Advisory Shares and its Valuation: A Complete Guide
One of the crucial parts of the founder’s job towards their company or organization is to manage company equity. It seeks oversights and administration. When building a business, it is difficult to have the cash flow to compensate each advisor, investor, or peer that helps a business.
Founders must be artful in compensating their earliest investors, experts, and advisors. It’s when advisory shares take place.
Advisory shares play the savior role in the earlier era of business when founders are out of cash flow or needed help to afford to compensate their advisors with real finance.
This is a general guide for all to learn details about advisory shares and their impact on businesses and startup valuations.
This might be helpful for you, read to the end!
Understanding Advisory Shares
Before anything, let us clear the image of advisory shares in your mind, what is it, how it works, when is it issued and for whom!
What are Advisory Shares?
The term “Advisory Shares” refers to the equity compensation offered to experts and advisors by the business in its early period.
Also known as advisor shares, these shares are the most common type of stock options given to the advisors of the business to replace their time and expertise.
Advisory shares are in the form of non-cash equity compensation which doesn’t come under the area of company profits or voting rights.
People who are not board members yet help the company grow and nurture are recognized as eligible for this type of share.
Startups use advisory shares when they necessitate expertise but are low on funds. Advisors only accept advisory shares when they believe that the startup has the potential to grow in the future and they have the capability to guide it to succeed.
Key Characteristics of Advisory Shares
- The most common type of stock options and a type of non-cash equity compensation.
- Granted as Non-Qualifies Stock Options(NSOs).
- Not allotted with the voting rights or a stake in the company’s profits.
- As per the advisory agreement, the company will not owe the entire vesting schedule to the advisor once the advisory services are stopped.
- Advisor shareholders might have higher claims and receive their investment back before equity shareholders.
- Advisory shares conventionally vest monthly over a 1-2 year period of time with no cliff.
Distinction Between Advisory Shares and Equity Shares
One primary difference between advisory shares and equity shares is that equity shareholders share ownership with the company whereas advisory shares are just an equity given to advisors of the company.
Role:
Advisory shares in business help to recognize experts to support the company. Equity shares are one way to raise company capital by giving ownership stakes and equities to investors and employees.
Receivers:
Advisory shares are often awarded to the experts, advisors, or consultants in exchange for their expertise. Founders, top management, or other staff of a company are usually offered equity shares.
Vesting Terms:
The holder’s input into the company’s strategic process decides the vesting of advisory shares, in contrast, equity shareholders are usually involved in the operations and directions of the company.
Decision-making:
The management team and board of decision-making fend the Advisory shareholders’ decisions. The decision-making process does not involve the equity shareholders as well.
Reasons for Issuing Advisory Shares
The reason for issuing advisory shares has a lot in common with the employee stock options – including incentive alignment and cashflow savings.
Besides that, the reasons pertaining to strategy are written below:
1. Motivating Key Advisors and Consultants
Advisory shares are used to incentivize advisors as the type of equity compensation, in replacement of which, advisors are expected to provide the utmost guidance, support, and expertise services to the company. Advisory shares line up the interest of advisors in the company by creating a sense of ownership and commitment.
2. Attracting Industry Experts
Advisory shares are one great way to attract experts from various industries. Start-ups face early challenges in their business that can be addressed with advisory shares. Industry experts provide guidance and strategic insight into the business in return for advisory shares in the business.
3. Building Strategic Partnerships
Issuing advisory shares can be a strategic way to build and cultivate valuable partnerships. By issuing advisory shares in the business, they can leverage the network of their advisors to secure advantageous collaborations, which can lead to a number of benefits.
Types of Advisory Shares
There are mainly two types of Advisory share issuance in companies – Restricted Stock Awards and Stock options.
Both types pose varied purposes and functions. The difference between them lies in their distinct legality. Let’s understand!
1. Restricted Stock Awards(RSAs):
Restricted stock awards are grants of the company and are generally bought upfront. RSAs are typically issued before the first round of financing when FMV(Fair Market Value) is low and the company has scarce money or cash.
The recipient of the RSAs might pay for these shares with cash or with the expertise services they provide. The ownership is transferred to the advisor as soon as the shares are granted.
2.Stock Options :
Stock options are kind of given rights to buy shares at a pre-determined price or say exercise or strike price. Two types of options are there – ISOs(Incentive Stock Options) and NSOs(Non-qualified Stock Options).
ISOs are tax-advantaged and are only for US employees, whereas NSOs trigger taxes. The specific terms of stock options granted to advisors vary depending on the company’s financial situation, the advisor’s experience, and the company’s expectations for the advisor’s contribution.
Issuer of Advisory Shares
The issuer of the advisory shares is the company that grants the shares to an advisor. The issuer is typically a start-up or early-stage company that is seeking advice or expertise from the advisor. The issuer may also be a large company that is looking to add an experienced advisor to its board of directors.
Receiver of Advisory Shares
The receiver of the advisory shares is an individual or an entity that is granted the shares, The receiver is typically an experienced advisor who can provide valuable guidance and support to the company. The receiver may be an industry expert, a mentor, or a member of the company’s board of directors.
Valuation of Advisory Shares
The industry standards say that any company can spend 0.25% to 1% of the total equity of a startup per advisor as the advisory shares in startups hugely affect their valuation.
The valuation of advisory shares is a complex process that involves considering numerous factors and utilizing different valuation methods.
A. Factors Influencing Advisory Shares’ Value
Generally, three types of factors can affect the value of advisory shares that can be advisor-specific, company-specific, and market-specific; including:
- Advisor’s Value
- Startup’s Stage
- Market Norms
- Legal and Financial Implications
B. Common Valuation Methods
Three primary valuation methods are used for the valuation of advisory shares.
- Market-based Valuation
- Income Approach
- Cost Approach
Valuation of Company
Valuation of the company is the systematic process done to determine the economic value and worth of a company. Company valuation involves an analysis of assets, the financial health of a company, market position, liabilities, and future growth prospects.
It is important to determine the shares to be allocated as it provides the benchmark for the value of each share. This helps to ensure that all investors are treated fairly and the company is not over-or-under-valued.
Advisory services play a significant role in a company’s growth and development. Their contributions should be appropriately valued to determine the number of shares to be allocated. Factors like expertise, experience, the scope of the services, and their impact on the company affect the company’s valuation.
Advisory services for company valuation benefits with transparency, clarity, fair allocation of shares, and long-term success.
Pros of Issuing Advisory Shares
- Attracts experienced advisors to join the company
- Aligns advisors’ interests with the company’s long-term success
- Gain access to strategic insights
- Protects the company’s confidentiality
Cons of Issuing Advisory Shares
- Dilutes existing shareholders’ ownership percentage
- Complexity and administrative burden on legal and tax considerations, vesting schedules, and recordkeeping
- Potential for conflicts of interest
- Uncertainty in future value
- Limited control and dilution of voting power
Importance of Advisory Shares in Startups and Businesses
Advisory shares are particularly important for both – startups and businesses. Companies in their early stage can get access to strategic guidance, networks, opportunities to grow, industrial insights, credibility, and reputation with the help of advisory shares.
Even established businesses can use advisory shares to attract top talent, stay competitive with expertise in product development, and innovation, increase operational efficiency, enter the global market, and many other benefits that help in overall management and development.
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