Advisory Shares: Definition, Types, and Key Terms

Advisory shares are a form of equity compensation offered to advisors who provide strategic guidance and expertise to a company. Startups often use advisory shares as a cost-effective way to attract and retain high-level talent without the immediate financial burden of cash compensation. 

Having invested in dozens of early-stage startups, I’ve seen firsthand how advisory shares can be a strategic tool for growth. Typically formalized through detailed agreements, these shares align the advisor’s interests with the company’s long-term success. This fosters a clear and productive relationship. 

Advisory Shares vs Board of Director Shares

Now, when exploring equity compensation, it’s essential to distinguish between advisory shares and board of director shares. Both play vital roles in a company’s growth strategy, but they serve distinct purposes and involve unique responsibilities.

Advisory shares, as defined earlier, are granted to advisors to incentivize their contributions without upfront cash payments. These shares motivate advisors to align with the company’s success by tying their compensation to its performance.

In contrast, Board of Director Shares are typically awarded to individuals who hold formal board positions. Board members have a more hands-on role in governance, overseeing the company’s operations and making strategic decisions, including those related to equity compensation and corporate structure.

Understanding the distinctions between these two types of equity compensation is crucial for startups, investors, and stakeholders, especially when addressing key founding questions regarding ownership, equity, and early governance. It influences how companies structure their equity packages, manage equity distributions, and ensure alignment between the interests of all parties involved.

Types of Advisory Board Compensation

Companies can choose from various methods when compensating advisory board members, with equity being a common and strategic choice. Each approach has its benefits and implications. This makes it crucial for startups to select the right model to attract and retain talent effectively.

Cash Compensation

Cash compensation offers immediate financial value for an advisor’s time and effort. It is straightforward, transparent, and easy to quantify, making it an attractive option for advisors who prioritize immediate rewards. However, it lacks the incentive to align the advisor’s long-term interests with the company’s growth, which can be a drawback for building enduring relationships.

For example, a startup in the e-commerce sector hires an advisor to guide its operations and pays them $5,000 per month for their services. This straightforward arrangement ensures the advisor’s expertise is fairly compensated without tying their rewards to the company’s future performance.

Equity Compensation

Equity compensation is a popular choice for aligning the advisor’s interests with the company’s success. As per Patrick Means of Charles Schwab:

“Equity compensation isn’t just money. It’s a chance to share in the ownership—and growth—of the company you work for.”

Equity compensation motivates advisors to contribute meaningfully as they receive an ownership stake in the company.  This means that their financial rewards depend on the company’s performance. There are three common forms of this compensation:

• Non-Qualified Stock Options (NSOs): This grants advisors the option to purchase shares at a set price in the future. Taxes are due when the option is exercised, based on the difference between the purchase price and the fair market value.
• Restricted Stock Units (RSUs): This provides shares upon vesting, with taxes applied when the shares are delivered. RSUs offer some tax relief as the fair market value of the shares can be deducted from taxable income at vesting.
• Restricted Stock Awards (RSAs): This grants shares upfront with specific restrictions, such as vesting schedules or performance milestones. Advisors gain ownership immediately but must meet certain conditions to fully benefit.

For example, a startup might offer different percentages of shares to its advisors. However, as per Eqvista, the most basic percentage is 0.5 to 1%. The vesting schedule includes a cliff period and vests monthly over 1-2 years. This arrangement ensures the advisor remains engaged over time, contributing to the company’s growth.

Mixed Compensation

Mixed compensation combines cash and equity, offering a balanced approach. This model provides immediate financial rewards while also incentivizing advisors to remain engaged and committed to the company’s long-term success. It’s an effective strategy for companies looking to balance short-term and long-term goals.

For example, a company might offer an advisor a monthly cash stipend along with 5,000 stock options vesting over two years. This ensures the advisor’s efforts are rewarded in the short term while motivating them to stay committed to the company’s goals.

No Compensation 

In rare cases, companies may offer no financial compensation, relying on the advisor’s passion for the industry, desire to expand their network or intrinsic motivation. While this approach reduces costs, it significantly narrows the pool of advisors willing to contribute their expertise without tangible rewards.

For example, a tech startup invites a highly respected industry expert to join its advisory board. The expert agrees to participate without financial compensation, motivated by their passion for innovation and their desire to influence the industry’s direction.

Key Terms in Advisory Share Agreements

Advisory share agreements are essential for formalizing the relationship between a company and its advisors. These agreements outline the terms and conditions under which advisory shares are granted, ensuring clarity and alignment between both parties.

Here are key terms in these agreements that people entering these agreements must be aware of:

The Advisor Agreement is the cornerstone of this relationship, detailing the advisor’s role, responsibilities, and expected contributions. This document serves as a roadmap for the advisor’s involvement with the company, providing a clear framework for their engagement.

A Vesting Schedule is a common feature in advisory share agreements, specifying the conditions under which the advisor receives their shares. Typically, vesting occurs over 2-4 years, ensuring that advisors remain committed to the company for a significant duration. This schedule aligns the advisor’s incentives with the company’s long-term goals, encouraging sustained contributions.

Performance Metrics are often included in advisory share agreements to tie the vesting of shares to specific deliverables or milestones. By linking compensation to performance, companies can ensure that advisors are making meaningful contributions that drive the business forward.

The Exercise Price is the predetermined price advisors can purchase their shares, usually set at the fair market value of the company’s stock at the time of grant. This price provides a baseline for the advisor’s potential financial gain, incentivizing them to contribute to the company’s growth and success.

Case Studies

Advisory shares are a common tool for attracting high-level talent in startups, particularly early-stage companies. These organizations often rely on equity or mixed compensation models to conserve cash while offering competitive compensation packages.

Industry standards for advisory board compensation vary based on several factors, including the following:

• Nature and scope of the role
• Level of responsibility
• Time commitment required
• Advisor’s expertise 

As per Visible, early-stage and smaller startups may lean towards equity or mixed compensation, while larger or more established companies might prefer cash, equity, or both to attract and retain top talent.

Let’s take a look at the real-life example of Uber. 

In its early stages, Google’s former CEO, Eric Schmidt, served as a strategic advisor to Uber. He also invested in shares in the company, aligning his interests with Uber’s long-term success. The advisors’ involvement helped Uber navigate regulatory challenges, expand into new markets, and refine its business strategies.

Common Pitfalls with Advisory Shares

Issuing advisory shares can be a powerful tool for startups and growing companies, but it comes with its own set of challenges. As a lecturer at the Wharton MBA program on product management, I’ve discussed these challenges with future leaders in the field.

Here are some common pitfalls to watch out for:

• Lack of Transparency: One of the biggest mistakes companies make is failing to communicate the terms and implications of advisory shares. This can lead to misunderstandings and disputes among stakeholders, including other shareholders who might question the value of these equity grants.
• Non-Compliance with Securities Laws: It’s essential to ensure that the issuance of advisory shares complies with applicable securities laws. Failure to do so can result in significant legal and financial consequences, which can be detrimental to a company’s growth trajectory.
• Tax Implications: Advisory shares can have complex tax implications for both the company and the advisor. For instance, if ‘phantom stock’ or ‘synthetic equity’ arrangements are used, it’s crucial to understand how these impact the advisor’s tax obligations and the company’s financial planning.
• Unclear Vesting Schedules: Poorly defined vesting schedules can lead to disputes over when and how advisors can exercise their shares. This can affect the advisor’s motivation and the company’s financial planning, especially if the vesting terms are not aligned with the company’s growth objectives.
• Insufficient Legal Documentation: Without a well-structured advisory share agreement, companies expose themselves to legal risks and disputes. It’s essential to have clear documentation that outlines the terms and conditions of the advisory shares, including vesting schedules, rights, and obligations of the advisor.

Tax Implications of Advisory Shares

Tax considerations are critical for both advisors and companies when offering advisory shares. A clear understanding of these implications can guide decision-making and financial planning.

Advisor Taxation

Advisors are taxed on the market value of shares at the time they vest, regardless of whether the shares are sold immediately. This is treated as ordinary income, and taxes are due accordingly. When shares are eventually sold, capital gains tax may apply based on the difference between the sale price and the value at vesting. 

Advisors may consider options like the 83(b) election to prepay taxes on restricted shares at grant, potentially reducing their overall tax liability.

Company Tax Deductions

For companies, granting advisory shares can reduce taxable income. The fair market value of the shares at vesting can be deducted, making this an attractive option for startups looking to conserve cash while compensating top talent.

Understanding these tax implications ensures that both advisors and companies can optimize their financial outcomes.

Rights and Responsibilities with Advisory Shares

Advisory shares come with specific rights and responsibilities that both advisors and companies need to understand. These rights and responsibilities are typically outlined in the shareholders’ agreement, such as:

• Basic Shareholder Rights: Advisory shares often come with standard shareholder rights, such as:
  • Voting Rights: Advisors may vote on key company decisions.
  • Dividend Rights: Advisors can benefit from dividends issued by the company.
  • Sale of Shares: Advisors may have the right to sell their shares, subject to any restrictions in the shareholders’ agreement.
• Terms and Conditions: The terms and conditions governing advisory shares are detailed in the shareholders’ agreement. This agreement outlines the vesting schedule, rights, and obligations of the advisor, including:
  • Share Transfer Provisions: Rules for selling or transferring shares.
  • Exit Scenarios: Clauses addressing what happens in cases such as the advisor’s departure or a company acquisition.
• Dispute Resolution: Disputes can arise in any business relationship, and advisory agreements are no exception. Shareholder agreements often include mechanisms to resolve disputes and protect the interests of all parties so conflicts are handled fairly and efficiently. These mechanisms cesses can include the following:
  • Mediation
  • Arbitration
  • Other forms of dispute resolution
• Legal Considerations: Given the complexities of advisory shares, companies should seek legal counsel when drafting agreements. Legal experts can:
  • Ensure compliance with securities laws and regulations.
  • Guide on structuring agreements to minimize tax liabilities.
  • Include clear provisions to protect both the company and the advisor from future legal issues.

Best Practices for Advisory Share Agreements

Effective negotiation and structuring of advisory share agreements are crucial for fostering mutually beneficial relationships.

Negotiating Advisory Share Agreements

Negotiating advisory share agreements requires a collaborative approach to align the interests of both parties. These practices can ensure successful negotiations:

• Value Alignment: Start by ensuring that the advisor’s values and goals align with the company’s mission. This alignment creates a strong foundation for a productive and enduring partnership.
• Highlight Mutual Benefits: Communicate the benefits for both the advisor and the company. Advisors should understand how their expertise will contribute to the company’s success and how they will be compensated in return.
• Flexibility: Be open to tailoring the terms based on the advisor’s unique skills, experience, and expected contributions. Flexibility demonstrates goodwill and helps secure commitment.
• Transparency: Foster trust by maintaining open communication about the terms of the agreement, including share allocation and expectations. Address any concerns early in the negotiation process to avoid misunderstandings later.
• Clear Expectations: Define the advisor’s role and deliverables during negotiations. This ensures both parties understand their responsibilities and how the advisor’s contributions will be evaluated.

Structuring Advisory Share Agreements

Once negotiations are complete, properly structuring the advisory share agreement is essential to protect the interests of both the company and the advisor.

• Detailed Shareholder Agreements: Develop a clear and comprehensive shareholder agreement.
• Transparency with Stakeholders: Inform all stakeholders about the issuance of advisory shares, explaining how they align with the company’s growth strategy and benefit the organization.
• Periodic Reviews: Regularly review and update the agreement to ensure it reflects changes in the company’s growth, market trends, and legal requirements. This keeps the agreement relevant and fair.
• Clarity in Terms: Ensure all terms are clearly defined, leaving no room for ambiguity. This reduces the likelihood of disputes and sets the stage for a smooth relationship.

Legal and Regulatory Compliance

When structuring advisory share arrangements, companies must navigate various legal and regulatory considerations to minimize risks and ensure compliance. 

Ensure legal and tax compliance by working with legal and financial experts to verify that the agreement adheres to securities laws and tax regulations. This includes understanding the implications of different equity types, such as NSOs, RSUs, or phantom equity.

Securities Laws Compliance

Advisory shares must be issued in compliance with applicable securities laws. This includes understanding different equity options, such as NSOs, RSUs, or phantom equity, and their legal and financial implications.

Companies must ensure proper documentation and disclosure to protect stakeholders and avoid legal complications. When issuing advisory shares, startups must also consider how their company structure choices can impact ownership distribution, voting rights, and future fundraising efforts.

Shareholder Agreements

A well-structured shareholder agreement is essential for outlining the terms and conditions of advisory shares. These agreements should include details such as:

• Vesting Schedules: Define when shares will vest to promote long-term engagement.
• Rights and Obligations: Specify the advisor’s responsibilities and their shareholder rights, such as voting, dividends, and the ability to sell shares.
• Transfer Provisions: Include rules for share transfers and conditions for buyback or exit scenarios.
• Dispute Resolution: Outline processes like mediation or arbitration to resolve potential conflicts efficiently and fairly.

Regulatory Requirements

Regulations, such as the Investment Company Act of 1940, stipulate that advisory agreements automatically terminate upon assignment unless otherwise specified. 

For instance, Rule 15a-4 of the Act provides a temporary exemption by allowing interim agreements for up to 150 days without shareholder approval. This promotes the continuity of advisory services during transitions. 

However, keep in mind that this rule applies in specific circumstances, such as after certain types of terminations of a prior investment advisory agreement. Some conditions must be met to rely on Rule 15a-4, including board approval of the interim contract and certain restrictions on the terms of the interim agreement 

With these legal and regulatory factors, companies can safeguard their interests and foster productive relationships with advisors.