Fundraising Agreements: Part 10 - Special Edition (Advisory Shares).

?? What Are Advisory Shares?

Advisory shares, also known as advisor shares, are typically offered as stock options to advisors in startup companies in exchange for their expert guidance and network access, rather than cash compensation. These are distinct from regular employee stock options or shares and are aimed at leveraging the strategic insights and networks of seasoned business professionals.

?? Who Gets Advisory Shares?

Advisory shares are primarily issued to individuals who have significant experience and expertise relevant to the startup's industry, such as former company founders or senior executives. These advisors provide strategic guidance rather than technical advice on areas like taxes or contracts, which would typically be the realm of paid professionals such as accountants or lawyers.

?? Types of Advisory Shares

Advisory shares come in two main forms:

A) Stock Options: These options grant the advisor the right to purchase shares at a preset price within a certain timeframe. They do not involve immediate equity transfer but allow advisors to buy into the company at a later date, potentially avoiding upfront tax implications.

B) Restricted Stock Units (RSUs): RSUs are promises to grant actual shares at future dates based on certain conditions, such as achieving performance milestones or continued engagement with the company.

?? Key Considerations in Issuing Advisory Shares

A) Vesting Periods: Typically, stock options for advisors vest over 1 to 2 years to ensure advisors remain engaged and contribute to the company’s long-term success.

B) Taxation at Vesting: For stock options, the advisor generally incurs a tax liability when they exercise the options, based on the difference between the exercise price and the fair market value. For RSUs, the taxation occurs when the shares vest, based on their market value at that time.

C) Equity Allocation: The percentage of equity allocated can vary significantly but is generally less than 5% of the company's total equity. Individual allocations might range from 0.25% to 1%, depending on the advisor's contribution level and the company's stage of development.

D) Tax Implications: Options can minimize immediate tax liabilities, but it's crucial to consider the tax implications when these options are exercised. RSUs are taxed as ordinary income upon delivery, which can be a significant tax event.

E) Reporting Obligations: Companies must report these compensation expenses to the relevant tax authorities and may need to withhold taxes appropriately.

F) Registration Exemptions: Since advisory shares are a form of equity compensation, they must comply with securities laws. In the U.S., these shares are typically exempt from registration under specific provisions (like Regulation D of the Securities Act) provided they are offered privately and not to the public.

G) Disclosure Requirements: Companies must provide advisors with sufficient information about the equity being offered, including details about the company's financial health and risks, to ensure informed consent.

? Pros and ? Cons of Advisory Shares

A) Pros:

Incentivize Expertise: Advisory shares can attract top-tier talent and strategic advisors without upfront cash, which is beneficial for cash-strapped startups.

Confidentiality and Non-compete: They can help ensure confidentiality and, through specific agreements, potentially limit conflicts of interest despite the advisor's involvement with other companies.

B) Cons:

Equity Dilution: Founders must be cautious of equity dilution, particularly as the company grows and each share becomes more valuable.

Complexity and Cost: Managing stock options and RSUs can be administratively complex and costly, especially for a young company.

Long-Term Commitments: Since advisors' shares typically vest over years, startups are making a long-term commitment, which might not always align with changing strategic needs.

?? Practical Tips for Startups Considering Advisory Shares

A) Formal Contract: An advisory agreement is crucial and should detail the specific terms of the engagement, including the responsibilities of the advisor, the equity compensation (stock options or RSUs), vesting schedule, and conditions under which the agreement might be terminated.

B) Confidentiality Clauses: To protect sensitive company information, advisory agreements often include confidentiality clauses that legally bind the advisor to secrecy regarding company affairs.

C) Non-compete and Non-solicit Clauses: These clauses may restrict advisors from engaging with competing businesses or poaching company employees or customers, although enforceability can vary significantly between jurisdictions.

D) Trial Periods: Consider implementing trial periods where advisory roles and equity grants can be evaluated and possibly terminated if expectations are not met.

E) Legal and Financial Guidance: Before issuing advisory shares, consult with legal and financial experts to understand all implications fully.

F) Regular Reviews: Establish mechanisms for regular performance reviews of advisors to ensure they continue to add value in line with the equity they hold.

?? Conclusion

While advisory shares are a valuable tool for startups looking to harness external expertise without immediate financial outlay, they require careful consideration and management. Startups should weigh the benefits against the potential long-term costs and complexities. Consulting with a financial advisor can provide personalized advice tailored to the specific needs and goals of the business.