow savings. By giving advisors direct skin in the game, they’ll ideally be more motivated to help the company succeed. At the same time, providing compensation in the form of equity allows startups to better manage their cash flows.
This leads to the natural follow-up question—who are these “advisors” and what can they offer to a startup that warrants such compensation?
Just like there is no legal definition of advisory shares, there is also no legal definition for what constitutes an advisor. Often, they’re just people who can offer valuable strategic insights and industry connections, much the same way actual investors do. For instance, they may have the network that can help the startup raise their next funding round or hire C-suite talent. An advisor could also be someone who has built and exited a successful company in the same space—and can share pitfalls to avoid on the path toward scalability.
In some cases, advisors can also be fund managers or General Partners (GPs) who operate and manage their own VC fund. It is not uncommon to find GPs who will both facilitate an investment into a startup, and then serve as an advisor to the same startup. In those instances, to avoid any conflict of interest, the GP will usually offset the value of the advisory shares against the management fee.
Because there is no regulatory standard for advisory shares, the amount of shares a startup may grant an advisor can differ from startup-to-startup and advisor-to-advisor. That said, the industry standard is 0.25% to 1% of a startup’s total equity on a per-advisor basis. If a startup has an advisory board, it is typical for the startup to allocate 5% of its total equity to be split amongst that board.
Again, these are just guidelines—not hard and fast rules. For instance, the younger the startup, the more advisory shares (as a percentage of total equity) they would likely have to offer to incentivize key advisors (and vice versa).
Like anything, advisory shares have both pros and cons. If you’re a founder, advisory shares enable you to:
All these benefits are valuable. But founders should also consider that:
Because of these considerations, it’s crucial that you as a founder use a proper advisory shares agreement when working with advisors. However, keep in mind that you would first need a valid equity incentive plan in place—and approval from your board of directors—before you can proceed with the advisory shares agreement.
An advisory shares agreement is just a document outlining the terms of your startup’s relationship with an advisor. While there is no standard format, you can find plenty of templates online. And if you’re a founder who came up through an accelerator program, there may already be an advisor-startup structure that you can just plug into.
Regardless of format, a properly structured advisory shares agreement should contain at least four things:
There’s a reason most startups have advisors—they can add real value to a company and accelerate its path towards scalability. In exchange, founders will likely have to offer advisory shares, which is why understanding their ins-and-outs and how to structure the relationship is so important.
If you are undecided about issuing advisory shares, or need further assistance on structuring an advisory share agreement, it’s always best to seek counsel on the matter before granting away any portion of your company.
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