Advisory shares refers to shares of a company that has been issued to advisors in exchange for their knowledge and expertise desired by the business.
So instead of getting a cash payoff or drawing a salary from the company, the advisor is remunerated with a stake in the company in the form of shares.
The better advise given to the company, the better the business performs, and the higher the value of the shares.
Advisory shares are most often issued as stock options that the receiver would be able to exercise within a specified time period.
For example, a person or entity might be granted stock options to purchase 1% of common stock in the company, which is valid for 12 months.
Stock options allow an advisor to decide whether it would be worthwhile to purchase shares at a specified price, enabling them to be vested at a later time when the outlook is clearer.
If for example, the company is doing badly and has no positive outlook, then it would make little sense to trigger the options and purchase the shares.
It must be said that when advisory shares are directly issued, they are usually “free”.
How advisory share affect company value
The issuance of advisory shares are a common occurrence in the world of venture capital where startups constantly need to raise money to sustain operations and growth until they hit critical mass.
And they cans sometimes be issued strategically to retain the value of the company.
The logic behind this is that startups raise money in phases, tranches, or rounds.
As the company grows, each following round of fund raising is expected by investors to raise the company value. This indicates that the business is growing, at least in an organic sense.
If a round of fund-raising values the company at less than the previous round, it is called a down round. And this is a particular red flag for venture capitalists (VC) as it indicates that a firm is losing market value.
As VCs are in the business of investing in growing companies, a down round can often be reason enough to say no to the company promoter. Otherwise, the VC would want to pay the same lower price as the last round for simple pragmatism.
In addition to this, seeing new investors paying a lower price for the company shares can anger previous investors who paid a higher price for each share.
When a down round becomes a serious possibility, company founders can use advisory shares to issue stock to investors without technically running into a down round.
For example, a previous round of fund raising convince an investor to come in at 5% for $50,000. Thus, valuing the company at $1m. If the current round of fund raising only finds an investor willing to invest $40,000 for 5% of shares, then the prospect of a down round becomes a real possibility. If such a deal goes ahead, the value of the shares would have effectively dropped by 20%.
To retain the value of the company shares, the founder can sell 4% of shares to the latest investor, keeping the company value stable. And issue 1% advisory shares to the investor.
After all, the investor can probably provide advise and add value to the company.
In such arrangements, the company shares technically did not drop in value. And the firm can move on to the next round of fund raising without a down round hanging over his head.
