Understanding Advisory Shares: a Comprehensive Guide for Investors

With the fear of another Great Recession looming, small startups are looking for an experienced hand to guide them. This is where advisors come in, taking many forms such as entrepreneurs, industry experts, or former executives. But how will startups pay these industry experts for their services? This is where an advisory share comes in as a form of compensation given to advisors for their expertise and guidance.

So, what are advisory shares, and why should you, as an investor, know about them?

Let’s understand the concept of advisory shares, find out how they work, their benefits and risks, and why they matter to companies and investors.

Understanding Advisory Share and Its Types

An advisory share is an equity instrument designed as a paycheck for these individuals. While typical shares are linked to actual ownership and voting rights, this kind of share is specific to advisors who don’t hold day-to-day operational roles in a fledgling company. You could think of it as a modern shift towards performance-based compensation.

Advisory creates a win-win scenario for both startups and advisors. Startups tap into the high-caliber expertise they need without immediate cash expenses, while advisors win a stake in a potential high-reward venture.

Advisory shares have different meanings, each aligned with advisor incentives and the company’s success.

Here are two major types:

1. Stock Options

Advisors receive the right to purchase company shares at a predetermined price, known as the exercise price, once they have met certain vesting conditions. Think of it as a bet on a startup’s future. If the company gains traction and its value skyrockets, advisors can buy the shares at a lower price and sell them at the current market rate, taking hefty financial rewards home.

2. Restricted Stock Units

Restricted Stock Units offer a more straightforward option for equity compensation. Instead of buying shares, advisors are promised to receive actual shares at a future date. Keep in mind that this will depend on meeting vesting requirements. These stocks are a delayed gift of the company’s stocks that will be all yours once the company achieves certain milestones. This type of reward provides immediate value without requiring advisors to spend their money.

What are the Financial Impacts of Advisory Shares on Investors?

An advisory share can change the outcome of ownership for investors. When startup CEOs reward advisors, investors have to understand how these shares will impact their own equity stake, company valuation, and negotiating powers in funding rounds.

Here are some factors to keep in mind:

Impact on Capital Structure

An advisory share can impact the capitalization table, which maps equity ownership to the financial structure of the company. Advisory shares add another layer to the current equity distribution which naturally increases the total number of outstanding shares. These minor adjustments can end up diluting the ownership percentage of existing shareholders, impacting the overall capital structure.

Let’s take an example of X startup with a capitalization table with 1 million outstanding shares. X hires a financial advisor to help them and in turn, they give 100,000 advisory shares. These advisory shares bump up the number of shares to 1.1 million, diluting the ownership percentage for the existing shareholders of the startup. What does this mean? Before this, if you owned 100,000 shares, you had a 10% stake. After the advisory shares are issued, your stake comes down to about 9.09%.

This dilution can affect control and voting power within the company.

Valuation Considerations

Advisory shares are a double-edged sword. When a startup introduces new shares, it signals to the market that the company is investing in high-level expertise, which will improve the startup’s chances of increasing its valuation.

But at the same time, the dilution effect can also impact the per-share value. From an investor’s perspective, adding high-caliber expertise from these advisors will be great for the startup you are investing in. On the other hand, these shares will eventually dilute the value of your share. So, pick your poison when evaluating a startup’s worth.

The Effect on Funding Rounds and Investor Negotiations

When a startup begins searching for additional capital, having an advisory share will affect the terms of investment deals made by different investors. Investors might negotiate for more terms in their favor or additional equity to compensate for the dilution risks.

For example, if a company has issued a large amount of advisory shares, investors can ask for high ownership percentages or improved terms to offset the impact of dilution. Advisory shares can also help startups get attention from new investors because they signal a commitment to growth.

How Much Equity Do Advisors Get?

Interested to see how this one-of-a-kind equity works for investors?

1. Early-Stage Startups

The early stages of a startup have a lot of growth potential, yet 38% of them still fail because they lack cash or capital. Advisors who are hired by these businesses get an equity of around 0.5% to 1%. The reason for this measly percentage is simple: startups don’t have enough financial resources to put large equity stakes on the table. This stage draws advisors who see the potential for a high reward in the future.

2. Growth Stage Companies

When startups move up the ladder, so does their valuation. However, the equity percentage given to advisors drops down from 0.05% to 1%. Why is that? This reduction is because of the high valuation and dilution of stakes. This reduction is due to the higher valuation of the company and the dilution of equity among a larger group of stakeholders.

3. Established Companies

As expected, the equity percentage drops to 0.01% to 0.5% for fully established startups. This drop in value shows that the company has a solid track record and is financially stable which eliminates the need to offer large advisory shares.

4. Equity Vesting

Equity vesting is a way to make sure advisors stay committed to the company. Instead of getting all their shares at once, advisors earn their shares over time. For example, if an advisor is promised 1% of the company’s equity with a 2-year vesting schedule and a 6-month cliff, they won’t get any shares until they have been with the company for six months. After that initial period, their shares are given out bit by bit, usually every month or quarter, over the next 18 months.

Wrapping Upadvisory shares meaning

Modern investors should know  before planning to invest in a venture. While these shares can boost a startup’s growth potential by bringing in valuable expertise, they also impact the capital structure and can dilute existing ownership stakes.

As an investor, your equity position can be subject to change in a startup if advisory shares are rewarded.

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