Advisory Shares Meaning and Examples
Advisory shares are a type of stock option that is given to company advisors rather than employees. They are usually issued to startup company advisors as a substitute for cash compensation. In other words, they are typically financial rewards that take the form of stock options. The company usually grants advisors options to buy shares rather than giving them the actual shares. Advisory shares can also be referred to as advisor shares.
Advisor shares can help to ensure that there is confidentiality as well as prevent conflicts of interest. However, they can also be costly for a juvenile company. Startup companies may not have the cash flow or revenues to cover the high salaries of their experts and advisors, they usually issue advisory shares as an alternative to cash payments and keep them on board.
Advisors who receive advisory shares are usually business people that have previous experience as company founders or senior executives. They exchange their insight and contacts for equity in startup companies.
These advisors are not the same as accountants, consultants, and attorneys that are likely to receive a fee for their services. Although they can also serve as advisors, they are more likely to charge a fee for their service. As earlier pointed out, experienced individuals with previous experience as founders, senior executives, or industry experts are usually provided with advisory shares.
Advisors who are bound to get advisory shares are likely not to be expected to give technical guidance to companies on taxes or contracts. They will rather be expected to supply strategic insights as well as access to networks of contacts. Advisors contribute to the growth of startup companies.
Depending on the nature of the advice that the company receives, it may choose to compensate the advisor with more or fewer options. Options tend to be better because they vest over a period of time ranging from one to three years.
Getting stock options gives the advisor the incentive to continue providing good and sound advice to the company, allowing it to grow thereby ensuring that the options will be worth exercising in the future. The more a company’s value goes up, the more valuable advisory shares become to its beneficiary.
Vesting schedule in advisory shares
The vesting schedule means a set of rules that determines how the advisor’s equity will be distributed. There usually exists a vesting schedule for advisors’ stock options. This allows the company to postpone the transfer of ownership to advisors while keeping them on board for long-term success.
The two types of vesting schedules are;
- Fixed term
- Time-based
The fixed-term option gives the advisors that expire after a set period of time while in the time-based, the share vest incrementally over time. For instance, 10% will vest after one year’s worth of service and an additional 10% will vest at two years’ worth of service, etc.
Advisory shares example
XYZ is a startup company that sells smartphones, laptops, ipads, and other devices that assist forgetful people in remembering their items such as phones, keys, etc., which they tend to forget. They offer a location-based tracking tag that sends an alert as soon as you hit your front door. They have the ability to produce these tags with raw materials coming from international suppliers at a great price.
Sales have been below projection and XYZ has been receiving complaints from customers that the trapping tag malfunctions thereby threatening its competitive advantage. With this, the company had to convince a technology marketing group to help them turn things around in exchange for 5% of its equity in advisory shares.
With the vesting schedule occurring over three years, the technology advisory group quickly determined that XYZ left out several opportunities by limiting their product to items that are commonly forgotten while defaulting on the development of their location-based Bluetooth technology and trapping tags.
The advisor group gave them a guide on how to go about the necessary changes which include research and development, rebranding, strategic market management, etc. After three years, XYZ became successful and fully vested the advisory group’s shares.
This example gives highlights on how advisory shares work as well as the exchange value that can occur even between investment opportunities that seem to be risky.
Advisor share startup
Although any company can issue advisory shares at any time, it is mostly issued by startups, In other words, they are issued at the early stage of the company’s life. Startups may need help when it comes to their product development, launch process, commercialization, etc. They may find it worth paying someone who is highly experienced in these areas with advisory shares.
A single advisor may receive 0.25% and 1% of total shares depending on the stage of the startup as well as the nature of advice provided. Up to 5% of the company’s total shares can be given to advisors. Sometimes, the startup will form an advisory board and allocate equity as an incentive for board members.
In other words, the shares given to advisors can vary considerably which is usually determined by the expertise and role of the advisor. It can also depend on the length of time the advisor and the company are to work together.
There are ways to structure such compensation in order to make sure that founders get value for those shares while retaining the flexibility to replace advisors without having to lose equity.
The more mature a company is, the smaller the percentage of shares advisors can expect to receive. For example, a company that is in the ideal state may give 0.25% of equity to an advisor who attends monthly meetings. A company that has passed the startup stage and is in the growth stage could cut the percentage to 0.15% for the same advisor.
Advantages of advisory shares
- Highly qualified advisors are attracted
- Confidentiality
- Prevents conflict of interest
Highly qualified advisors are attracted
The major advantage of advisory shares is that a company can attract advisors who are highly qualified at a very crucial stage in the company’s development. This implies that a company can obtain highly strategic advice from senior business executives, investors, or business professionals. Advisor shares are not only attractive and highly profitable for the advisors, but the company can also use equity to compensate them without having to touch its cash reserves.
Confidentiality
Another advantage of issuing advisory shares to key advisors is that the company can include confidentiality terms to ensure that the advisor does not provide the same advice to a rival company.
Prevents conflicts of interest
Issuing advisory shares will also help in preventing potential conflicts of interest between the advisor and the company. Typically, advisors are bound to be in touch with many firms, companies, and organizations, therefore, enforcing restrictive covenants may be difficult for them. However, it is still possible for a company to contractually put certain parameters in place to reduce the risk that the advisor advises a rival company/competitor.
Disadvantages
- Tendency of overcompensation
- The risk of not benefiting from the advice
Tendency of overcompensation
The major disadvantage of issuing advisory shares is that a startup company is bound to overcompensate advisors. When a startup company is at the stage of development, issuing stock options to advisors may look appealing as the company may not have enough capital to compensate them otherwise.
However, as the company grows, the advisory share that is issued can represent an important percentage of the company’s share capital. The company may gain immediate benefits from the advice but later regret issuing valuable equity stocks to them.
The risk of not benefiting from the advice
Another disadvantage of issuing advisory shares is that a company may issue options to an advisor who ends up not giving the strategic advice needed. The advisor may also end up not putting the company in touch with the key business contact. In such cases, the company may issue advisory shares without getting the benefit of the advice.
To reduce this risk, it is important to put an advisory agreement in place where the advisor must advise the company for a period of three to six months before the company issues any option to them. It is through this way that the company can try the services of the advisors before committing to any stock options.
It is, however, important to keep in mind that advisors are bound to work with several companies. This can mean that firms that issue advisory shares may not have the power to restrict advisors from working with rival companies. With this, it is important to clarify in advance respect to whether advisors have pre-existing arrangements that can affect the advisors’ ability to give impartial advice.
Difference between advisory shares and equity
An advisory share is different from many other types of equity in the sense that the shareholder is not entitled to voting power, the right to trade shares, or to receive dividends. In most instances, the advisory share does not entitle the shareholder to any rights at all. By implication, an advisory share carries no risk and should be viewed as just another form of compensation by the company to its advisors.
