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September 19, 2014

How Do You Compensate Directors of Startup Companies?

One question high impact entrepreneurs often struggle with is how various members of the board of directors should be compensated.  Directors come in a variety of flavors, and should be compensated accordingly.  Now, while every situation is unique, there are some good rules of thumb that entrepreneurs should keep in mind—if only as a place to start.

Identifying the various categories of directors is important. The vast majority of directors in the startup context fall into one of four categories:

1.) The “insider directors” — consisting of founders and managers of the startup.

2.) The ”independent directors” — These folks are usually on the board because they are independent of both the entrepreneurial team and the investors in the deal. They typically bring some “value add” to the table, most often in the form of knowledge, connections and/or reputation in the business space the startup is targeting.

3.) The “professional investor directors” — they represent institutional venture capital investors in the deal.

4.) The “angel directors” — this type of director is often the most problematic in terms of figuring out compensation. These directors are also angel investors.

Let’s start with the easy cases: the insider and professional investor directors.  These folks should get nothing.  That is, nothing for their service on the Board of Directors.

In the case of the insider director, the reasoning is that they are already being adequately compensated for their role in building the company and, in almost every case, serving as a director is a reward in and of itself.  A founder or manager who asks for compensation over and above the package they negotiated for themselves in their primary role is a sign to others–including more sophisticated investors–that they don’t really know the rules of the game.

Similarly, professional investor directors generally don’t get any compensation for serving on the board of directors because such service is part of their basic job description.  In fact, most institutional venture capital funds will have their own rules prohibiting individual fund managers from receiving personal compensation from portfolio companies, and as a matter of practice, will factor in any residual notion that service on the board of directors of a portfolio company merits any special reward into the underlying investment terms with the company.

Now we get to the first case where the rules are not quite as simple.  What should independent directors expect in the way of compensation for serving on a startup’s board of directors?  Let’s go straight to the bottom line, and then backtrack to the thinking. Independent directors, in the startup context, will generally get something like a quarter point (0.25%) to two points (2.0%) of equity, vesting over two years—or perhaps three or four years in exceptional cases.

I wish I could tell you that these figures for independent directors are written somewhere in stone, or can be found on an authoritative mobile application at your app store of choice–but they are not. These figures are just rules of thumb that I use based on a quarter century in and around the venture capital and high impact entrepreneurship space.

The range of equity I’ve suggested for independent directors is admittedly a pretty substantial range; almost an order of magnitude. And as for where a particular independent director fits in that range, a couple of considerations–beyond what the particular director candidate wants, and what you are willing to give–stand out.  How much value does the independent director really add (in terms of coaching, networks, validation, etc.)? And how much will the grant plausibly be worth if the startup ultimately has a 10x or so exit (10x being a pretty good proxy for what early stage venture investors want to see as their potential return)? While answering these questions with any precision is problematic at best, they provide, in my experience, a decent enough framework for solving the independent director compensation problem.

As for the vesting schedule, in most cases the value add an independent director adds at the startup stage is usually going to be concentrated in the first couple of years of service.  After two years (more or less, of course) either there will be a new value add calculation (likely resulting in an additional modest equity grant), or the director will move off the board.  Exceptions to the two year rule usually reflect business/investment models that play out over longer periods, for example startup biopharmaceutical companies.

Last up among the categories of startup directors comes the most problematic, and sometimes contentious species: the angel director.  Compensation for angel directors is one of those issues where the right answer and the actual answer often don’t match. After having been all four directors at some point in my career, I believe an angel investor should not get anything for service on a startup board of directors.  As far as I am concerned, an angel director, in terms of possible compensation, is in the same boat as the professional investor director. Service on the board is something to be negotiate; and compensated from within the confines of the investment, and not, in effect, an opportunity to “double dip.”  Whether a particular angel director represents themselves or an angel investor group, their “value add” is something that should be reflected in the terms (including of course, valuation) of his/her group’s investment.

Alas, as suggested above, too many angel investors see service on the board of directors of a portfolio company differently (or at least they say the do).  When they do, my advice to entrepreneurs is to push back hard. And if the better part of valor suggests caving on the issue, try to factor the value of any equity grant to an angel director into the terms of the angel’s investment.  Make sure–discretely– that if the angel director is representing a group of angels, the whole group knows about the deal.

A couple of concluding notes:

I did not talk about cash compensation because a startup director should know that startups can’t afford to pay directors anything.  If a potential director of your startup doesn’t know that, well, buyer beware.  The no cash compensation rule does not apply to reasonable out-of-pocket expenses, which are often reimbursed.  Finally, the above rules of thumb are not very useful in the case of the independent “superstar” director.  If, say, Jeff Bezos (founder of Amazon.com) is so excited about your startup that he is willing to be on the board of directors, well, personally, I would be sorely tempted to accept just about any deal he put on the table.

© MICHAEL BEST & FRIEDRICH LLP

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About this Author

paul a. jones, of counsel, michael best law firm
Of Counsel

Paul Jones is Of Counsel to the Business Practice Group and Co-chair of the Venture BestTM team. Mr. Jones writes a blog found here: http://www.venturebest.com. His practice concentrates on representing emerging technology and life sciences companies in financing and other strategic transactions as well as general corporate matters. He also represents venture capital firms and other investors in emerging technology and other high impact businesses.

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