Advisory Shares | What are they and How do they differ?
Although starting a company may sound like a great idea, 95% of start-ups fail and 99.5% of start-ups never get funded. Being part of a start-up is like riding a rollercoaster: there are a lot of highs and a lot of lows. The journey to product market fit is long and continuous. Businesses succeed or fail by the decisions that they make. Not being able to check their decisions is a common limitation that early stage start-ups experience.
To combat this, a good option may be to hire an experienced advisor, who can provide strategic advice. In some cases, advisors just want to see you succeed. But if you want to get their dedication, a start-up should pay their advisors. The problem is that it is necessary to have money to pay the advisor. Money that generally the small companies do not have.
This is where advisory shares come into play. They provide companies with the ability to provide their advisors with deferred compensation in the form of stock options and shares. Thanks to this, companies can pool their resources in driving product market fit and acquiring customers and the advisors can receive something valuable in return for their expertise.
The additional benefit of advisory shares is that they create a better and continuous alignment between the company and the advisor. The more the company succeeds the bigger the internal satisfaction and the bigger is the payday for advisors.
In this article we will talk about what advisory shares are, how they work and what benefits they can bring to your company.
What are advisory shares?
Advisory shares are stock options that are delivered to advisors hired by the company. This is usually done as compensation for services provided, especially in the case of start-up companies. They can also be given to ensure the confidentiality of the business advisor. The advisory share grants are tied to a set of quantitative and qualitative measures that advisors have to achieve to earn the grants.
What share class are advisory shares?
A common misconception exists that there is a share class called Advisory Shares. There are no share classes called Advisory or Founder shares. The share classes are defined by the Articles of Incorporation for a company. The Corporate Secretary or the person serving in that capacity defines each of the share classes and the rights and obligations that these classes carry. Most companies would set aside a pool of shares, from one of their common equity classes, that they would issue to Advisors.
How do advisory shares work?
Who can become an advisor is usually tied to a knowledge and experience gap that the company is trying to close by acquiring the expertise externally in the form of advice. Usually, the beneficiaries of this type of stocks are entrepreneurs with a long and successful track record. They provide a smaller company with strategic knowledge in exchange for some of the company’s shares. In addition, this type of entrepreneur usually provides the company with a network of contacts that can boost the company’s development. Good advisors can often be the accelerant a company needs.
Engaging an Advisor to join the company’s Advisory Board should be accompanied by an Advisory Agreement that spells out the agreed upon rights and expectations between an Advisor and a company. But this is a topic on its own that we will tackle in a separate post.
With advisory shares, advisors have the option on some of the company’s shares in the future, as agreed upon in the Advisory Agreement which is then tied to the stock options grant.
In general, these types of stock options are usually delivered in different percentages, taking into account the participation and value that each advisor drives. For example, an Advisory Board may be entitled to up to 2% of a company’s common stock. This is the pool of shares (issued or not) that the company has set aside to attract advisors. Each individual advisor is entitled to a portion of the pool in alignment with the Advisory Agreement. Like any stock option instrument, companies can establish different vesting rights based upon the immediacy of the value delivered by the advisor.
The percentage of advisory shares that advisors receive also depends very much on the size of the company. An early stage company carries a smaller valuation than an established mature company. As such, an advisor typically would receive a larger proportion of the company. The relative percentage is the wrong metric to focus. What is more important to establish is what is the overall value of the company and how would or did the advice drive the value of the company upwards.
But are advisory shares always delivered under these conditions? While they usually are, it can also happen that a company has not yet been formally launched. In this case, advisory shares can be issued not only to get advisors to provide expertise in various fields, but also for the advisors to help the company secure financing.
Although this may sound like a win-win, this comes with a potential risk. Advisors will own a portion of the company. Like any other investor, they will have a say, in proportion to their ownership, over the direction and decisions the company makes. Unlike other investors, they will have more knowledge of the company and more influence. Choosing the right advisor is of the utmost importance. Just like finding the right partner to share your life with takes time, take your time to search and attract the right advisors.
Do advisory shares get diluted?
Before answering this question, it is necessary to clarify that the relative ownership (% of shares) an individual or company holds in a company fluctuates over time. As the company grows and matures, more and more shares (or pools of shares) are issued to employees, advisors, investors, strategic partners and so forth.
So there are more and more people or corporations who own these shares Thus, with every additional share issued, the relative ownership of a share in the company gets smaller resulting in what is commonly referred to as dilution. What is important to underscore is that in an up round (when the current value company is higher than the value at the time of receiving the stock grant) this is not an issue. Whilst the overall ownership of the company is diluted, the value of this ownership continues to appreciate. The issue is when this is a down round.
Next, we will introduce you to the main differences between the advisory shares and other types of shares.
Advisory Shares vs. (Common) Equity Shares: Myths
Here are some of the most common myths:
- Advisory shares do not imply the delivery of shares, but rather the purchase option on them. — Incorrect. When the vesting conditions are met, the stock option converts into a grant.
- Advisory shares are delivered to the company’s advisors, who do not necessarily own a part of the company. Equity charges, on the other hand, are usually in the hands of the people who own a part of the company. — Incorrect. Advisory shares are not a standalone share class. As such, they would carry the rights and obligations of that class.
- While those who own advisory shares do not necessarily have the right to vote within the company, the owners of equity shares do have the right to vote. — Incorrect. Once the stock options vest and convert into shares, those shares carry the same rights and obligations as all of the shares in that share class. What determines who can vote are the voting rights for the share class. Both common and preferred shares can have voting rights. The most famous example of common shares with special voting rights is when Facebook went public, Mark Zuckerberg’s shares were in a common share class that carried 10X the voting rights compared to the other common share classes. This was an intentional move to preserve his decision making rights once the dilution from the public share issuance took place.
- While in advisory shares not all advisors have the same percentage of options on the shares, in the case of equity shares all members have the same percentage of the company. — Incorrect. The share class dictates the rights and obligations associated with a given share in that class. The Advisory Agreement dictates how many shares an advisor is entitled to receive. The stock option grant in the mechanism by which this occurs.
- While advisory shares are given to advisors in exchange for their strategic advice, common shares are available for purchase on the public market. — Incorrect. Advisory shares more often than not come from a common share class. Public markets trade both common and preferred shares. Listing on stock exchanges are specific to a share class. A company may have one or more listings.
- Owning advisory shares does not imply having influence in the company’s decisions, although it is something that can occur. On the other hand, owning common shares does give the right to vote in different business decisions, for example when there are intentions to merge that company with another. — Incorrect. Legally, advisory shares will have the rights bestowed upon them from the share class and in proportion with the share ownership. But informally, advisors’ voices will have a higher level of importance than other investors as they are more actively involved and familiar with the business.
3 Major Benefits of Advisory Shares
1. Keeps cash in the company
Early stage companies tend to have limited resources while their need for strategic advice is arguably much higher. Preserving as much cash in the company to be able to extend the run room is of critical importance. While at the same time attracting the right advisors can have a catalytic impact on the company.
Instead of compensating advisors with cash now, advisory shares allow these companies to defer the compensation to a future date. Pay later is almost always more expensive than pay now but it brings a myriad of other tangible benefits with it.
2. Advisory actions could encourage an advisor to work harder on your company
By owning advisory shares in your company, an advisor will probably want your company to do well, as this will increase the value of his shares in the future and make him more money. For that reason, many advisors, especially those who invest money in a small company, decide to give a network of contacts to the CEO or board of directors, which will allow them to boost the development of the company. Quite often, advisors become the first investors in the company as they are living the due diligence with the company day-to-day.
3. Taps into an extended networks
Advisors are typically highly connected and regarded professionals with large networks of contacts. Just like you are doing due diligence on advisors they are doing due diligence on the company. Attracting the right advisors borrows credibility from the advisors’ reputation. This is the reason why many early stage companies are so willingly disclosing who sits on their Advisory Board even though unlike the Board of Directors, Advisors have no fiduciary or oversight responsibility to the other shareholders or stakeholder groups.
Advisory shares example
So, let’s introduce you to one of the most common situations involving advisory shares.
Let’s say Company A is new, and it’s in the business of offering cloud services. The company has hit a plateau. The Founders are trying to raise capital to hire more talent. But investors are shy as they can see that growth has slowed down or flattened.
So the company decides to look for new alternatives. In a meeting between the founders, one of them suggests contacting an entrepreneur. But not just any entrepreneur: one with a lot of experience in the market, who can offer the company strategic guidance.
But the problem of money comes up again. At this point, one of the other founders suggests offering advisory shares in lieu of cash, with a cliff vest of 50% after 1 year, 25% after year 2 with the remainder at the end of year 3.
The rest of the founders support this idea, so the decision is made to look for an entrepreneur who wants to fulfill the role of advisor.
On the other hand, there is also company B, which, unlike company A, already has a large customer base and is very successful. One of the company’s founding entrepreneurs has more than 15 years of experience in the market and has previously worked with companies offering services similar to those of company A.
The founding entrepreneurs of company A decide to contact the entrepreneur of company B. They share their current situation with him and tell him that, in exchange for his experience and advice, they can offer him 0.5% of the company in terms of advisory shares, with vesting over 3 years.
The entrepreneur, after analyzing the situation, decides to accept the offer to advise the company for a period of 3 years.
A few days later, after signing an Advisory Agreement, the entrepreneur begins to have meetings with the Board of Directors, to get fully immersed into the company’s situation.
The advisor begins to give some advice to company A on how they can start to improve their product and service offering, and even offers some contacts of other companies that might be interested in their services.
As time goes by, Company A begins to develop better quality products and increase its customer base. This causes the value of the company to rise, and some investors and advisors become interested in the company.
Company A then decides to raise new financing. This improves the company’s liquidity and provides them with a much needed injection of capital to invest in R&D and drive customer acquisition.
Starting a company is froth with risks and opportunities. Companies are defined by the risks that they manage and avoid as well as by the opportunities that they seize. Speed matters! Engaging an advisor that can help you accelerate while avoiding the risks that lie on the road to success could be the difference between becoming a market leader and being a distant follower.