Advisory Shares: A Guide for Startup Founders

In the tech startup sphere, advisory shares are a double-edged sword. They're an interplay of equity, wisdom, trust, and strategy, potentially leading you to peaks or pitfalls.

Deciding who to entrust with these shares, how to correctly allocate compensation, and where to distinguish them from regular equity - these are critical questions for early-stage founders.

Let's venture into the realm of startup advisory shares, addressing the whys, whos, and hows - a key to an enlightened entrepreneurial path.

What are advisory shares?

Advisory shares, also known as “advisor shares”, are a type of stock given to company advisors instead of employees. In other words they are financial rewards provided to advisors in the form of stock options (technically speaking, advisory shares are stock options given in exchange for expertise while regular shares are stock units sold on the open market). This is usually done at the “we really respect your time, expertise, and network but lack the funds to adequately compensate you” stage of the company (although more mature companies may also bring on advisors depending on the industry).

Advisory shares, also known as “advisor shares,” are a type of stock granted to company advisors instead of employees. They serve as financial rewards provided to advisors in the form of stock options. Technically speaking, advisory shares are stock options exchanged for expertise, while regular shares are stock units sold on the open market. This practice typically occurs when startups say, "We respect your time, expertise, and network, but we lack the funds to compensate you adequately," though more mature companies may also engage advisors depending on the industry.

Why is this the case?

Startups traditionally face limitations, particularly regarding available capital to properly compensate advisors. Advisory shares allow a startup, especially in its early stages, to offer a non-cash stock option in exchange for the advisor’s expertise and time. This strategy enables the startup to allocate its limited capital to other critical areas.

Furthermore, advisory shares provide an incentive for advisors to remain with the company over the long term. Rather than a simple one-time cash exchange, advisory shares are appealing to advisors because they link their earning potential to the company's long-term success.

Types of advisory shares

Restricted Stock Awards (RSA)

Restricted Stock Awards (RSA) are shares given to advisors that come with certain restrictions, such as vesting periods or performance milestones. These shares often require advisors to remain with the company for a specified time before they can fully own or sell the shares, creating a strong incentive for continued involvement and support. RSAs can also be beneficial for startups because they reduce the risk of immediate dilution of ownership and can align the advisor's interests with the company's long-term goals, making them a preferred choice for early-stage companies seeking strategic guidance.

Stock Options

Stock options provide advisors with the right to purchase shares at a predetermined price, known as the exercise or strike price, within a specified timeframe. This arrangement can motivate advisors to actively contribute to the company's growth, as the potential for profit increases if the company's stock value rises above the exercise price. Unlike RSAs, stock options do not confer ownership until exercised, allowing startups to manage their equity distribution strategically. Additionally, stock options can offer tax advantages for both the company and the advisor, depending on how and when they are exercised.

Who are the advisors?

The advisors given advisory shares are usually business professionals who are former founders or senior executives in the same operating industry as the startup. The advisors provide insight and connections in exchange for equity in the startup.

Like anything startup related, founders need to exercise caution. They need to be careful of who they approach to be an advisor. Not everyone can provide the value that they may claim to have. In the best case scenario, an advisor can open doors and be a boon to the startup, positioning it for success. In the worst case scenario, they can be a waste of time and even a liability.

It should be noted that accountants, attorneys, and other professionals receive cash compensation for their services and are usually not advisors. This is especially the case if you don’t have a pre-existing relationship and are just looking to cut costs.

The right advisors are the people who can shore up a weakness that the founder or startup may have. Here are a few types of advisors to keep in mind.

How do you know which advisor should get which compensation?

Roughly speaking, no more than 5% of a company’s total equity should be allocated to advisors - and it can be much less. A company can also form an advisory board to help with this. Individual advisors can be compensated depending upon their contribution to the startup. An advisor who serves as a pipeline for new customers may receive a larger percentage than an advisor who simply provides a monthly ideation phone call.

It also depends on the stage of the company. That early stage pre-seed company may provide more equity to an advisor than a Series A company would for an advisor doing the same amount of work. Simply put, it is easier to part with 1% of a company that has no real valuation than a company valued at $10 million or more.

Founders need to realize that advisors could also be working with multiple companies and this may include rival organizations. Advisors need to be able to provide impartial advice so founders need to know who they are going to be working with and more importantly, who they can trust.

We often hear about product-market fit but very little on founder-advisor fit. This is often the result of multiple meetings and conversations rather than a simple DM or email.

Finding the right advisors is a time-consuming process. It may take a bit but could prove beneficial, especially if the fit proves to be correct. As advisors have a unique perspective on the company, it isn’t uncommon for many to become employees or even future investors.

What are typical terms for advisory shares?

The terms for advisory shares can differ depending on who you ask.

Carta provides this graph and insights for advisor shares issued in 2019 for companies that raised under $2 million. Their information is based on RSAs (restricted stock award in which shares are bought upfront) and NSOs (non-qualified stock options to buy shares which are awarded later on). Advisor RSAs receive 0.2-1% of a company while advisor NSOs receive 0.1-0.5% of a company.

According to Y Combinator partner Eric Migicovsky, a common set up is granting 0.25% to 0.75% of equity to the advisor - with a monthly vesting over 2 years.

It should also be noted that RSAs are larger because they are issued after incorporation but before there is an increase in the fair market value of a company. EQVISTA breaks it down further with this easy to use infographic.

What is a vesting schedule?

It also helps to understand a vesting schedule. This is an incentive program instituted by the employer to give the employees the right to specific asset classes. It is used to incentivize employees to remain with the company for longer. But vesting doesn’t work the same way for advisors as it does for employees. The advisory share vesting schedules are usually two years (meaning the shares vest or are granted in monthly increments over a two year period). The advisor is not owed the entire vesting schedule if they stop being an advisor.

Some advisory agreements also call for a trial period - say 2 or 3 months - where the deal can be terminated with no options being transferred to the advisor.

Keep in mind that advisors are not forever. You might need a product-oriented advisor at early-stage, and a more strategic advisor at later-stage. Your rooster of advisors will evolve over time, hence the 2-year vesting.

Best Practices for Advisory Vesting Schedules

Advisor shares vs. normal equity

If you are going to be an advisor, you need to know the difference between advisor shares and equity. Here is a list to help you keep it in check.

Pros and cons of advisory shares

Pros of Advisory Shares

Cons of Advisory Shares

How do I manage my advisors and their shares?

So you are the founder of the next Facebook but for insects and have some great advisors on board. Now you need to know how to manage their advisory shares as well as provide them with the proper documentation.

One last word of caution

Talk is cheap. If you're a first-time founder, you might be impressed by a supposedly "big shot" business guy who claims to have all the answers and know all the right people. And he will help you in exchange for equity.

As with everything, exercise caution. Do a trial period, run a background check, and make sure this person will actually bring value.

Few things are worse than a backseat driver.

Conclusion

Founders can’t know everything (and the ones that claim they do should be avoided at all costs). It is essential for founders to seek out the wise and offer them advisory shares. But it is just as essential for advisors to know how these shares work and how they can benefit. After all, when it works out, it is a win-win for everyone involved.