When most people hear the term "shares," they think of stocks. But advisory shares are different from traditional shares. Discover the difference, as well as the purpose of advisory shares.
Advisory shares are a type of stock option, but they are not stocks themselves. Startups commonly use advisory shares to compensate early advisors, as this doesn't require the startup to give up capital directly. The biggest difference between advisory and regular shares is that anyone can buy regular shares on the stock market.
Take a closer look at what advisory shares are as well as the fine points of the difference between them and regular shares.
Advisory Shares: What to Know and How They Differ from Shares
Advisory shares let startups compensate business experts and advisors without having to pay them some of their extremely limited capital. You are most likely to hear about advisory shares in relationships between advisors, business experts, and startups. Established businesses can also use them to compensate experts.
What Is an Advisory Share in a Company?
As mentioned, an advisory share in a company is a stock option. But there are some important things to mention. These factors separate advisory shares from employee stock options and from regular stocks.
They Are NSOs, Not ISOs
One important thing to keep in mind about advisory shares is that they are NSOs (non-qualified stock options). This contrasts with ISOs (incentive stock options). The most common example of ISOs is employee stock options.
In practical terms, this affects how advisory shares are taxed. You pay regular income taxes on NSOs when you exercise your stock option. By contrast, if you exercise your ISO stock option, you won't have to pay income tax on it then.
What's a Common Advisory Share?
The size of the advisory share can vary greatly, as it depends on what the startup and advisor agree on. It will depend on multiple factors, including:
- How much they will participate in the company
- Their background knowledge and experience
- The age of the business/startup
That being said, it is average for an advisory board to receive advisory shares totaling around 5% of the total equity of the company. For an individual advisor, the advisory shares are usually somewhere between 0.25 percent and 1 percent of the total equity.
As a rule of thumb, newer startups usually need to offer higher amounts of advisory shares to compensate for the risk. By contrast, more mature startups will be more established and have less of a risk, so they can offer lower percentages.
What's A Common Vesting Schedule For Advisory Shares?
For most advisory shares, there will be a vesting schedule of two years without a cliff. When shares vest, this means they become available. A 2-year vesting schedule with no cliff means that the shares become available in smaller monthly amounts over the course of 24 months. Most advisory agreements will be set up so that if the advisor stops working with the startup, they won't receive the entire vesting schedule.
As mentioned, the most common vesting schedule for advisory shares won't have cliffs. Cliffs are periods of time without vestments. They are common for employee stock options, but they are uncommon for advisory shares.
Advantages and Disadvantages of Advisory Shares
Advisory shares can be incredibly useful, but there are some disadvantages that anyone considering them should be aware of.
The following are some of the most notable advantages:
- Startups can use them to attract experienced advisors.
- Advisory shares and agreements can include signing non-disclosure and confidentiality agreements.
- Startups can reduce the risk of an advisor having a conflict of interest by researching the advisor before signing an agreement.
The following are some disadvantages:
- Advisors frequently work with multiple companies, potentially including rivals.
- It is easy for startups to accidentally overcompensate advisors, not realizing how much each advisory share will be worth when the company grows. (That's why larger, more established companies offer smaller advisory shares.)
The Best Advice: Take it Slow and Consider Everything
Because of the potential disadvantages of advisory shares, especially the equity in the company, it is best to take it slowly. Don't just jump into an advisory agreement. Think about the future of the company and what the advisor has to offer. You can also consider including a short trial period in the advisory share agreement. A three-month trial period is not uncommon.
What Is An Advisory Share On Shark Tank?
Advisory shares on Shark Tank are the exact same as advisory shares in any other situation. This is simply a way for the "sharks" on Shark Tank to invest in the startups pitched to them. Essentially, the sharks receive shares in the business in exchange for their expertise.
Keep in mind that this is different from an investment in the company that gives the sharks a share of the ownership. With an advisory share, no funds are initially exchanged, and the "shark" provides their expertise to the startup. Their advisory shares will hopefully increase in value and become compensation. When a "shark" invests in the startup, the company gets capital to work towards its goals and gets a share of the ownership in return.
How to Calculate Shareholders' Equity
Whether you are talking about advisory shares or regular shares, shareholders' equity can come up. Shareholders' equity (SE) refers to how much shareholders would receive if the company liquidated all of its assets and repaid all of its debts. This is a representation of the company's net worth. You will usually find the shareholders' equity on a company's balance sheet.
The Calculation
Calculating shareholders' equity is very straightforward. It is just the total assets of the company minus its total liabilities. The formula would appear as follows:
Shareholders' equity = Total assets – Total liabilities
But what do each of those terms mean? The total assets can be non-current or current assets. Current assets are those that the company can turn into cash within a year. Examples include inventory and accounts receivable. By contrast, non-current or long-term assets can't be consumed or moved to cash within a year. Examples of these include equipment, patents and other intangible items, manufacturing plants, and real estate properties.
The total liabilities also include both current and long-term versions. Current liabilities have repayment due within a year. Examples are taxes payable and accounts payable. Long-term liabilities are not due for payment until more than a year passes. Examples include pension obligations, leases, and bonds payable.
How to Calculate Shareholder's Equity Step-by-Step
While the above equation tells you how to calculate shareholders' equity, you will have to gather some important information about the company before you can use it.
Start by looking at the company's balance sheet to find the total assets of the company. Then, look at the balance sheet for all of the liabilities. Add those up. From there, you can subtract the total liabilities from the total assets.
As mentioned earlier, companies usually list shareholders' equity on their balance sheets. You can confirm their figure and your calculations with this. Just add the total liabilities to the shareholders' equity. You should get the same figure as the total assets.
Why Does Shareholders' Equity Matter?
Analysts look at the figure to get a feel for the overall fiscal health of a company. The most basic information from the shareholders' equity (SE) is whether it is positive or negative. Positive SE is good news as it means the company has enough assets to cover all of its liabilities.
By contrast, negative SE means that the liabilities are greater than the assets. This tends to make potential investors view the company as risky. That, in turn, makes it harder for the company to attract investors. Going back to advisory shares, experts are less likely to enter an advisory share agreement with a company that has negative shareholders' equity.
But savvy investors know that shareholders' equity is not the only information to consider. You need to combine it with other metrics to evaluate a company's health. For example, the retained earnings can bring the calculation down. Retained earnings are the portion of net earnings that shareholders don't receive as dividends. They can be used to help grow the business, such as by paying for other expenses.
SE is also involved in calculating some important ratios, including:
- D/E (debt-to-equity ratio)
- ROE (return on equity)
- BVPS (book value of equity per share)
The Investor's Equation or Share Capital Method
While the above formula is most commonly used to calculate shareholders' equity, there is also another version. This is as follows:
Shareholders' equity = Share capital + Retained earnings – Treasury stock
In that calculation, the retained earnings are the cumulative earnings of the company after it pays dividends. You can find it on the balance sheet under the shareholders' equity section.
Conclusion
Advisory shares are stock options that businesses give to advisors to compensate them for their advice. They are commonly used by startups with limited capital, as they essentially let the company wait to compensate the advisor.
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Shawn Manaher is a former financial advisor, has founded 5 online businesses, and is a coach, speaker, podcast host, and author. He's been featured on Forbes, The Consults Corner on TAE Radio, The Writing Biz, What's Your Story, and more.