Board of Director Compensation in Early Stage Software Companies

In my continuing series on board of directors at expansion stage software companies, the time has come to cover compensation practices in more detail. Within this post, I also reference my previous posts on the overall topic of developing your board. I’ve also referenced a really good report by the National Association of Corporate Directors (NACD): The Director Compensation Report 2010-2011.

Before you figure out the compensation plan for a board member, you need to define the role

Early stage software company boards tend to follow a familiar pattern:

Start-up phase: if there is a board, it tends to have three to five members. One to three seats are typically occupied by founders with some to no experience in being on a board. One to two seats are typically occupied by angel or early stage investors. And one or two seats are occupied by advisers. At this stage, board members rarely receive cash compensation, and may receive some common shares or stock options. I won’t go into details here, since board setup (and most other things at this phase) tends to be very dynamic and situation-based.

Expansion phase: this is the crucial phase where a software company is transitioning from $2-10 million in revenue to $40-50 million. At this stage, the foundations of the company need to be set, including formalizing the board and its responsibilities. The expansion phase is typically when the company raises its first formal fund raise from an established venture capital firm. This process has a side effect of formalizing the board and its composition. At this point, the board is typically a five seat board, with two members occupied by management/founders, two seats occupied by one or two investor firms, and one independent board member. At least, this is what I recommend when mentoring software CEOs.

Board Personas and Roles

Before thinking about compensation, think about the personas and roles of your board members.

• Chairman of the Board: According to the NACD report, 40% of “micro” sized companies have a combined CEO/COB role in the CEO. I don’t think this is a good reflection of what we see at the startup and expansion phases (which are earlier than NACD’s micro phase). At these phases in US software companies, the majority have a combined CEO/COB role. European early stage companies are the opposite, where the majority of companies do have an independent COB. The COB is almost never one of the investors in the company, unless the investor is majority owner. The split between an independent member and a management member (other than the CEO) is somewhat even. But most early stage companies don’t even bother with formalizing the COB role. I have written about the role of the Chairman here.
• Investor Director: Investor board members come in after an investment event. Their role is to represent the interests of the shareholders and the investors. They typically have more rights than management and independent board members by virtue of the investor rights that they required with their investment. These board members are not compensated, either with cash or stock. Their expenses are covered.
• Management Director: this is typically a founder or a non-founding CEO/COO. Their role is to represent the interests of employees and shareholders. They are not compensated for board participation, except for expenses.
• Independent Director: this is a person who is not affiliated with the company or the investors. The independent brings a particular skill set or point of view to the company. Independent directors are best when they are dedicated to their board responsibilities and are not coupling them with a full-time job. Therefore, properly compensating the independent member is necessary, and required.

Board Compensation Practices

Let’s start with the independent board member. According to the NACD report, the total compensation for a board member in “micro” software companies is:

• $140k including cash (retainer and board meeting fee) and equity
• $151k including cash, equity and committee comp

This is significantly higher than the median across all sectors of $91k. The majority of that delta comes from the equity side of the total comp.

The report shows a breakdown of cash to equity of:

• Cash: $42k – this is at the upper range of the compensation we see at expansion stage companies; a range of $15-36k.
• Equity: $97k – equity is a tricky one to compare for the expansion phase, so let’s talk about this some more.

Equity compensation in expansion stage software companies tends to range quite a bit depending on the perceived potential of the company. I have seen equity compensation range from 0.25% to 1% of outstanding shares.

Determining the percentage to offer, as with any kind of recruiting, has everything to do with expectations and negotiation. I have seen companies starting with a number at the beginning of the recruitment process, and negotiate from there. I find that equity negotiation should begin once a final (or near final) candidate has been selected, and then use the candidate’s worth and expectations to arrive to a starting offer.

In a recent recruitment for one of our companies, the candidate indicated that his goal is to have enough options to make $600k on an exit event. The CEO has the ambition to get the company to a minimum exit of $200M. Using both these numbers resulted in the option allocation to the role. Pretty creative, I thought.

The equity tends to be allocated in the form of stock options, with a vesting period. The vesting period ranges from 2-4 years. I lean more towards a two year vest period, as I think that two years is the optimal shelf life of an independent board member. Things change so fast for expansion stage companies that board members should be recycled every two years in order to bring in fresh sets of talent that are more aligned to the company’s then current needs.

Chairman of the board compensation should obviously get more in both cash and equity compensation than other independent board members. The multiple for chair compensation over a non-chair comp is typically a 50% uplift. I have seen Chairman equity compensation go as high as 2% with a two year vest. But that kind of compensation was tied to responsibilities over and beyond merely chairing the board.

Lots more information in the NACD report.