An In-depth Guide to Running Early Stage Startup Boards — Part 2 of 3

Part 2: Recruiting, compensating and protecting your Board of Directors

Recruiting, compensating and protecting your Board of Directors in startups

In Part 1 of this three-part series titled: “In-depth Guide to Running Early Stage Startup Boards ”, I discussed the importance of early stage startup boards, legal responsibilities of a board director, and board composition including observers, chairperson/executive chairperson, as well as the importance of diversity and inclusion. In case you need a recap on these topics, check out Part 1 here.

In Part 2, I will discuss strategies to recruit board directors, their compensation and the importance of protecting them from liabilities.

Board Member Recruitment Strategy

I mentioned in the last post that during a financing round some investors may request board seats. Therefore, it is important to be strategic about who you raise capital from and to whom you grant a board seat. For the purpose of this post, I will discuss recruitment strategies for independent board directors.

Independent Directors

As a recap, an independent director is usually neither an investor in the company nor involved in its day-to-day management. They are often brought in from the outside to add specific expertise or ensure that “control” of the board is not swayed in the direction of the founders or investors.

They often come with an unencumbered perspective on the business. The management of the company often tends to be caught up with day-to-day activities and are sometimes too close to the problems to see the bigger picture. Venture capitalists (VCs) can naturally be conflicted as they have to think about returns for their limited partners (LPs), which may not always align with the best interest of the company. VCs may also be thinking about 10 other companies that they manage.

Independent board members can provide a wide-angle view and are not beholden to LPs or investors. They are appointed to the board to act independently in the best interests of all shareholders. An independent director may also help solve the issue of an even-numbered board, where voting could result in a tie. For example, an early stage startup board might be composed of its CEO, the lead investor and an independent director.

Companies of different sizes and stages will need different attributes in their independent directors. Detailed below, the CEO and existing directors need to be thoughtful about what skills would be complementary additions to the board. An independent director who has been a successful entrepreneur or is an experienced executive can be a great coach and mentor to the CEO. They may provide the perspective of other stakeholders in the startup, such as clients, partners, suppliers, or they may bring industry-specific expertise that is lacking on the company’s board.

Too often, the independent director seat within a startup board remains empty for months. Management gets busy with execution and operations, and months can go by before they are able to formalize a recruitment process, if at all. This is a missed opportunity.

Independent Board Member Recruitment Process

The recruitment process for an independent director should follow that of a senior executive. Establishing a clear process ensures accountability of those responsible for the recruitment. It also demonstrates the quality of the board to prospective candidates. If you want strong candidates, you need to prove that your company and board is worth their time — simple.

Following are some high-level recruiting tips:

• Identify the expertise required from an independent director, including the following considerations:
• Industry specific experience
• Successful operator or executive who can mentor the company’s CEO
• Functional expertise (such as sales, marketing, product development, partner relationships)
• Prior board experience
• Ability to act in the best interest of all shareholders and truly act independently of other board members

In reality, it may be very difficult to find someone who meets all or most of your requirements. That’s why Aly Dhalla, CEO of our portfolio company Finaeo, recommends creating a few different candidate profiles that would bring great value to the board. Although you would want to find a fit for your best case scenario, this allows you to stay open to other profiles of people who could fill the role as well.

As discussed in my last post, having a diverse board is important and can be very beneficial for a company. Identify what kind of diversity is missing from your current board and consciously make the effort to consider candidates who could bring this diversity to the board.

• Determine the point person(s) responsible for running the recruitment process. At the early stages, I recommend that the CEO leads this process as it is usually their responsibility to manage the board.
• Set a target date by when you would like to have the independent director join your board. This will help you stay focused. Don’t be surprised if it takes three to four months for the whole process.
• Create a “job description” highlighting the responsibilities and the type of profile required. Ask your network, investors, current directors and trusted advisors to help identify and connect you with the right candidates. Share the profile you are seeking with them for it to be passed along to potential candidates.
• Retaining a recruiter can also be an option when possible, however, this may be cost prohibitive for early stage startups. You can also consider online sites such as theBoardlist.
• Understand the motivations behind why someone might join your board and speak to those points when presenting the opportunity. Ideally, this individual believes in the mission of the specific company and has relevant skills to contribute to its growth. However, if they are just looking to be associated with the company’s brand or the people involved, or if they are strictly motivated by compensation, they might not be the right fit for an early stage startup.
• Present a shortlist of your top candidates to the current board and discuss why these candidates are suitable for the role and any weaknesses or drawbacks in recruiting them. It is important to keep current board members up-to-date on the recruitment process as they will vote on the potential independent director.
• Once you are in decision mode, Yves-Gabriel, CEO of our portfolio company Flinks, recommends introducing the top candidates to the existing directors, both in a group setting and on a one-on-one basis.
• Gather feedback on the candidates from the board members and decide together on the candidate with the best fit. Once a decision has been made, hold a formal vote to recruit this person as the new independent director.
• Onboard the new director properly after recruiting them. Supply them with some of the recent board meeting material. The CEO should also familiarize them with the company’s board meeting format, cadence, norms and so on.

Director Compensation

At the early stages, when a company is strapped for cash, compensating directors with cash does not make sense. Executive directors and investor directors typically do not receive any additional compensation for being part of the board. The section below focuses mostly on independent directors.

Stock options

• It is common to grant company options (to purchase shares) to independent directors. Director compensation options are often granted from the employee stock option pool.
• The amount of options granted depends on numerous factors, including the value the independent director is expected to bring to the table, the amount of time and effort they will be required to put in, the stage and fair market value of the company, negotiations and so on.
• As a general guide, it may be between 0.1% and 1.5% of the company’s fully-diluted capitalization. However, every situation is different so you will have to work together on an amount that makes the most sense. For example, a company at the Series A stage with a highly engaged and involved independent director may compensate them with 0.7% of the fully-diluted capitalization of the company. A company at the Series B stage with a moderately involved independent director may compensate them with 0.3% of the fully-diluted capitalization of the company. Similarly, an independent director who brings both industry specific knowledge and a successful entrepreneurship background may be valued differently than those who bring only one of those two attributes.
• Once the amount is agreed upon, the options grant is always provided as a whole number of shares, not a percentage of the company’s equity.
• Options should vest over a period of two to four years, depending on how long the person remains a director. Clarify upfront how vesting will work in case the director leaves or is removed from the board. Once the director leaves, most commonly, their options should stop vesting since they are no longer providing services to the company.

Out-of-pocket expenses

• Startups may choose to reimburse reasonable expenses incurred by its directors such as travel costs related to attending board meetings. Ensure that the directors are aware of your company’s reimbursement policies to avoid unexpected big ticket amounts.

Director Liability Protection

In my last post, I discussed the legal duties and liabilities of board directors. Claims made by various parties against the actions of directors can put their personal assets at risk. Directors may be sued for various claims such as breach of fiduciary duty resulting in financial loss or bankruptcy, lack of corporate governance, unfair trade practices, violation of laws including taxes, wrongful termination of an employee and much more.

Startups are often required to enter an indemnification agreement with each of their directors to outline expenses and proceedings for which it will pay or reimburse the directors. In addition, startups may be required to purchase Directors and Officers (D&O) Insurance, a form of liability insurance, which provides the company’s directors and executives coverage against lawsuits and claims.

Many independent board member candidates will not join a board until D&O insurance is in place (rightfully so, in my view). However, startups may often delay the process because of other business priorities. Unforeseen delays can arise — for example it can be difficult to source D&O insurance for foreign directors of a business. I highly recommend getting this done immediately after funding.

Startups can reach out to their business insurance brokers to purchase a suitable D&O insurance policy. According to CoverWallet, startups usually purchase D&O policies covering between $1-$3 million, however certain industries such as fintech and healthcare may have higher D&O risks requiring higher premium payments. The cost per $1 million of coverage can be between $4-$10 thousand per year.

Conclusion

It is important to be thoughtful and process-driven when recruiting, on-boarding, compensating and protecting a startup’s directors because a strong board can be an invaluable asset for a startup.

This is the second blog of a three-part series on early stage startup boards. Make sure to follow us to find out when we post the final part, which will cover topics including board meeting formats, board packages and do’s and don’ts of running board meetings.

We hope this post was helpful and if you have any comments, questions or suggestions, feel free to reach out to us.

Contributors

I would like to thank Aly Dhalla, CEO of Finaeo, and Yves-Gabriel Leboeuf, CEO of Flinks, for sharing their experiences in recruiting independent directors for their respective boards.

- Laviva Mazhar, Investment Analyst