Equity is the lifeblood of young startups. Founders trade equity shares to raise funding from investors and give them to employees to incentivize performance and motivate them to stay with the company. Startups also issue a unique form of equity—advisory shares—to attract industry experts.
Advisory shares and equity shares are crucial for structuring ownership and compensation in startups in Nigeria and outside. While both terms refer to allocations of company ownership, they differ significantly in their purposes, rights, and implications. Understanding these differences is essential for startup founders, advisors, and investors to navigate equity agreements effectively.
By the end of this article, you will understand the key aspects of advisory and equity shares, their purposes, typical terms, and their impact on dilution, voting rights, and compensation.
TL;DR: Key takeaways
- Advisory shares are granted to advisors in exchange for their expertise. They typically have no voting rights and are subject to vesting schedules.
- Equity shares represent ownership in the company given to investors, founders, and employees, often with voting rights and potential financial returns.
- Advisory shares typically have less impact on dilution than equity shares.
- Founders and startups must weigh the role and value of advisors when deciding between advisory and equity shares.
- Tax implications differ for advisory and equity shares, so consulting a financial professional is essential.
What are advisory shares and equity shares?
Advisory shares are a form of equity allocation granted to individuals — described as advisors — who provide strategic guidance or industry expertise to startups. These shares are typically offered to advisors rather than employees or investors.
Advisory shares are often seen as a way for startups to reward advisors for their mentorship, industry knowledge, or network access without involvement in daily operations. This allows startups to tap into valuable expertise while minimizing costs. They also dilute ownership less than traditional equity.
Key features of advisory shares:
- Non-voting: Advisory shares typically don’t carry voting rights, meaning advisors can’t influence company decisions.
- Vesting schedules: These shares often vest over time and are sometimes tied to achieving specific milestones, ensuring that advisors remain committed to the startup over a specified period.
- Limited ownership: Advisory shares usually represent a small percentage of total equity.
Definition of equity shares (ordinary shares)
Equity shares, often called ordinary shares, represent actual ownership in the company. These shares are typically allocated to employees and founders in exchange for their labor and to investors in exchange for their capital. These shares grant these individuals a stake in the company’s success and growth.
Equity incentivizes stakeholders to contribute to the startup's success, ensuring ongoing dedication and alignment with its goals. While equity can attract top talent and significant funding, it also results in proportional dilution for existing shareholders.
Key features of equity shares:
- Voting rights: Equity grants usually include voting rights, which allow holders to participate in key company decisions.
- Financial returns: Shareholders may receive dividends or financial gains during exit events like IPOs or acquisitions.
- Higher ownership impact: Equity shares often involve larger allocations than advisory shares.
Key differences between advisory shares and equity shares
Advisory shares and equity shares differ significantly, and here’s how:
1. Recipients:
- Advisory shares: Issued to external advisors who offer expertise or guidance without operational involvement.
- Equity shares: Allocated to core team members, such as co-founders, employees, and investors, who often participate in running the company day to day.
2. Commitment level:
- Advisory shares: Require limited involvement, typically for strategic or periodic advice.
- Equity shares: Demands significant involvement, often tied to operational roles or financial investments.
3. Purpose and allocation
- Advisory shares: Designed to compensate advisors for their expertise and contributions without involving them in day-to-day operations.
- Equity shares: Serve as ownership stakes in the company, typically allocated to founders, employees, or investors to incentivize long-term commitment.
4. Voting rights and decision-making power
- Advisory shares: Generally non-voting, which means advisors can’t influence company governance.
- Equity shares: Often include voting privileges, enabling shareholders to partake in strategic decisions such as board appointments or mergers.
5. Vesting schedules and conditions
- Advisory shares: Vesting schedules for advisory shares can be milestone-based or time-based, rewarding advisors as they achieve agreed-upon contributions.
- Equity shares: Employees and founders often receive equity shares with time-based cliff vesting schedules, typically over four years with a one-year cliff.
6. Dilution and impact on ownership
- Advisory shares: While they contribute to overall dilution, their impact is usually minimal due to the smaller percentage granted.
- Equity shares: Significantly affect ownership percentages during funding rounds as more shares are typically issued to investors and employees.
7. Tax implications
Tax treatments for advisory and equity shares differ based on jurisdiction and the individual’s role. Advisory shares may not be taxed as heavily as equity shares granted to employees or founders, but consulting a tax professional is crucial to navigating these complexities.
Written by Omoruyi Edoigiawerie, a seasoned startup attorney with over a decade of experience. Learn more.
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- Advisory shares: They are typically taxed when exercised (in the case of stock options) or vested (in the case of restricted stock). The taxable event generates ordinary income based on the fair market value of the shares minus the exercise price (if applicable) at the time of exercise or vesting. Any subsequent gains after holding the shares may be subject to capital gains tax when sold.
- Equity shares: Equity shares are typically not taxed at acquisition unless acquired at a discount or through certain taxable events (e.g., as part of compensation). Instead, they are taxed when sold, and the resulting profit (or gain) is subject to capital gains tax. The tax rate depends on the holding period.
8. Use case
The choice between offering advisory shares or equity depends on the startup’s stage, priorities, and the individual’s role.
- Advisory shares: Ideal for bringing in industry experts or mentors who can provide occasional guidance without involvement in day-to-day operations.
- Equity shares: Better suited for those who are integral to the company’s growth, such as employees or major investors who contribute capital or strategic direction.
| Advisory shares | Equity shares | |
| Who gets it | Advisors who offer expertise or guidance. | Founders, employees, and investors. |
| Commitment levels | Limited investment | Take up operational roles or make a significant financial investment. |
| Purpose | Designed to compensate advisors for their expertise. | Serve as ownership stakes in the company. |
| Voting rights | No, generally doesn’t have voting rights. | Yes, it often includes voting rights. |
| Vesting schedule | Time-based or milestone-based dependent on agreed-upon contributions. | Typically, time-based cliff vesting schedules over four years with a one-year cliff. |
| Dilution | Minimal | Significant |
| Tax implication | Taxed when vested or exercised. | Generally taxed when sold. |
| Use case | Attracting relevant industry experts or mentors who can provide advice and guidance. | Incentivizing founders and employees and attracting investors. |
How to determine advisory and equity share price
How Is the price of regular shares determined?
For public companies, the price of regular shares is shaped by market forces such as supply and demand. Factors like market trends, company announcements, and economic conditions further influence it.
For instance, events like earnings releases, mergers, or acquisitions can cause share prices to fluctuate significantly. Additionally, a company’s operational performance and reputation are critical in influencing investor confidence and, consequently, its stock price.
In private companies, share pricing follows a different process. The fair market value (FMV) is established through valuation. The valuation involves using financial projections, industry benchmarks, and startup valuation multiples to derive an objective estimate of the company’s worth. The result is a more precise determination of the FMV, which is crucial for equity compensation and regulatory compliance.
How is the price of advisory shares determined?
Startups issue advisory shares to compensate experts who provide strategic guidance during critical growth stages. Since startups may need more cash flow to pay these advisors outright, they offer stock options.
The pricing of these options is based on the strike price or exercise price — the cost at which the advisor can purchase the stock in the future. The strike price is typically pegged to the FMV of the company’s common shares, as determined by the valuation.
Common questions about advisory shares
What does 5% in advisory shares mean?
When a company offers 5% in advisory shares, the advisor is granted ownership equivalent to 5% of the company’s total equity. However, this percentage is usually calculated before subsequent funding rounds, so the actual value may change as dilution occurs.
Can advisory shares be diluted?
Advisory shares can be diluted when new shares are issued during funding rounds. However, because advisors generally own a smaller stake, the dilution impact is relatively low compared to founders or major investors.
Do advisory shares have vesting periods?
Yes, advisory shares are often subject to vesting periods, which may be time-based (e.g., vesting over two years) or milestone-based (e.g., vesting upon securing partnerships or achieving specific business goals).
Pros and cons of advisory shares and equity shares
Pros of advisory shares
- Flexible compensation for advisors without significant equity dilution.
- Aligns advisors’ interests with company success.
- Doesn’t dilute the voting power of existing shareholders.
Cons of advisory shares
- Lack of voting rights may reduce their attractiveness to high-profile advisors.
- Dilution still occurs, even though minimally.
- Limited financial upside compared to ordinary equity shares.
Pros of equity shares
- Grants real ownership and voting rights to founders, employees, and investors.
- Potential for high financial returns in successful companies.
- Attracts and retains employees and investors with a vested interest in growth.
Cons of equity shares
- Significant dilution in ownership during funding rounds.
- Tax implications can be complex.
- Shareholders may face extended vesting periods restricting liquidity.
How to decide between advisory shares and equity shares
For founders and startup teams
When deciding between advisory and equity shares, consider the following:
- The advisor’s role and expected contribution.
- The company’s stage and available equity pool.
- The importance of retaining voting control.
For advisors
Prospective advisors should assess the following:
- The company’s growth potential and valuation.
- Whether the advisory share allocation aligns with their expectations.
- Terms of the vesting schedule and dilution risks.
Examples of advisory shares in action
- A fintech startup grants 2% advisory shares to a seasoned banker for strategic guidance in navigating regulatory challenges.
- A healthcare startup offers 1% advisory shares to a medical expert to enhance credibility and develop new products.
FAQs about advisory shares and equity shares
What is the difference between advisory shares and ordinary shares?
Advisory shares are typically non-voting stock options granted to advisors as compensation for their expertise. They don’t provide full ownership rights. Ordinary shares, on the other hand, represent true ownership in the company, offering voting rights, dividends, and a claim on assets in the event of liquidation.
How much equity do advisors typically get?
Advisors are generally granted 0.25% to 5% of a company’s equity, depending on their level of involvement, the stage of the company (early-stage companies may offer higher percentages), and the advisor’s expertise and reputation.
Are advisory shares always von-voting?
Yes, advisory shares are usually non-voting unless explicitly stated in the shareholder or grant agreement. This distinction helps maintain control for founders and primary shareholders while compensating advisors.
Conclusion
Advisory shares and equity shares serve distinct purposes in the startup ecosystem. While advisory shares are ideal for compensating advisors without diluting voting power, equity shares offer true ownership and financial rewards for stakeholders actively involved in the company. Whether you’re a founder, advisor, or investor, understanding the differences is essential for making informed decisions.
For personalized advice, consult with legal and financial professionals to structure equity agreements tailored to your needs.
