Advisory Shares

Advisory shares refer to shares of a company's stock that are granted to individuals who provide valuable advice, guidance, or expertise to the company, typically in a non-employee capacity.
Advisory Shares
3 min
28-August-2024
Advisory shares are a category of stock options given to advisors of a business entity rather than employees. A very common term in the start-up space, they are offered to the advisors of a start-up instead of cash remuneration. Start-up advisors are typically granted the option to buy shares rather than owning the actual shares. They represent a form of non-monetary remuneration provided to start-up advisors for their strategic advice, domain expertise, and experience.

Start-ups usually need advice on a plethora of business functions. An experienced professional who has extensive experience in such functions usually comes onboard as an advisor. Early-stage start-ups are cash-crunched and prefer to invest money in their core operations. Even if the start-up is in good financial health, it makes sense to reward advisors with advisory shares instead of cash so that they do not prioritise immediate gain over long term returns and stay invested.

Start-ups can choose to compensate advisors by offering them a percentage of their ownership, and thereby part ownership through advisory shares. Let us understand what are advisory shares, working mechanisms, advantages and disadvantages, types of advisory shares, and the difference between advisory shares and ordinary shares.

What are Advisory shares?

Advisory shares refer to an overarching term for compensation in the form of equity usually offered to advisors of a start-up in their incipient stages. They can be given to advisors in exchange of cash or in addition to cash compensation. Advisory shares can include Restricted Stock Options (RSAs) or common stock options that are awarded to specialised professionals offering advice to start-ups rather than employees. Advisory shares do not grant voting rights to advisors or profit sharing.

They are a form of financial compensation offered to advisors so that they have an incentive to continue advising the start-up. These advisors might be successful start-up founders themselves or industry professionals. These advisors are not like typical professional consultants such as a lawyer or a CA who provide specific advice in return for a professional fee. Rather, they play a larger role as they advise start-ups on broader and strategic issues such as - increasing the customer base, cost rationalisation through strategic sourcing of raw materials, and other such long-term issues that are tied more to business expansion than tactical tasks.

How do advisory shares work?

Advisory shares are afterall a type of equity instrument but have their own characteristics such as vesting schedules, performance milestones, and equity dilution. A key feature of advisory shares is that they are subject to ‘vesting’ for the entire period of the advisor – start-up professional relationship. Therefore, by the process of ‘vesting, advisors earn these advisory shares over time and not at once. This incentivises advisors to stick with a start-up for a long time and prevents backtracking on prior commitments.

Moreover, this earning of advisory shares may be linked to key milestones in the relationship. These milestones should be measurable and represent a significant step in the growth trajectory of a start-up - securing funding from VCs or PE firms, bagging a long-term B2B contract, achieving revenue targets, rollout of a patented product, etc. This tie between advisory shares and performance milestones ensures that advisors remain committed towards start-up success and their insights result in successful outcomes that are measurable. Linking these performance milestones with advisory shares also motivates an advisor to offer advice that is the most relevant and helpful for the start-up’s success.

An inherent mechanism associated with advisory shares is equity dilution for the original founders of a start-up. The ownership stake of the founders declines due to granting of advisory shares. But the trade-off for this equity dilution is that the founders gain business insights and domain knowledge. They also get access to the advisor’s valuable network and contacts which opens up numerous opportunities. Therefore, start-ups need to decide the level of outside knowledge they require in order to shape their growth path and weigh the value of issuing advisory shares to an advisor against the prospect of equity dilution and make a well-informed decision.

Benefits of advisory shares

Issuing advisory shares has a number of benefits for a start-up - maintenance of cash reserves, getting insights for a non-monetary mode of payment, and ensuring advisor’s commitment. Advisory shares enable start-ups to reward advisors while not depleting their cash reserves. Liquid cash is a very valuable asset for an early-stage start-up and it should be prioritised for spending on core operations rather than business advice. Business liabilities such as payables and other obligations can be fulfilled if a start-up has adequate cash reserves.

Advisory shares are a form of non-cash compensation to advisors in exchange for business guidance, insights, and access to valuable networks. Usually, large companies seek advice from consulting firms in return for a fixed fee payment which is quite hefty. For start-ups, advisory shares serve as an alternate mode of rewarding advisors for their valuable advice and support.

An advisor who has agreed to come on board a start-up will always have a long-term commitment towards the start-up's success if he knows that the compensation he will receive are in the form of advisory shares typically tied to business performance and they must be earned by the process of ‘vesting’. Also, advisors know that for a promising start-up, the value of advisory shares in the future will be greatly multiplied by the present value. Therefore, even advisors prefer to receive advisory shares instead of monetary payment.

Who manages advisory shares?

Generally, an early stage or growth stage start-up issues and manages advisory shares. These start-ups typically have progressed from the ideation stage to implementation stage and may be in the pilot testing phase, product rollout phase, or scale up phase.

The equity that is offered to advisors can differ according to the contribution of the advisor, time commitment, strategic or tactical role, expertise, and life cycle of the start-up. Individual advisors may receive equity stake in the range of 0.25% - 1% in the form of advisory shares. Generally, a total 5% equity stake can be given to the advisors combined. These figures are not recommended but only serve as pointers.

A business advisor who attends meetings on a monthly basis will get more equity than an advisor who attends the annual business performance review. An advisor who arranges a meeting with a business prospect that results in a long-term award of contract for the start-up may get 1% equity. Also, the more advanced a start-up is in its lifecycle, the quantum of equity stake reduces. A fully mature start-up might offer as low as 0.1% - 0.15% equity ownership to business advisors.

Example of an advisory share

For implementing an offer of advisory share, the start-up needs to develop a plan enumerating the number of shares, schedule of vesting, performance milestones, rights, and other terms. Next, the start-up requires the approval from its board. The start-up can choose to offer the advisory shares through private placement. In that case, the start-up needs to do the filing with regulatory authorities such as SEBI and MCA. Once all approvals are in place, the start-up can issue advisory shares to the advisor as per the pre-decided vesting schedule.

Suppose the market valuation of a start-up A comes to Rs. 20 crore. The start-up seeks the services of professional K who is a leading expert on market entry for different geographies. Now, the start-up agrees to offer 0.5% of its equity to the advisor who will advise the start-up for entering the European market and introduce the founders to his erstwhile European clients.

In the above example, if the value of one share is determined to be Rs. 500, there are in total 4,00,000 shares of which 0.5%, i.e. 2000 shares currently worth Rs. 10 lakh are to be given to the advisor based on the vesting schedule.

Types of advisory shares

Advisory shares are offered via two modes - Restricted Stock Awards and Stock options.

1. Restricted stock awards (RSA)

Restricted Stock Awards (RSAs) are advisory shares that are promised to be given to the advisor depending on completion of commitments of business performance and vestige schedules. RSAs are not granted until the mentioned conditions are fulfilled. The taxability of RSAs comes into the picture only during vesting - the time when shares are actually issued to the advisor.

RSAs are often offered to early-stage start-up advisors when the start-up has not raised any money and the market valuation of the start-up is very low. An RSA can be paid for either by cash or through services and a start-up generally wants an advisor to earn their RSAs over time rather than an outright purchase. The vesting requirement serves as a safeguard to the start-up if the advisor leaves midway. In that scenario, the start-up can repurchase the unvested shares.

2. Stock options

Stock options are ordinary shares of a start-up that can be offered to employees, contractors, or advisors at a pre-set price called grant price or exercise price. The specific price of a share remains valid for a limited time and someone who intends to buy those shares requires to exercise his options in that time duration. The volume of stock options offered to an advisor can vary depending on his time commitment, expertise, and network. An advisor who can set up meetings on a monthly basis with high-value clients will be awarded more stock options than an advisor who simply provides advice on the annual business performance. Investors and the board of the start-up have to sign off before any stock options can be awarded.

Can advisory shares be sold?

Advisory shares represent the ownership of a start-up or any business entity and can be sold if the start-up - advisor relationship breaks down or because of other exigencies. These can be sold like any other type of stock. However, it is always more likely that a start-up will not be listed on a stock exchange as it does not yet need public money. Therefore, the advisory shares have to be sold through a private placement process.

Disadvantages of advisory shares

Advisory shares have some limitations. Confidentiality is compromised when advisory shares are issued. A start-up’s several secrets of Intellectual Properties (IPs) such as product, monetisation plans, marketing plans, etc. have to be revealed to the advisor for him to offer in-depth insights on the best course of action. As a result, advisors have to sign non-disclosure and confidentiality agreements with the start-up they intend to advise. In the confidentiality agreements, an advisor has to disclose his working relationship with the start-up’s peers that might result in a conflict and affect his objectivity in offering impartial advice.

Another drawback of offering advisory shares is that even a small percentage of a start-up today might be worth billions in the future. Start-up founders may find it convenient to part with ownership in exchange for business advice. However, even famous industry experts may face issues while working with a start-up - fit with a start-up - oriented fast-paced culture, loss of context (the context in which the professional has worked might be totally different even if the products and solutions are similar), out of sync with the current knowledge of the domain, and many others. There could be a trial period when the start-up and the advisor gauge if they can be a good fit. Also, since the start-up does not issue any shares during this trial period, it is under no obligation to part with its ownership if the relationship does not work.

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What is the difference between shares and advisory shares?

A key difference between shares and advisory shares is on the basis of the recipient. Shares are offered by a start-up to its employees. But advisory shares are reserved for advisors who advise the start-up at various stages in their journey. Typically, normal shares do not have a vesting schedule and they are typically granted upfront as a part of employee acquisition or retention strategy. On the other hand granting of advisory shares includes a ‘vesting schedule’ clause as per which an advisor has to earn those shares over time by providing strategic guidance or access to network and potential customers to start-ups.

Key Takeaways

  • Advisory shares is a blanket term used to refer to non-cash or equity remuneration to early-stage start-up advisors. They are generally offered in the form of Restricted Share Agreements or non-qualified stock options.
  • The reason for offering advisory shares by a start-up are the same as offering stock options for employees - preserving cash for business operations while incentivising employees to remain with the start-up.
  • For advisory share agreements to work and for the best chances of start-up - advisor success, both the parties must have every expectation and commitment in black and white on a legal document called an ‘advisory shares agreement’.

Conclusion

Advisory shares signify a form of financial compensation paid to advisors of early-stage start-ups for advice, guidance, and access to valuable networks that ultimately fuels business expansion. While issuing advisory shares, a start-up should keep in mind to document all expectations and commitments, vesting schedules, and terms of the engagement on an advisory shares agreement. The document should also clearly spell out the process to be followed in case of unavoidable circumstances - the start-up shuts down or the advisor stops working. An advisory shares agreement listing all these important points can result in a smooth working relationship between the start-up and the advisor. It can help the start-up progress rapidly because of access to new insights, new networks, or new markets.

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Frequently asked questions

What is the difference between ownership and advisory shares?
Regular share ownership is intended for stocks that are traded on the stock exchange with the aim of generating returns. The aim of advisory shares is to give the advisor a sense of ownership in the start-up that he is advising.

What are the downsides of advisory shares?
Advisory shares have several limitations such as equity dilution for the start-up, loss of confidentiality, problems in the advisor-start-up relationship in the long run, etc.

What is 5% advisory shares?
Usually, up to 5% of the start-up ownership is offered to all the business advisors combined. Therefore, these 5% represent the limit of advisory shares a start-up issues.

Do advisory shares get dividends?
Advisors are incentivised towards long-term commitment for a start-up through regular dividends. Therefore, advisory shares do earn dividends.

Can you sell advisory shares?
Yes, advisory shares can be sold. It is unlikely that shares of a start-up will be listed on a stock exchange. So, a private placement process needs to be followed while selling advisory shares by an advisor.

What are advisory shares in India?
Advisory shares are the same as the regular shares except that they are intended for start-up advisors and not available for regular employees. Also, they are not directly given to the advisor but delivered at regular intervals as defined in the vesting schedule.

What is the difference between regular shares and advisory shares?
The primary difference is that advisory shares are only meant for advisors of start-ups. By becoming part owner of a start-up, advisors are expected to display a more long-term commitment.

How do you make money from advisory shares?
Advisory shares are not intended to generate immediate money. But they can be sold at profit by an advisor after the commitment officially comes to an end.

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