Equity: pros and cons
Finding the right compensation model is a tough balancing act for startups.
As tempting as it may be to oversimplify matters, there is no one-size-fits-all recommendation to be made, and choosing the best approach will require considering many factors:
The size and type of the market in which a startup operates, the preferences of both the board members themselves and of the shareholders and mere practicalities of cash flow are but a few examples of such factors.
Let’s dive into some of them in more detail.
A recommendation that one frequently sees is to compensate board members with a percentage of equity, and there are two compelling reasons to do so. One, it avoids tapping into the cash flow, which is the main pain point of any startup in the early stages of its development. Two, it reassures stakeholders regarding the board members’ alignment on making sure the company performs as well as it possibly can. It makes sense to assume that if the board members have some “skin in the game” they will take their duties more seriously. Not only will they eagerly grow the company’s value — doing so will grow their own portion of that value, and therefore their final compensation — but they will also take on a portion of the risk, as if the company doesn’t succeed, they will have lost the hours of work they invested. In addition, if a board member sits on the boards of several companies, giving them a larger portion of equity is expected to incentivize them to focus on the company that provides the highest compensation.
Compensating board members through equity makes a lot of sense, especially in an international context, and in the United States in particular. That being said, some other factors should also be taken into account. Some of these are specific to the Swiss startup landscape and the legal framework that governs it, but some are more general.
In Switzerland, from a legal standpoint, board members can’t just focus on making the shareholders happy by ensuring the company’s profitability. They must consider all stakeholders involved and work towards making the business sustainable. Their duties include but aren’t limited to ensuring that the employees receive their salaries on time, their social charges are covered by the company as required, the VAT tax is properly charged when billing clients, and the service and equipment providers get paid. Therefore, when shareholders worry about board members not having enough skin in the game, it is usually because they are ill-informed regarding the level of personal liability board members face. If things go wrong, the authorities and third parties can prosecute each board member individually, which represents a considerable personal risk. In and of itself, it should therefore be enough to motivate board members to fulfill their duties responsibly and to always act in the best financial interest of the company.
More broadly speaking, paying board members in equity opens the door to some conflicts of interest and may create additional challenges within the company. One must always keep in mind that while a board member’s equity percentage might seem small, as the company grows, the actual amount of cash it represents may become considerable. While assuming ill-intent in such scenarios is counter-productive, disregarding the risk that board members might favor their own financial interests over those of the company can prove disastrous, especially once the startup gets closer to an exit.
It may so happen that it is in the best interest of the company to invest additional funds into a restructuring. Such processes may be time-consuming and rather costly. If the current funds the startup has at its disposal are insufficient and a new financing round is required to implement a restructuring, board members who hold equity might decide against one, so as not to see their own equity diluted by new investors. If they have some personal financial interests vested in the startup’s exit, these might outweigh the board members’ commitment to the company. They could become reluctant to restructure or optimize, and instead rush into selling and cashing out as quickly as possible, perhaps for personal reasons that have little to do with the health of the company.
When setting up a compensation plan, many factors must be considered, and no approach is perfect. To make the right decision, one must keep in mind that the point of providing compensation is to motivate all involved to do their best work and to act in the best interest of the company and to do their best work.
Virginie Verdon, Managing Director, Startup Board Academy
