When you're watching Shark Tank, you might hear the sharks discuss advisory shares. But what are advisory shares, and how do they work?
In this article, we will define advisory shares and explain how they operate. We'll also look at the advantages and disadvantages of this type of share ownership. Finally, we'll answer some frequently asked questions about advisory shares.
What are advisory shares?
They are a type of stock that is given to an advisor in exchange for their professional advice and guidance. Advisory shares usually come with some sort of voting rights, which means that the advisor can have a say in how the company is run.
However, it's important to note that advisory shares do not always come with an equal share of the company. Most of the time, advisory shares are a very small percentage of the total number of shares.
This is because the advisor is not an owner or employee of the company; they are simply there to provide guidance. Compared to the number of employees and investors, advisors are few and far between.
They are given the option to buy the shares but are not given any guarantee that they will make any money from them. The reason why guarantees are difficult to give is that this share structure is often used for pre-revenue startups where it is difficult to value the company.
That's why retail investors in the stock market won't have the opportunity to buy these types of shares. However, it's still important to be aware of them as they can have a big impact on a company's future success.
If you are an early-stage investor, you may come across companies that are offering advisory shares quite often. Be sure to do your due diligence before investing, as these types of investments can be very risky. But if you can add value through your advice, guidance, and connections, you can also reap a large financial reward down the road.
What is the meaning of advisory shares?
To break down what advisory shares are, we must look at the word "advisory." This refers to giving professional or expert advice. In the business world, an advisor is somebody who guides a company's management team.
Advisors can be found in many different industries, and they often have a lot of experience and expertise in their field.
How advisory shares work
Advisory shares usually have a vesting period, meaning the recipient will only receive them after a certain amount of time has passed (usually 12-24 months). The number of shares an advisor gets is typically based on the company's performance during that vesting period.
For example, if a company does well and its stock price goes up, the advisor may get more shares. If the company does poorly and its stock price goes down, the advisor may get fewer shares.
However, it's also common that advisors will receive a percentage cut as a part of the deal. 0.25%-1% is the typical amount of equity the advisors will receive after the scheduled vesting period. Of course, some negotiations can lead to a larger percentage of equity ownership. It depends on each specific deal.
An advisor will rarely receive more than a few percent of the company even if they are excellent negotiators. But as the startup grows, a few percentages can grow to be a lot of money.
For example, if a company is sold for $100 million and the advisor owns 0.25% of the company, the advisor would make $250,000 from the sale. Now, that's not bad for sharing some advice and guidance. Most mentorship deals pale in comparison.
The vesting period creates the vested interest that the advisor has in the company's success. Startups and young companies need all the help they can get, so it's important to have people on board who are invested in the company's success.
Advisory shares may also come with certain rights and privileges, such as the right to attend board meetings or the right to receive information about the company's financials. However, these rights are typically granted at the discretion of the company's board of directors and may be revoked at any time.
An NDA (non-disclosure agreement) is also common in these situations, as the advisor may have access to sensitive information about the company.
Advisory shares example
Let's say you are an advisor for a startup that is developing a new app. The company is pre-revenue, so it's difficult to value the business. However, you believe in the team and the product, so you decide to take on the risk and invest your time and advice in exchange for equity.
The company offers you 0.25% of the business in advisory shares. This means that after the vesting period (let's say 12 months), you will own 0.25% of the company. If the company does well and its stock price goes up, your shares will be worth more money. If your advice isn't helpful and the stock price reflects that, you won't maximize the potential of the company and your equity stake.
You understand that the company is in a risky position but you feel like your advice can help ensure its success. They don't have much other guidance and you feel like the time commitment and strategic thinking are going to be worth more to the company than 0.25%.
You decide to negotiate up to 0.50% and the board of directors accepts, except with an extended vested period of 4 years rather than the standard 12-24 months. You agree to meet for an hour each month.
Now, you're an advisor with skin in the game. You have a vested interest in the company's success and you're committed to helping it grow. Over the next four years, you offer your advice and guidance on everything from marketing to product development. Thanks to your help, the company can raise additional funding, launch its product successfully, and grow its user base.
After four years, the company was sold for $100 million. Because you own advisory shares that vest after four years, you receive $500,000 from the sale ($100 million x 0.50%). That's about $2600 per hour of advice you gave over the four years. This might seem like a lot of money for the app company to give up.
But if your advice was the difference maker between being bankrupt and being sold for $100 million, the company will likely be grateful.
Advantages of advisory shares
The advantage of advisory shares for company owners is that it delays the transfer of equity ownership to their advisors. While in the meantime, they still receive their advice and guidance as advisory shares will lead to equity ownership in the future.
This incentivizes the advisors to help the company succeed to maximize its future equity stake. The advantage for the investor is that they can negotiate a larger equity stake than they would receive in an outright sale.
They also get the benefit of being able to see how the company performs over time before fully committing. If they are confident that their knowledge and experience can help the company grow, it can be stimulating to play a more active role as an advisor.
Of course, the payout potential is also very enticing. For the company's success, it's advantageous to have a vested interest and proper advice from someone that's not just looking for a quick buck. Investors can provide capital.
Employees help with the day-to-day operations. But an advisor can help with high-level strategic decisions that will make or break a company. That guidance can be a competitive advantage for young companies. If the name is popular, it can even attract other investors and employees.
Disadvantages of advisory shares
The disadvantage of advisory shares is that they can create tension and conflict between the company's founders and its advisors. Advisors may feel that they are not being adequately compensated for their work, while founders may feel that they are giving up too much equity.
This conflict can be resolved through open communication and negotiation, but it can sometimes lead to the advisors leaving the company. Another disadvantage of advisory shares for company owners is that it can be difficult to value the shares.
This is because they are not yet equity and do not have a set price. It's also difficult to determine how beneficial an advisor's guidance will be to the company's success. This can make it difficult to negotiate a fair price for the shares.
Finally, it can be difficult for the board of directors and the advisors to conclude exactly what role the advisors will play in the company. If the role is not clearly defined, it can lead to confusion and conflict down the road.
What are advisory shares in Shark Tank?
In the hit television show Shark Tank, advisory shares are often used as a way to entice the sharks to invest in companies. The company will offer the sharks a certain number of advisory shares, which will convert to equity if the companies are successful.
This gives the sharks an incentive to help the company grow, as they will receive a larger equity stake if they do. While this can be a good way to attract investors, it can also lead to conflict. Many deals made on the show don't go through when the end credits roll.
This is because as we mentioned, it can be difficult to decide exactly what role the sharks will play in the company. If they are only meant to be advisory, then they may not have as much skin in the game and may be less likely to see the deal through.
However, if the advisory shares are accepted by both parties, the experience, connection, and knowledge a shark can bring to a company can be invaluable. If you're considering offering advisory shares to potential investors, make sure you have a clear plan for what role they will play.
If you ever make it on the show, remember that advisory shares can come up during the negotiations. Make sure you are well aware of the ins and outs of this type of deal before going into the tank. They can be quite vicious if you aren't properly prepared.
Do advisory shares get diluted?
Yes, advisory shares can be diluted if the company raises additional funding through equity financing. This is because the diluted shares will convert to equity at a lower price than the original advisory shares.
As an investor, this is something to be aware of. However, it should not be a deal breaker because the advisor will still have a significant stake in the company.
How are advisory shares taxed?
Advisory shares are taxed as ordinary income when they are received. However, the advisor can elect to defer the taxes by reinvesting the shares into the company. This is often done when the shares are received as part of an employee compensation package.
If the advisor leaves the company before the shares vest, they will owe ordinary income taxes on the shares at that time. Taxes on this share option can be different depending on your jurisdiction and individual income bracket.
It's always best to have a detailed conversation with your CPA or tax professional before entering any deals. Taxes are likely not the first thing that comes to mind when being offered advisory shares, but they can have a big impact on your bottom line.
Advisory shares are a way for startup companies to attract and retain top talent. By offering equity in the company, startups can lure inexperienced advisors who can help them navigate the early stages of growth.
However, it's important to remember that advisory shares come with certain risks and responsibilities. Before accepting any advisory shares, be sure to understand the terms of the agreement and what you're getting yourself into.