How do advisor shares work?

Advisory shares, also called advisory equity, are a form of ownership that a firm gives to individuals who offer advice and guidance to the company. Most of the time, these people are not employees of the company, but they may have valuable knowledge in a certain area. Options, restricted stock, and warrants are all examples of advisory shares. Most of the time, the terms of the advisory shares are written in a contract between the company and the advisor. This contract outlines each party’s rights and responsibilities.

Advisory shares are issued by private firms and are primarily used as pay for non-employee consultants. Typically, the company’s legal department will issue advisory shares after receiving approval from the board of directors.

To better understand how advisory shares work in practice, let’s look at an example scenario:

Imagine that you are the founder of a new company and that you just hired a seasoned industry expert to help you with your business. You gave them 2% of the company’s equity in the form of advisory shares in exchange for their input.

Your agreement with the advisor has a four-year vesting schedule with a one-year cliff vesting period. This means that the advisor must stay with the company for at least one year before any shares vest. After that, the shares will become fully paid up each month for the next three years.

At the time of issuance, your company is worth $10 million, so the advisor’s 2% stake is worth $200,000.

Over the next year, the advisor will give your company sound advice and suggestions that will help it grow and do well. At the end of the year, they get their first set of shares, which is equal to 25% of their total stake in the company. This is equal to 0.5% of the company’s equity, or $50,000 based on the current valuation.

Assuming the company keeps growing and does well over the next three years, the advisor will get more shares each month until they have their full 2% equity stake.

But if the advisor left the company before the one-year cliff vesting period was over, they wouldn’t get any shares at all. In the same way, if they didn’t meet any of the performance metrics or obligations in the contract, their shares could be taken away or reduced.

This is just one example of how advisory shares might work. The specific terms and conditions of each agreement will depend on the needs of the company and the advisor. But by giving equity in exchange for advisory services, startups and other companies can get the advice and expertise of experienced professionals while aligning their interests with those of the company.

Tesla: In 2017, Tesla gave 6.3 million shares of stock to its non-executive directors as compensation for their advice. The value of the shares at the time of issuance was approximately $2.6 billion.

Common Advisory Shares Vesting Schedule

The terms of the contract between the company and the advisor can have a big effect on when advisory shares become fully paid. But it’s common for advisory shares to have a schedule for when they can be used like that of employee stock options.

Most of the time, advisory shares will become fully vested for several years, with a certain number of shares becoming fully vested at regular intervals. For example, an advisor might get 25% of their shares after one year of service, with the rest of their shares becoming theirs at a rate of 25% per year for the next three years.

The purpose of the vesting schedule is to encourage the advisor to keep giving the company advice since they will only get the full value of their shares if they stay with the company for the whole vesting period.

Difference Between Regular Shares and Advisory Shares

The main difference between regular shares and advisory shares is the receiver of the shares. Regular shares are given to employees as part of their compensation package. On the other hand, advisory shares are given to people who are not employees in exchange for their advice.

The vesting schedule is another important difference. Even though regular shares may have a schedule for when they become fully paid, they are usually fully paid when they are issued. Advisory shares usually have a vesting schedule that requires the advisor to keep working for the company to get the full value of their shares.

Examples of Advisory Shares

Airbnb: In 2011, Airbnb gave 10% of the company’s equity as advisory shares to a group of industry experts, including the founder of Craigslist and the former CEO of eBay. The advisors were asked to give the company direction and advice to enable it to expand and prosper.

A startup software company could give advisory shares to a software engineering expert who could help them build their product and develop their technology. The shares may become fully paid up over several years, with the advisor getting a portion of the shares each year for as long as they keep helping the company.

For example, let’s say the startup gives the software engineer 10,000 advisory shares with a four-year vesting period and a 25% cliff vesting schedule (meaning the advisor must remain with the company for one year before any shares vest). The shares are worth $1 each at the moment.

After working for a year, the advisor would get 2,500 shares, which is 25% of 10,000 shares and is worth $2,500. After two years, the advisor would get an extra 2,500 shares, which at the current price would be worth $2,500. The advisor would get another 2,500 shares after three years, and the last 2,500 shares after four years. If the company does well and the share price goes up, the advisor’s shares could be worth a lot more than what they were worth when they were first given out.

Salary or Equity?

Advisors often wonder if they would be better off with a salary or advisory shares as a form of compensation. The advisor’s risk tolerance, the state of the company’s finances, and the state of the market are just a few of the variables that will determine the answer to this question.

Advisors who require a stable income to meet their financial obligations may find salary remuneration an attractive choice. Advisors who are more comfortable with risk and prepared to take on more in exchange for the potential upside of stock remuneration may find salary compensation less enticing.

But, if the company is successful, employees who receive equity remuneration can make substantial gains. But, if the company fails, the value of the shares may drop to zero, making the equity pay hazardous. Financial advisors who prefer compensation in the form of equity must be prepared to take on additional risk and think in the long term.

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