Reprint permission from and originally published in Deal Terms, Aspatore Books, All Rights Reserved.
Directors, whether they are independent directors with industry expertise or VCs with investment expertise, can be a source of significant added value to a company. The worst form of directors are the "pigeons": as the analogy goes, they fly in to a board meeting, eat lunch, crap all over a company, and then fly off again, only to reappear for the next board meeting. Active, value-adding directors serve on board committees - compensation, audit, and planning committees, for example - and their effectiveness is a direct result of their ability to apply experience and specific expertise in finance or operations to their roles on the board and on the committees to which they have been assigned.
Many entrepreneurs scratch their heads at the value certain kinds of directors, specifically VCs, may play as a company evolves. I remember being particularly proud when a founder of a fast-growing and successful enterprise software company whose board I served on turned to me at a board meeting and said with a degree of humility and excitement that he finally realized how valuable VC directors were to the company. The company had weathered a soul-searching period of flat revenues, and the VC directors had rallied the company's board to adopt a dynamic compensation program that had proved particularly effective at another one of their portfolio companies. Through focus and better allocation of resources, the other company had managed to increase its revenues over the previous year by a factor of ten and, quite appropriately, energized management with generous incentive bonuses.
I am not quite certain whether it ever impressed the founder that VC directors do not typically personally receive stock options in their role as directors. In many pre-IPO companies, independent directors and employees are the only groups serving on boards who receive director stock options. When the decision is made to award financial investors with stock options as compensation for their role as company directors, their respective partnerships typically require those shares to be assigned to their partnerships and not received personally. The driver behind this requirement is the management agreement between VCs and their limited partners or investors. When serving on the board of a private company, VCs typically are required to deduct compensation they receive for services they would otherwise be paid for under their management agreement from the fees they charge their limited partners. To receive fees from investors and to be paid stock for serving as a director of a private company in which a VC's fund has invested is viewed as "double-dipping" and an improper alignment of interest.
VCs are, however, likely to be able to receive options personally when they serve on the board of a public company, even when that company is part of a VC's limited partner's portfolio. The rationale in this instance is that, in serving on a public company, the VC accepts a higher degree of liability personally and for this liability should be personally compensated.
To illustrate the typical costs of attracting and retaining competent board members, I have consulted Stephen Fowler at BoardSeat, a retained search firm that focuses exclusively on board director and advisor searches. The group takes as its primary focus public and venture-backed companies and conducts surveys because of the considerable uncertainty of many companies, investors, and professional advisors about market rates for compensation of board directors and advisory board members of venture-backed companies. In compiling survey data, they take the opportunity to ask key questions about how venture-backed companies administer their boards and advisory boards.
A copy of BoardSeat's first set of survey results is featured in the VC Experts premium content chapter 15 Best Practices and represents a comprehensive study of the administration and compensation of boards and advisory boards for private companies. According to BoardSeat, the data from the survey includes feedback from 100 companies, the majority of which have received substantial backing from tier-one venture firms. Validating the value of this information, many tier-one VC firms, according to BoardSeat, purchase their reports, including Apax, General Atlantic, Highland, Kleiner Perkins, Lightspeed, Mayfield, NEA, Norwest, Redpoint, Sevin Rosen, Sierra Ventures, TVM, and Versant. The company can be consulted at www.boardseat.com.
BoardSeat sent a questionnaire concerning board director and advisory board practices and compensation to 400 private venture capital backed companies, the majority of which had received more than $10 million in venture funding. According to BoardSeat, most companies had received backing by tier-one venture capital firms. Perhaps not surprisingly, as companies raised more money, their board of directors tended to get bigger, a trend typically attributable to the addition of constituencies and new sources of guidance as a company expands. BoardSeat claims the average board size for companies that had raised less than $10 million is 5.3 members; whereas, the average board size for companies that had raised more than $50 million is 6.7 members.
Perhaps more interesting to entrepreneurs is BoardSeat's data reflecting compensation for directors and advisors. For companies that raised under $10 million, BoardSeat reports the mean percentage of shares granted to independent board directors per year is between 0.07 percent and 0.08 percent of the fully diluted shares. The number drops to less than 0.05 percent for companies that raised over $50 million, reflecting the appropriate ratio of compensation to a significantly larger number of shares typically outstanding for companies that have raised such large amounts of capital.
While the role of an advisory board in my experience varies depending upon industry and company, more than half the companies BoardSeat surveyed had some type of advisory board and were more likely to have one in the early stages of development than in the more mature stages. Interestingly, the compensation received by directors as compared to advisors was predictably skewed in favor of directors. BoardSeat found that companies that had raised less than $10 million pay advisors 0.043 percent per year per advisor on average, a number that BoardSeat concludes equals about half that paid to directors. Companies that had raised more than $50 million paid advisors about one quarter the number of shares paid to board directors.