Director Compensation for Startups

One issue that comes up fairly early for most start-ups – certainly by the time of the first outside funding if not before – is how members of the Board of Directors should be compensated.  Every situation is unique, but what follows is my take on the generic question. 

As a preliminary matter, Directors can fall into several categories, and compensation is most often tied to those categories.  Inside directors include the founders and management team.  Investor Directors are those who are associated with, or themselves are, material third party investors.  The classic example is a director who is appointed by and affiliated with a venture capital investor or angel investor group.  A significant “lone wolf” angel investor would also fit here (more on that later).  Finally, everyone else – typically people who bring industry expertise or contacts, or are mentors for the management team – is pooled together as Independent Directors.  Independent Directors may have made small investments in the business, but are not significant in terms of their capital contribution.

 Ok, what do all these folks get for their Board service?

 Let’s start with the easy ones.  Insiders typically get nothing for their service on the Board.  These folks, being founders or members of the management team, are already well compensated for their service.  Being on the Board is a reward (of sorts) in itself, and simply goes with the territory.

 Investor Directors are more or less in the same boat.  They are by definition material investors (or represent material investors) in the business and serving on Boards of portfolio companies is part of their job, just as part of the CEO’s job typically includes serving on the Board.  If the investment does well, they will be amply rewarded by the people or fund they represent.

 That leaves the Independent Director.  The easier cases, here, is the truly independent director who is not affiliated with or representing an investor group and has made no independent investment, or has made only a token independent investment.  Depending on level of experience and perceived value add, these folks may get something in the twenty-five to two hundred basis points range – something between 0.25% and 2.0% of the equity, typically vesting over two years.  Beyond expense reimbursement, you should not have to pay these folks any cash compensation (beyond expenses), at least not until the company is actually generating cash in the business.

 While these are good general rules, there are some common situations that sometimes don’t fit within them so easily – or at least the Director in question might think they don’t.  The first of these situations, and the easiest to deal with, is the “superstar” director.  For example, if Steve Jobs tells you that he is really excited about your iPhone applications company and would be willing to serve on your board of directors for a hefty chunk of equity, don’t feel bound to tell him that the most you can offer is two hundred basis points.

 In my experience the most contentious Board compensation issues arise when a Director affiliated with a fund of some sort, typically a group of angels, wants an independent equity stake for serving as a Director.  My own view, and I think the majority view in the major venture capital centers, is that these folks are in the Investor Director camp and should not “double dip” in terms of their equity compensation.  If the angel group they are affiliated with wants to provide them with some deal specific incentive compensation they should do it by carving out a piece of the equity they purchased.  That said, in tight capital markets, and in places (like Wisconsin) with limited risk capital access in even good times, this is an area where entrepreneurs are often forced to cave on the principles of the matter to get a deal done.  If the “independent investor” insists on compensation, try to keep it under 100 basis points.

 Board compensation for start-up companies is as much art as science, and the above guidelines are just the thoughts – albeit based on 25 years in and around these deals with multiple experiences as an Inside, Independent and Investor Director – of one man.  But as a starting point, I think they will serve startup companies well.

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About Paul A. Jones

Serial venture capital backed entrepreneur, angel investor and venture capital investor; Co-chair of the VentureBest team at Michael Best & Friedrich, LLP.
This entry was posted in Entrepreneurship, Venture Captal and Angel Investing. Bookmark the permalink.

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