By Jordan Green
The company is completing its first formal round of investment with funding from Angel investors. The investors want a non-executive director (NED) seat on the Board to help facilitate company growth and success.
While the founders have registered themselves as directors as required by ASIC, they have not had a formal Board and been managing the company in a very collaborative way. That is very normal and very sensible however, once the founders take other people’s money to fund their venture it becomes important to provide formal stewardship of the business. It doesn’t matter whether that money is taken in equity (selling shares), or debt (convertible note), or as a gift (SAFE) forming a Board that includes non-employee directors becomes an important and very useful priority.
There are many case-specific issues that will influence how a Board is populated, how often it meets, the independence of its members and how the directors are compensated for their work. This article will focus on the last item and, as such, must make a few assumptions about the rest. Let’s consider a relatively common, sensible and equitable arrangement in the context of an equity investment by the Angel investors in a pre-revenue, or early revenue venture. Post-investment the Board will comprise the Founder/CEO as an Executive Director and a nominee non-executive director appointed by a vote of all the investors in the round (usually this starts as a one investor-one vote process but, if there is any contention it can be resolved to a one dollar-one vote process). Ideally, the agreements will provide for a second NED, an independent director who will serve as chair. However, this is often beyond the capacity of the company to fund at the time.
[su_box title=”Founder Frustration” style=”noise” box_color=”#394a8e” radius=”20″ id=”Founderfrustration”]When confronted with paying a nominee NED the founder declares, “You are already a shareholder. You should want to do whatever you can for the success of the company and the value of your shares without getting paid.”
If that’s a reasonable and acceptable view then surely it means that the founder should work without any additional compensation, e.g. salary, for the same reason. Afterall, the founder likely has a much larger shareholding.[/su_box]
Executive directors are called that because they are already being paid for their full-time role as an executive of the company and, as such, do not normally receive any additional compensation for their role as a director. Non-executive directors are not otherwise employed by the company so they usually receive compensation for their role as a director. To be clear, I believe very strongly that directors should be compensated by the company since they are, effectively employees of the company. It is inappropriate for nominee directors to be paid by the shareholders who nominate them. While that is certainly true for me in the Angel scenario, in the case of venture capital fund managers and others being paid to invest someone else’s money, it is common practice that the director fees to be waived, or paid to the fund. In this way, the director fee is not additional income for the individual who is already being paid by the employer to undertake these board roles.
A second founder might be included in Board meetings as Company Secretary. Typically, the Company Secretary does not vote in the Board room yet, in this way the founders can ensure full engagement in the important discussions and debates, the investors can ensure the company is getting the benefit of the experience and expertise of the founders, all while preserving the other priorities addressed by the voting model.
On that, one last remark before we turn to the compensation issue. It is very, very poor governance to allow an investor nominee director to exercise shareholder rights through director votes in the Board room. Governance regulations are quite clear that the first priority in obligations of a director’s duty of care is to all shareholders. So, the voting model in the Board room should be one director-one vote and, most often, the chair should NOT have a casting a vote (a second vote used to break a tie). If the Board can’t agree on an issue, or otherwise requires the vote of the members (shareholders) then the Board should call a general meeting and let the members vote on the matter, that exercise of the shareholder vote should not be done by the nominee director in the Board room.
A NED is doing real work for the company while taking on significant personal and professional liability which, in the extreme, can put all that person’s personal wealth and assets at risk. Of course, that extreme case only occurs when the director breaches his or her duty of care and the professional conduct required by the legislation and regulations. However, even if the director does not personally act badly, if the company finds its way into unfortunate circumstances, then the directors can suffer both financial and professional penalties. This risk deserves consideration and respect.
The role of a NED is not a sinecure and it is not about “watching the money”. The role of the NED is to make proactive and valuable contributions to the leadership, growth and success of the venture through that person’s own efforts and through the introductions to be made to useful contacts, whether amongst the Angel investor syndicate, or more broadly.
It is common that even after a round of investment an early-revenue company cannot sensibly afford cash payments to remunerate its NED. Even when cash flow grows to enable cash payments, it is unlikely that the company will be able to afford cash remuneration to the full value of the work being done by the NED. For all these reasons it is very common that a start-up will use equity to provide some or all of the remuneration for the NED.
“Work is valuable, equity is currency”
Once you start using equity then two issues arise. First, the mechanism by which equity is transferred is important because it may have significant tax consequences for the NED. Second, everyone needs to recognise that the likelihood of the equity ever actually converting into a realised cash benefit to the director is low, given the success rates of start-ups, so the quantum of equity needs to reflect that higher risk of the director ultimately having done all the work and never getting paid.
It is generally considered good practice for the equity compensation to be put on a vesting model which creates alignment between the director and the company over a period of years. In this way, if the director leaves prior to the mutually agreed initial term of service then the unvested equity is retained by the company and can be applied to attract, reward and retain a replacement director.
The actual mechanism, as mentioned previously, should be the most tax effective the company can reasonably achieve (the company to ensure it remains compliant with superannuation and other regulatory obligations related to director compensation). Options are a common tool but, the details of how to handle the tax issues are beyond the scope of this article.
There should be agreement between the company and the NED on the in-principal value of remuneration for the role. People are often tempted to significantly discount this value due to the stage of the venture but, it is worth recognising two key issues: first, the work of the start-up NED is no less (and often substantially more) than the work of a NED for a well-established private business; and second, the whole market generally pays NED at a grossly undervalued rate due to the history and evolution of the directorship model.
Assuming a start-up NED will attend half-day Board meetings every 4-6 weeks for at least the first couple of years and, likely, spend the equivalent of at least half a day a week doing work for the benefit of the company, one could consider the level of effort as being at least 3 days per month. In my experience, while it is not quite that evenly distributed, the level of effort is more like at least one week a month. I offer these thoughts because people often want to develop a comparative rationale for the compensation and these estimates allow one to suggest that compensation is for between 15% and 25% of a full-time load.
Which full-time compensation should be the comparator?
The CEO, because that is the level of responsibility, accountability and liability being undertaken by the NED who, by the way, is responsible for hiring, firing and setting the remuneration of the CEO. So, if the CEO is being paid $150k per year plus compulsory superannuation then the NED would be paid $22.5k-$37.5k plus compulsory superannuation. It is common that if a NED takes up the chair role that the remuneration is 1.2x to 1.5x of the base NED rate to recognise the additional workload and responsibility.
For the period from the close of the round of investment, when the nominee NED is appointed – The post-money valuation of the company is $5m so, assuming an agreed value of $25k for director remuneration exclusive of compulsory superannuation payments, and NED receiving no cash payment for at least 12 months, there will be an award of equity entitlement equal to 2% of the equity of the company with anti-dilution protection until the end of an approximately four-year vesting period. This award will vest on a monthly basis, at the end of each month, at the rate of 0.04%/mth for 50 months, or at exit, whichever occurs first. 50 months is chosen over 48 months (4 years) to make the arithmetic easier for everybody and avoid unintended conflict while not substantively changing the duration of the commitment but, it should be clear in the agreement that all fractional amounts round up in favour of the director.
Once the company achieves a monthly surplus cash flow from operating and/or investment activities in excess of $50k for at least 3 consecutive months and the Board is of the view that such performance is sustainable and scalable then the company will start paying a cash director fee, exclusive of compulsory superannuation, to the NED of $1k at the beginning of each month.
Thereafter, measured on a quarterly basis, for every sustained increase in the monthly surplus cash flow from operating and/or investment activities in excess of $30k the NED director fee will increase by $500 per month until it reaches a total of $2.09k per month. That is, the full run rate of the agreed $25k total NED remuneration.
The company will pay, or promptly reimburse, all reasonable costs of directors in attending meetings and/or conducting business on behalf of the company.
The company should be required to secure insurance coverage to provide the directors with reasonable protection effective in every jurisdiction in which the company will operate.
Where Directors do not serve the full term, pro rata rates to apply.
The term of appointment of each non-executive director is for 50 months and either party may terminate without cause by written notice, such termination to be effective at the end of the month in which the notice is given, or at such other time set by mutual agreement. Regardless of the term, the Constitution of the company requires every director to be re-elected each year at the Annual General Meeting of the company. Directors are eligible to stand for re-election without limit. In the case of the nominee director, who is appointed and not elected, the appointment is to be renewed at each AGM.
There are many other ways people go about determining the quantum of NED remuneration. However you do it, once agreed, it is then a matter of agreeing on the relevant proportions of cash and equity that will comprise the remuneration and how that mix may change over time. I’ve already outlined the major considerations so let’s just work with an example.
Shareholders should be required to approve a total remuneration pool from which the company will provide cash compensation to Non-Executive Directors. They should also be required to approve an equity compensation pool from which the company will allocate equity to attract, retain and reward staff. Those approvals are normally incorporated in the terms of the investment by the Angel investors as either a condition precedent, or a condition subsequent.
This is only an example and you may well have reasons for using different numbers and different assumptions. Just don’t forget that equity compensation is an agreement by the NED to accept high-risk work and high-risk compensation in recognition of the importance of prioritising cash for company growth and success. All forms of compensation are an expectation by the company that the NED will make a material and sustained contribution to the leadership, stewardship and success of the company.
©2023 Jordan Green