Imagine that you came to our CEO and said, “Alyona, I want you to be an investor in my company.” After dealing with the procedure, we estimated this was a good idea. Then instead of our CEO Alyona being a part of your company, she would choose to have advisory shares. How is this concept beneficial for a startup and a person who gets these shares?
As an advisor, they would get non-voting shares along with the percentage of the company that would constitute the reward, but would affect neither you as a founder nor your day-to-day operations. In the meantime, Alyona might become your literal advisor and help your business with financial management. Our CRO has been expanding her company during Covid-19 and during a literal war, so her take on crisis management and growth can be helpful for young entrepreneurs.
How can you set it up? You can do that with operating agreements. A spoiler, you don’t have to put everybody in the company to have investors. So there are two ways to do it. And if you go down that route, you can form a single-member LLC. Or a limited liability company with a single owner. And set up promissory notes or contracts with the people who want to invest in your startup. It can look as simple as, “The investor gives X company $20,000. I am gonna give this investor this amount of a return on their investment by this date”.
Lawyerish speaking, it is a promissory note; anyone can do that for any reason at any time. Advisory shares are a win-win situation since, according to their concept, they make people feel like they’re involved in their investing. And they’re getting a return without actually affecting your company. But, on the other hand, they don’t know how to run the business you are in, and they don’t share your vision.
Advisory shares allow you to attract new investors that you can build into the company through the operating agreement. Still, they are only going to be bound by the advisory shares. But anytime a business makes money, they get X percent because they have sponsored your idea by being original investors.
Advisory shares are also a beneficial equity agreement between startups and business professionals.
What are advisory shares? Business vocab.
Advisory shares are a type of stock option given to company advisors rather than employees. The shares may be given to startup company advisors in place of cash repayment.
The idea of advisory shares revolves around granting options to buy shares rather than giving the actual shares, and getting guidelines from more experienced people who have been in the business longer and want to share their insights in exchange for an X percent.
Have you seen a lot of early-stage startups with a lot of cash? Exactly. That is why startups without substantial money often share equity to reimburse advisors adequately. In this scenario, startups do get a couple of valuable lessons on growth. But at this point, don’t these lessons become too expensive? So handing out equity is something that founders need to do carefully.
Rule #1: GIVE SHARES TO ADVISORS WHO WILL HELP YOUR STARTUP
If you’ve got your networking part covered and given a helping hand to other fellow entrepreneurs, you can probably get a lot of help without giving out shares in your company. But suppose you want a committed, monogamous relationship with an advisor who will be consistently involved in your company for a long time. In that case, you may want to give them 25 basis points, which is 0.25% of the company.
You can extend the offer as much as 100 basis points or 1% if they have an extensive network and can make a funding round come together.
However, you would want to vest that amount over four years to ensure they continually work with you.
OTHER TYPES OF “ADVISORS”
Look out. Vultures are coming
Some people would like to make a living off young and naive entrepreneurs. Therefore, they will gladly take significant chunks of advisor shares and may be over-promising the amount of help they can provide.
If something sounds too good to be true, it probably is. You may encounter people who promise you the Moon and the sky, who will take care of all your fundraising for 5% of the company. Then, call the police because you are getting robbed.
If they were, in fact, that well-connected, they would invest in your company.
Also, play safe with matches and name-dropping. Some founders will distribute equity to people who “lend” their names to your company but make no contribution to your startup.
Name-dropping does not necessarily generate sales or funding.
How to choose the advisors wisely?
Find a mentor in the same domain. Or a similar field startup founder who is three years ahead of you. Or even someone from a different realm but with strategic insights and knowledge.
High-quality advisors can help your company in the most concealed ways. The only sure thing is that the best way to celebrate this union is by documenting the agreements with your lawyer and the advisors and setting up a vesting schedule.
Operating advisory shares
Advisory shares are used to incentivize a variety of roles. Moreover, they deliver a way to offer payment without the tax limitations and accounting intricacies of stock options if the company grants advisory shares worth a significant amount.
Keep in mind the conceptual difference between advising and getting outsourcing assistance. For instance, although attorneys could serve as advisors for a business, they are more likely to charge for their assistance. While founders, senior executives, or industry experts are usually rewarded with advisory shares.
How do advisory shares work?
What differentiates an advisory share from any other type of equity?
- It does not entitle the shareholder to voting power
- it does not allow the shareholder to sell or trade shares
- or to receive dividends.
In most cases, an advisory share does not entitle the shareholder to any responsibility or risks.
Instead, it is a kind of compensation by the company.
The vesting schedule allows the company to postpone transferring ownership to advisors while keeping them on board long-term.
How the advisor’s equity will be distributed?
The rule can vary from a fixed term, best-fit, to time-based policies.
There are two types of vesting schedules:
1) Fixed term. The fixed-term option gives the advisors shares that can be expired after a set period.
2) Time-based. The shares vest gradually over time.
For example, 10% will vest after one year’s service, and an additional 10% will vest at two years’ worth of service.
A 3-month cliff agreement allows the parties to determine if the relationship will provide mutual benefits.
Cliffs are periods without stock vestments. This vesting schedule is usually a requirement of employee stock options and not part of the advisory shares vesting schedule.
Newbies tend overcompensating advisors with stock options. It might seem that those fractions of equity are not particularly valuable at an early stage. But at some point, they would be worth extensively more. So do not be the guy who sold his 10% stake in Apple for $800. Maybe not the best analogy, but a wise one.
*Any company’s advisory share allocation is usually capped at 5%. This is to discourage companies from issuing too many of them.
How much equity do advisors get?
Like workers, advisors acquire shares of common stock, which vest over time. Advisors usually receive one of the following options:
- Restricted stock agreements (RSAs)
- Non-qualified stock options (NSOs)
What are the differences between RSAs and NSOs?
Restricted stock agreements (RSAs) are the shares you purchase upfront. A vesting schedule restricts the shares. At the same time, Non-qualified stock options (NSOs) are an option to get shares that are usually granted later. RSAs typically get higher since they are given instantly after incorporation before a company’s market value has increased.
An advisor who joins a company earlier usually receives higher fully-diluted shares.
Individual advisors’ percentage depends on how much the advisor contributes to the company’s growth. They can expect anywhere from 0.25% to 1% of the company’s equity.
You may want to consider the amount based on their experience, influence, and role. It also depends on how long the advisor and the company plan to work together.
For instance, an advisor who brings in new customers would likely receive 1.5% for their direct involvement. At the same time, an advisor offering industry insights for two years would get 0.5% of the company’s shares.
Keep in mind that early-stage and seed companies will be willing to give up a higher percentage of their equity to an advisor. In contrast, growth-stage and mature companies will only offer a smaller portion.
Check out the recent stats: startups that raised less than $2 million in 2019 gave their
- RSAs Advisor: from 0.2% to 1% of a startup
- NSOs Advisor: from 0.1% to 0.5% of a startup
Maybe you don’t need an advisor in your startup development. Instead, you need a digital CFO to tell you when to look for one. So book a quick call with our financial manager to determine if you got your LTV right.